There is a long-standing debate going on among auditors that the audit fee being paid by listed companies for external audit of financial statements is low and is hurting the audit practice.

While this may seem a rather boring and obscure debate concerning auditors alone, in reality, there is a great deal of public interest at stake.

How much is the audit fee?

Audit fee is mutually agreed between the auditor and the client company. Among other things, it depends on the complexity of the assignment, the resources needed, timelines and the risks involved.

The economic size of the audit client and brand name of the auditor also play a significant factor.

Of the nearly 100 firms registered with the Audit Oversight Board (AOB), which are permitted to audit the financial statements of a listed company, only about 65 have a listed client.

Using annual reports of listed companies, a dataset on auditors was put together by a team of graduate students from NUST for their final year project. Of the 543 listed companies that were studied, data was available for 478 companies for the year ended 2019. Of these, 20 per cent had a total audit fee of no more than Rs375,000.

There were large variations across and within sectors. Out of the larger sectors in terms of market capitalisation, the highest average fee, about Rs11 million, was in commercial banking whereas the lowest average, just about Rs350,000, was in modarabas.

The average for textile (spinning, weaving, and composite) was approximately Rs800,000. The single highest audit fee of Rs99 million was paid by a commercial bank, however, more than half of it was attributed to overseas operations. The lowest fee, Rs35,000, was paid by a textile company though there are several other companies which paid less than Rs100,000.

The market share of BIG4 – PwC, KPMG, EY, Deloitte – in terms of proportion of clients was 39pc but in terms of proportion of audit fee, it was 71pc (Deloitte has subsequently exited from Pakistan).

Concentration of audits in BIG4 is an international phenomenon. For example, it is 80pc for Indonesia, 81pc for Malaysia, 89pc for Thailand, and more than 90pc for the UK and the US.

BIG4 firms have larger clients and charge greater fee than others. The average fee for BIG4 was Rs2.8 million versus only Rs0.8 million for the rest – around 3.5 times higher. The largest firm in terms of number of client companies was KPMG whereas the largest in terms of audit fee was PwC (or A.F. Ferguson).

The overall average audit fee across all companies and auditors was Rs1.6 million.

How does low audit fee involve public interest?

Why does it matter to public interest if the audit fee appears too low to be meaningful, in some cases Rs100,000 or even lower?

It matters because listed companies are significant contributors to Pakistan’s GDP and some of the largest taxpayers and employers in the country. Many a wrongdoing in these listed companies that touch upon financial statements ought to be made difficult by the fear that it might be exposed during the external audit.

The more reputable the auditor, the more credible the financial statements and vice versa. External audit of financial statements is a line of defence for the shareholders, creditors and other stakeholders of every listed company.

One way or the other, much of the cost of wrongdoings in listed companies, be it unpaid debts, job cuts, unpaid tax, or bail out package, is eventually borne by the general public.

It does not help the cause of foreign portfolio investment in PSX listed companies if the audit fee seems surprisingly low. It is held as one of the reasons behind the recent exit of Deloitte from Pakistan.

It also affects the career and quality of life of young men and women who are doing their audit training and undertaking all the hard work on the ground.

Above all, low fee implies low audit quality, a compromise on the rigor that’s needed to bring credibility to the company’s financial statements. That’s why it is a public interest issue.

Proponents: Those who argue audit fee is low

A study published by the Institute of Chartered Accountants of Pakistan (ICAP) using data from 2015 compared the audit fee in five countries: Pakistan, India, Sri Lanka, Malaysia and the UK.

The number of companies included in the sample from each country ranged from 126 (Sri Lanka) to 483 (UK). A comparison of the ratio of audit fee to companies’ sales and assets showed that Pakistan had the lowest relative audit fee by far.

A survey of 296 audit partners by the Audit Oversight Board in 2019 found that there was broad agreement that audit fee is low.

Responding to the question, “How would you describe the prevailing level of audit fee?”, 80pc respondents chose “low”, 20pc chose “appropriate”, and none chose “high”.

That the audit fee is low has long been argued by auditors. Of ICAP’s approximately 6,500 members who are based in Pakistan, nearly a quarter are working in public practice including audit. However, audit is considered a declining field.

Proponents say that fresh talent is reluctant to join the audit side of practice and those working in audit at a firm keep thinking of switching to the finance or internal audit function of a company.

The International Federation of Accountants (IFAC) also recognises that pressure to lower fees is one of the top challenges facing small- and medium-sized practices internationally.

Proponents argue that low fee has far-reaching implications.

Some firms see audit as a loss-making service that’s offered mainly to get clients for profit-making services such as tax advisory. This exacerbates the conflict of interest faced by auditors in protecting the independence and objectivity of audit work.

The dataset does show that for the 478 listed companies as a whole, non-audit fee was 35pc more than the audit fee and there were nearly 120 instances where the non-audit fee was greater.

Proponents argue that the audit fee is low because of the technical nature of the subject and lack of knowledge by the users of financial statements. They doubt that most credit officers in a bank or fund managers in an asset management company understand audit and its value.

Proponents caution that audit is a check on the power of those holding top positions in a company; a check on power is quite unwelcome in our culture in general, which is why audit is kept weak through a low fee.

Opponents: Those who argue audit fee is not low

While the audit partners firmly believe that audit fee is low, the chief financial officers (CFO) and audit committees of listed companies disagree. In a survey of CFOs of 100 listed companies by AOB in 2020, responding to the same question, “How would you describe the prevailing level of audit fee?”, only 11pc chose “low”, 68pc chose appropriate, and 21pc chose “high”.

