Independence issues aside, hiring your auditor as a consultant can help avoid lawsuits.
Non-Audit Fees and Independence
Arthur Anderson was famously paid more by Enron for consultancy work than for audit work. Arthur Anderson’s loss of independence, along with allegations that they had participated in Enron’s fraud, destroyed the largest accounting firm in the world.
Legislation currently requires that every public company disclose how much money it pays its auditor. Companies must also distinguish between money paid for the legally required audit (audit fees), and money paid for other services (non-audit fees).
Regulators like the SEC and the FRC are concerned with the effect that non-audit work can have on auditor independence. Different regulators have different thresholds for deciding when non-audit work potentially raises a red flag for independence issues, ranging from 10-30% of the total fee. Despite the widespread agreement by regulators that non-audit fees create independence issues, the academic literature is mixed.
At Watchdog Research we follow the lead of major regulators and assign a yellow flag whenever non-audit fees exceed 30% of the total fee paid to the independent auditor.
Non-Audit Fees are Negatively Correlated with Securities Class Action Litigation
We used the Audit Analytics database, which has over 20 years of data, to examine the relationship between non-audit fees and securities class action litigation.
We found that the presence of a yellow flag for non-audit fees in a given year is negatively correlated with securities class action lawsuits for that year. Companies with a yellow flag for non-audit fees were 12% less likely to be named as a defendant in a securities class action lawsuit.
Even more surprising, this negative correlation persists for the following year. Companies assigned a yellow flag for non-audit fees in a given year were 7% less likely to be named a defendant in a securities class action in the following year.
Almost every public company has complex tax and accounting issues, but companies vary widely in how many resources they allocate to address these issues. It is possible that non-audit fees are negatively associated with litigation because these companies are dedicating more resources to resolving complex accounting and tax issues instead of letting them fester.
Investment and insurance professionals should carefully consider the overall resources the company allocates to addressing complex accounting and tax issues, including non-audit fees. Too little investment increases the risk of costly mistakes, which can lead to costly litigation. For D&O underwriters, the level of non-audit fees could be a helpful factor to consider when setting a price.
Our Watchdog Reports can help investment and insurance professionals by putting lots of critical information, including audit and non-audit fees, in one place. Email firstname.lastname@example.org for a demo today.