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© The Z/Yen Group of Companies 2008
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Michael
Mainelli, Z/Yen
Limited
Ian Harris, Z/Yen
Limited
Alan Helmore-Simpson, Z/Yen
Limited
[A version of this article originally
appeared in "The Auditor's Cross Subsidy" (statistical modelling of
audit prices), Strategic
Planning Society Newsletter (June 2003). Also published as
"Anti-dumping Measures & Inflation Accounting: Calculating the
Non-Audit Subsidy" (19 June 2003)]
Subsidy, What Subsidy?
For at least two decades, maybe longer, big accountancy firms have been loudly
protesting that cross-subsidy of audit by non-audit services never occurs, and
that low-balling of audit proposal fees in order to win a client’s other
business is a vile slur on the integrity of the audit profession.
Audit was a separate business, they said, uninfluenced by the add-on,
sell-on businesses of consulting and tax. Consulting
and tax favoured the incumbent audit provider because of the client and industry
knowledge gained, not because audit was a loss-leading product.
Then one of the Big Four broke ranks.
PricewaterhouseCoopers (PwC) was reported as acknowledging that “a company could
secure a discount if it provided an accounting firm with non-audit work as well
as the audit” [Financial Times, 30 June 2002].
To most of us, this sounds obvious; quantity discounts and loss leaders are a
feature of most markets, and it isn’t really very shocking to learn that audit
firms behave like other commercial organisations. Nonetheless, the same article reported that “three of the
big four accounting firms denied any involvement in ‘low balling’…”
Then PwC went further. PwC’s global
chief executive, Samuel DiPiazza, sought “a way that we can at least return
enough to make our profession worthwhile” [12 December 2002].
A couple of months later, the firm reported that its ratio of audit to
non-audit fees from FTSE-100 clients rose from 28% to 71% [Accountancy Age, 6
February 2003]. Making a
virtue of necessity, the firm also announced that audit objectivity was no
longer under threat as it raised fees markedly.
We are not trying to pick on PwC, particularly as it seems to be starting
to come clean about cross-subsidy.
At least it’s facing public criticism as it puts its house in order. The other three of the Big Four, in the best traditions of
the profession, have kept mum.
Increased
audit risk is reflected in costs both within firms, i.e. what partners demand in
risk-adjusted terms, as well as outside firms, e.g. insurance costs,
supplier terms, cost of staff. As
the perception of audit risk has risen, audit prices should rise.
Financial Director [January 2003] has already recorded a steep 10%
year-on-year increase in audit fees, but expects much more as its sixth annual
survey of FTSE-100 audit fees was only starting to pick up post-Enron concerns
about loss of consultancy income.
Risk, and the perception of risk, is rising at the same time as firms are having
more problems cross-selling services, due to a combination of regulatory
disapproval and client unwillingness to be seen to be buying advisory services
combined with audit. Without cross-sales and the
implicit subsidy, audit fees need to rise even more.
You Saw the Whole of the Moon
We wondered how much audit fees might need to rise in order to cover the loss of
subsidy. We were particularly
curious because we realise that many of the recent price rises are being made in
an unstable market. The market is
unsure how much the “Enron” effect may adjust risk.
The market is unsure how much non-audit business audit firms may be
allowed to retain for larger listed companies.
It might be interesting for finance directors to have an idea of how much
further prices might rise. The
answer, as shall be seen later, is significant.
In order to answer the question of “how high prices might rise”, we needed to
build a statistical model of audit and non-audit fees among all UK firms.
Our data came from BvD’s FAME database of 1.4 million UK companies.
The data includes hundreds of data points for each firm, e.g.
turnover, audit fees, balance sheet, employees, SIC codes, etc. We loaded the FAME data for the last three years into Z/Yen’s
PropheZy risk/reward engine, a software tool developed by our Auguri research
team. PropheZy takes databases and
builds predictive models. PropheZy
uses advanced statistical techniques, including a support vector machine, an
optimiser and a set of decision tree tools to produce an easily interrogated
“what-if?” program. We tested
PropheZy’s models by asking it to provide a “Price-Your-Audit!” service.
PropheZy scored very well in predicting audit prices, meeting or
exceeding most tests of statistical accuracy across 200,000 companies.
We
also built a “Recommend-an-Auditor?” model that seemed to identify the
correct auditor for industries which concentrate on a few audit firms, e.g.
specialist insurance. Likewise,
Recommend-an-Auditor? seemed to “know” which industries preferred to “spread”
audits around, presumably to avoid conflicts of interest, sensibly indicating
that several would be adequate.
