The annual audit instills confidence in the financial statements and the capital markets, something nobody misses until it’s too late – like in the early 2000’s. Yet investors rarely pay attention to the audit’s clearly stated cost, because audit fees don’t create waves that upset earnings forecasts.
Another reason investors care little about fees is the auditor’s opinion itself. The auditor’s opinion is the financial reporting equivalent of a horseshoe crab – a living fossil, hardly changed since prehistoric days. Basically a rubber stamp, the audit opinion says nothing about the work and thinking behind it. The proxy statement gives investors the amount of audit and other fees paid, along with sanitary assurances of propriety by the audit committee. Mildly reassuring, the disclosures are often boilerplate and convey little beyond the audit committee declaring, “We did our job.” Investors crave information, but this isn’t information they crave.
Quantitatively driven as they are, investors ignore the basic data on audit fees and miss some puzzling questions. Consider one pair of companies: Apple (AAPL)
and Microsoft(MSFT). Sure, they’re different: one is the dominant computer-based consumer products company on the entire planet, and the other one is a monolithic software company. Apple has $231.8 billion in assets compared to Microsoft’s $172.4 billion, and Apple’s $182.8 billion of revenues eclipse Microsoft’s revenues of $82.7 billion. Who has the higher audit costs? In 2014, Apple’s total Ernst & Young audit fees: $10.6 million. Microsoft’s total Deloitte audit fees: $46.2 million.
Why does it cost nearly 4.5 times more to audit the smaller one of the two? Is Microsoft that much more complex to audit than Apple? Are Apple’s financial reporting controls so superior to Microsoft’s that the auditors have less work to do? Without background color provided about the quality of the audits, investors can only look at a few numbers and scratch their heads.
Here’s another pairing that puzzles: AT&T (T) and Verizon(VZ). They’re definitely in the same business, and share roughly the same dimensions. AT&T’s assets and revenues are $292.8 billion and $132.5 billion, respectively, while Verizon’s assets and revenues are $232.7 billion and $127.1 billion, respectively. They were even once the same company, and they still share Ernst & Young as auditor. Intuitively, you would expect Verizon to have lower total audit fees than AT&T, being the lesser of the two. Yet in 2014, Verizon’s total audit cost was $36.3 million, compared to $27.7 million for AT&T. Why? There’s no satisfactory intuitive answer – and there’s no additional information that makes it clearer.
In the banking world, it’s slightly more intuitive when you compare Citigroup (C) and Wells Fargo (WF). In regard to assets and revenues, the giants are nearly the same: $1.8 trillion in assets for Citi compared to $1.7 trillion for Wells Fargo, and $90.6 billion in revenues for Citi compared to $88.4 billion for Wells. In 2014, the total tab for Citi’s audit: $92.0 million; for Wells, it’s $41.9 million. Again, they share the same auditor: KPMG. Citigroup is a far more global enterprise than Wells Fargo – but should it cost $50 million more because of geographic dispersion? And if it really is the reason for the same auditor to cost that much more, shouldn’t investors know more about the reasons? Does the Citigroup board know that the same auditing firm costs so much less at a comparably sized bank – and if they know, do they care enough to know the reasons why?
It’s a sad statement that investors aren’t more curious about the nature of an audit – something provided strictly for their benefit. Maybe it’s because it doesn’t usually rock earnings per share or forecasts, or maybe it’s because companies haven’t imploded frequently since the beginning of the century.
An early-stage proposal from the Public Company Accounting Oversight Board (PCAOB) might provide much more quantitative information about the work behind the audit. It could make investors care without companies vaporizing on a daily basis.
The PCAOB intends to have audit firms develop “audit quality indicators” for both firms and individual engagements. These quality indicators would be available for investors’ evaluation – and many of them would be quantitative, making them more interesting to investors. In its first pass, the PCAOB lists 28 possible indicators. Some of the potentially useful ones deal with the level of involvement of the engagement partner on an audit; the engagement partner’s workload, and the workload of the manager and staff on the audit engagement; hours spent on an engagement by persons with specialized skill; the years of experience for partners and staff on an engagement; the turnover rate of audit personnel; percentage of audit work outsourced to others; and level of investment in training personnel.
It’s an ambitious project, one that won’t be concluded any time soon. If the PCAOB can pull it off, though, they just might make investors care about what’s going into an audit, beyond ticking off a box on a proxy to “accept the board’s recommendation to appoint auditor XYZ.”
Jack T. Ciesielski is president of R.G. Associates, Inc., an asset management and research firm in Baltimore that publishes The Analyst’s Accounting Observer, a research service for institutional investors. Ciesielski and his clients own shares of Microsoft.