Spend enough time with any CFO and she will eventually bemoan audit costs.
Most blame excessive pay increases but the real cause is the rising expense of fines and awards imposed on auditors deemed to have breached standards in companies that fail due to fraud. The cost of indemnity insurance for auditors has soared. The only solution is to change the way indemnity insurance is calculated. It should reflect the company-specific risk associated with each individual audit.
At Transparently.AI, we are more than happy to help.
In December last year, the 100 Group, which represents the chief financial officers of the FTSE 100 companies, wrote an open letter to the Big 4 accounting firms demanding that they cut costs and avoid further significant price increases. The group said that audit fees had risen 22% in the four prior years.
Rising audit cost is by no means exclusive to the UK. Every year the International Federation of Accountants conducts a survey to assess how audit fees have moved in relation to corporate revenue. The 2022 survey, which covered data until 2020, showed a rising trend in most regions.
Figure I. Average audit fees as a percentage of revenue*
Pay rates might explain some, but not all of the increase. To understand the less than expected significance of labor cost, consider the difference in audit costs across jurisdictions.
Audit cost disparities
Audit costs in the US, by way of example, are a third higher than in Canada and more than double than in the UK as a share of corporate revenue. However, according to Glassdoor, the average auditor in the US gets US$52,800 versus US$51,400 in Canada and US$41,816 in the UK.
Admittedly, these are not Big 4 salaries but top level auditors tend to be highly mobile and big salary differences get arbitraged. To be sure, auditors do not get paid four times more in the US than in Germany.
Some of the disparity might be explained by differences in average firm size among regions, and differences in sector composition. In the Russell 3000, for example, the audit cost of a mega-cap company tends to be a tenth of the cost of a small-cap as a percentage of revenue. However, even allowing for size, big differences remain. In the US, for example, the average audit cost of a small-cap in 2018 was 0.60% of revenue, whereas in Europe it was less than a third at 0.17%.
Figure II. Average Audit Fees as a Percentage of Revenue by market cap*
Since all countries follow basically the same accounting standards, the most reasonable explanation is that differences in audit costs between countries reflect differences in regulatory and legal frameworks.
Most important, is the degree to which different countries have functioning class action regimes, the size of the settlements in each jurisdiction and the aggression of regulators.
The more prevalent are class-action suits, the greater the award, the higher the indemnity insurance expense and the higher audit cost will be.
Rising audit costs
Since class actions are becoming increasingly prevalent everywhere, and awards are growing, audit costs have to rise.
Even countries not previously known for class action suits, such as Dubai, are getting involved. In March, a court in Dubai found that KPMG Lower Gulf breached international standards by approving the financial statements of an infrastructure fund managed by collapsed private equity firm Abraaj Group.
The court ordered KPMG Lower Gulf to pay more than US$231 million in damages to investors who lost money in the fund.
This award is huge, one of the largest against an accounting firm anywhere. It exceeds the auditor’s revenues of US$210 million in 2022. KPMG Lower Gulf is certain to appeal but professional indemnity insurance for auditors in the Gulf states will never be the same again.
In February, KPMG’s UK business settled a £1.3 billion claim by liquidators in relation to its audit work for the contractor Carillion, for an undisclosed sum. The unit’s revenue in 2022 was £2.2bn.
Awards have become enormous. Depending on the situation, professional indemnity insurance may cover the cost to the auditor but the current method of evaluating indemnity insurance makes no allowance for the company-specific risk associated with each audit. The way indemnity insurance is evaluated at the present time, honest companies subsidize the audits of fraudulent companies.
Fraud is the bête noire of the insurance industry. Over time, however, the industry has always found ways to minimize the impact of fraud. If not, insurance would be too expensive.
In this situation, the cost of indemnity insurance should reflect the joint probability that a company is manipulating its accounts and is likely to fail.
It is no accident that this is precisely what the Transparently.AI manipulation risk score sets out to measure. In the absence of innovation in indemnity insurance pricing, our platform is tailor-made for auditors wishing to avoid high risk companies and for insurers wishing to avoid high risk auditors.