In another survey, members of audit committees from 30 listed companies had a similar take, only 13pc chose “low”, 80pc chose appropriate, and 7pc chose “high”.

The opponents are quick to point out that trying to regulate prices in a market economy is bound to fail and the audit fee is no exception.

They highlight that whether the fee is low, appropriate, or high, the auditor still has to conduct the audit according to the same international auditing standards, therefore, in principle, quality under the auditing standards has to be maintained.

The opponents are of the view that a low fee, if the fee indeed is low, is mainly a problem facing small and medium practices and not larger firms.

They say that the auditors are appointed and their fee is approved in a general meeting of the shareholders under section 246 of the Companies Act, 2017. Where the shareholders think the fee is low, they have the opportunity to address it. There is also a specific restriction against low balling under section 330.4 of ICAP’s code of ethics but it is not effectively enforced.

They argue that it is a generally low audit quality level that explains the low audit fee and not the other way round.

Many companies listed on PSX have poor governance, they do not want their auditor to do a thorough job and therefore prefer the low-quality auditors with a low fee. Some of these companies press the auditor to help with preparation of accounts, which is a blatant violation under the law, auditing standards, and ethics.

Paying more audit fee won’t change audit quality for such companies, they argue.

The opponents caution that a high fee could compromise auditor's independence because of the higher pressure to retain the client. There are many international examples in living memory where even a very large firm charging a huge fee did not do the audit as per standards, from Enron to Carillion.

In Pakistan, there have been major scandals in sector after sector, from cement to sugar, where the role of auditor remains a question mark. The orders issued by the AOB against audit firms are an indicator that there is much to fix in the audit practice.

According to the opponents, the issue of audit quality is better addressed through more inspections and enforcement actions by regulators against errant firms and companies rather than worrying about fee level.

But audit fee does appear low for many companies

While the arguments put forth by both the proponents and opponents have merit, there is no denying that the fee does appear low for many companies, which is a cause of concern in terms of public interest.

While the audit quality does not linearly increase with fee, a low fee reduces both the incentive and room for the auditor to do a thorough job.

The link between audit fee and quality is intuitive and it would be wrong to dismiss it. The primary cost involved in audit is the cost of time spent by qualified professionals. Like doctors and lawyers, auditors put in many years of hard work to gain subject matter expertise and charge for their time.

Audit requires a tonne of work checking the company’s financial statements to provide reasonable assurance – be it sales, inventory, or cash balance. Something that may appear rather simple such as cash on a balance sheet requires obtaining independent confirmations from each bank and may turn out to be far from simple depending upon the evidence received.

The more complex the issue, the more estimation and judgement involved, the more time it needs by senior practitioners and outside experts. All this time costs money.

Can regulation set a minimum fee?

Back in 2008, through a technical release, ICAP sought to address the problem of low audit fee by setting a minimum hourly charge out rate and minimum fee for audit engagements.

Things didn't quite go as planned. Because of the apparent anti-competitive nature of the release, ICAP got into a prolonged legal battle with the Competition Commission of Pakistan (CCP). After a series of decisions and appeals over a decade, the legal conclusion remains pending.

In 2019, ICAP changed course and issued a directive on “recommended” audit fee. This directive links the recommended minimum fee to the turnover of a listed company spreading it over four slabs. The minimum fee is set at Rs600,000 and it goes up to Rs6.4 million.

Interestingly, in 2019, there were more than 150 listed companies with an audit fee of less Rs600,000. On the other hand, there were less than 20 companies with an audit fee of Rs6.4 million or more.

Experience has shown that using regulation to set some sort of a minimum fee, whether mandatory or recommended, is unlikely to work. There is no silver bullet to solve this problem in the short term and it cannot be addressed by any one organisation alone.

How to protect public interest in audit fee and quality?

Perhaps the solution lies in explaining the value of audit quality to relevant parties including audit committees of listed companies, institutional investors, lending institutions, research analysts and all the sectoral regulators concerned.

Without being prescriptive about the fee, through the code of corporate governance, the audit committees of listed companies ought to be required to carefully assess that the audit fee is appropriate.

The directors training programme should have a module specific to the audit where its value proposition should be clearly communicated and the issue of fee explained. Regulation is needed to inspect more audit records and take strict action where the auditors crossed the line.

Lenders, research analysts, and institutional investors, the primary users of audited financial statements, need to be engaged and woken up to the fact that a low audit fee is a red flag that is not to be overlooked.

No less importantly, we need more data and research regarding the audit of both listed and non-listed companies. There should be an annual update on the health of the audit practice with detailed analysis that should be publicly available and it will not let questionable audits go under the radar.

Someone will have to take the lead and it might well be the SECP, which administers the companies law and regulates listed companies, auditors, asset management companies, and research analysts.

In an encouraging development, on April 5, 2021, SECP constituted a committee for addressing the quality of audit. It includes representatives from SECP, ICAP, and AOB.

Let’s hope that the committee engages with other parties, including the lenders, and comes up with some solid proposals to address the issue because a low audit fee is not just a matter concerning private profit but one involving public interest.

The writer is a former CEO of the Audit Oversight Board, Executive Director at the Securities and Exchange Commission and content director at CFA Institute (London).He tweets @Usman_Hayat