Both Predict-Your-Audit! and Recommend-an-Auditor? ought to be useful
tools for any audit committee. PropheZy
has a number of other applications in finance, ranging from predicting
restatements to replacing Z-scores, forensic assignments, finding new clients or
identifying anomalous audit conclusions.
Augur,
Augur on the Wall
Satisfied with PropheZy’s ability to predict, we then examined the largest 100
companies in the UK by turnover. Seven of the
100 do not currently purchase non-audit services from their auditors.
We then asked PropheZy to predict what audit fees would be in two years
if non-audit fees were reduced to nil for the other 93.
PropheZy referenced its statistical model, taking into account the
correlations it had built using 200,000 UK companies.
The results are shown in the table below:
|
Top
100 UK Firms
|
Current
Audits
|
Predicted
Audits
|
|
Total
turnover
|
£801,000,000,000
|
£801,000,000,000
|
|
Total
audit fees
|
£197,000,000
|
£311,800,000
|
|
Audit
fees/turnover
|
0.025%
|
0.039%
|
|
Total
profits
|
£19,727,000,000
|
£19,614,000,000
|
|
Audit
fees/profit
|
1.00%
|
1.58%
|
|
Total
non-audit fees
|
£474,000,000
|
-
|
|
Non-audit
fees/turnover
|
0.06%
|
-
|
|
Employees
|
4,467,000
|
4,467,000
|
|
Audit
fees/employee
|
£45
|
£70
|
|
Audit
fee range
|
£40,000
to £17,000,000
|
£300,000
to £17,500,000
|
|
Audit
fee median
|
£1,394,000
|
£2,900,000
|
|
Audit
fee mean
|
£1,973,000
|
£3,118,000
|
|
Non-audit
fee range
|
£0
to £47,000,000
|
-
|
So, the Top 100 UK companies are looking at an estimated rise of £115,000,000 in
audit fees. Profits will be hit by
0.58%, a not insignificant amount.
Even at current P/E ratios, this would knock well over £1 billion off the market
capitalisation of the Top 100.
PropheZy can only predict when the data supports prediction, but recent rises in
risk perception will be only weakly indicated in the data.
If, as many pundits do, one believes these risk costs are rising, then
PropheZy’s predictions are low.
It is clear that smaller companies are going to be hit harder, as evidenced in
both the sharp rise from the lowest audit fee of £40,000 today to £300,000 in
two years, as well as the sharp rise in the median audit fee from £1,394,000 to
£2,900,000, a total of 108%. This is probably
explained by the fact that the very largest audits, e.g. BP, Unilever,
Tesco, are substantial projects priced in their own right, while for smaller
companies auditors count on sell-on business.
As one senior partner of a large firm remarked on seeing this data, “we’re still
trying to break even on small audits”.
As the smallest of the Top 100 companies has a turnover exceeding £3
billion, this bodes ill for mainstream companies whose turnover is measured in
millions of pounds.
After decades of relative price reduction, perhaps as a subsidy to win other
services, prices are rising. Audit committees are under huge pressure to play safe and be
seen to be allowing their auditors to do a good job. Audit firms may think they have audit committees over a
barrel. It would look as if finance
directors and audit committees would benefit from a Price-Your-Audit! predictor
as they prepare to negotiate for bigger stakes than they know.
Surely, audit firms are already working on theirs.
More information:
Michael
Mainelli, FCCA, originally did
aerospace and computing research, before stooping to finance.
Michael was a partner in a large international accountancy practice for
seven years before a spell as Corporate Development Director of Europe’s
largest R&D organisation, the UK’s Defence Evaluation and Research Agency,
and becoming a director of Z/Yen (Michael_Mainelli@zyen.com).
Ian
Harris, ACA, made an absurd decision in his youth, thus landing in accountancy
rather than law. He spent a number
of years writing humorous songs bemoaning his choice while advising his
management consulting firm’s clients about mid-range and large-scale financial
systems before co-founding Z/Yen with Michael (Ian_Harris@zyen.com).
Alan
Helmore-Simpson leads Z/Yen’s
Auguri Project and the development of PropheZy.
Alan has a deep mathematical and information technology background
ranging from investment banking through interactive television, defence and
cryptography.
Z/Yen
Limited is a risk/reward
management firm working to improve business performance through better
decisions. Z/Yen undertakes
strategy, finance, systems, marketing and organisational projects in a wide
variety of fields (www.zyen.com), such as
recent projects managing development of a client profitability system or the
benchmarking of transaction costs across 25 European investment banks.
Michael and Ian’s humorous risk/reward management novel, “Clean Business
Cuisine: Now and Z/Yen”, was published in 2000; it was a Sunday Times Book of
the Week and even Accountancy Age described it as “surprisingly funny
considering it is written by a couple of accountants”.
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