When the SEC Sends Comment Letters, Auditing Services Get More Pricey
After the Sarbanes-Oxley Act (SOX) of 2002 American financial regulators adopted a more attentive stance and the SEC is required to review all issuers no less than once every three years. When the SEC deems something unsatisfactory, the process of requesting additional information is started by a "comment letter" addressed to the company and both the letter and company responses are made public.
In External Auditor Reassessment of Client Business Risk Following the Issuance of a Comment Letter by the SEC (with Miles Gietzmann, Cass Business School, forthcoming in European Accounting Review) Angela Pettinicchio (Department of Accounting) finds that audit firms ask higher audit fees to companies which received a comment letter, and that the higher price persists at least for the following two years, even though the problem raised by the SEC is solved and the company doesn't receive any further communication.
Comment letters, the authors explain, lead auditors to fundamentally change their perception of the client risk. "The detection of manipulation of one accounting line item may suggest management has a propensity to manipulate other items or provide inadequate disclosures", meaning higher reputation and litigation risk. And in the post-SOX world audit fees increase with client risk.
The scholars reject the alternative hypothesis that the fee hike is only due to the additional work audit firms have to perform in order to respond to the comment letter because, in this case, in the following years the audit fees should go back to their pre-comment letter level. The persistence of higher fees suggests that auditors revise upwards their assessment of client risk.
Pettinicchio and Gietzmann observe that 33.4% of firm-year observations received a comment letter in their sample period (2004-2008), but only letters referring to accounting issues and risk issues (not the ones related to disclosure issues) entailed a hike in audit fees averaging 3%. Further investigation is needed, the authors concede, in order to disentangle the effect on total audit fees arising from additional billing hours versus audit pricing.