Insurance companies understand something that many CPAs do not. Pricing for risk.
Pricing for Risk
Let’s consider the following bid situations.
1. The company is 30 years and has had steady profits for the last decade. It is owned by two brothers who are compatible. The company has one loan for $5 million that requires an audit. Total assets are $500 million. The bookkeeper has been with the organization for twenty years, and the auditors have proposed less than three journal entries for the last five years. The year-end for the company is September 30, a time when the audit firm is moderately busy. Estimated time for the engagement is 200 hours.
2. This company is two years old and has total assets of $50 million. They’ve changed bookkeepers twice since the company started. The company has a line of credit for $5 million that is fully drawn and a long term loan for $25 million. Working capital is negative and cash flows from operations was negative ($5 million) in year two. The former auditors are not bidding on the engagement. The former auditors proposed forty-five journal entries. The year-end for the company is May 31, a time when the audit firm is not busy. Estimated time for the engagement is 200 hours.
Since the estimated time for the engagements is the same, should the fee be the same? No. And yet I have witnessed the bidding process long enough to know that at least one firm will discount the second engagement, possibly substantially. The audit firm desires the engagement because it fits their work calendar. It comes at a time when the audit firm is not busy. But does it make sense to discount high-risk work, even if it fits the calendar?
Discounting high-risk work creates two potential problems:
- Sufficient time is not invested
- Litigation exposure increases
Sufficient Time is Not Invested
Some auditors will cut corners when faced with limited time budgets. Why? The engagement partner might push the audit team to stay within budget, even though he or she chose to discount the bid. The partner desires to make a profit even though the original thought was, “I’ll bid low so we’ll have something to do.” And when sufficient time is not invested in a high-risk engagement, litigation exposure increases.
Litigation Exposure Increases
So you decide to accept the high-risk engagement and the audit team delivers the discounted job within budget, but two years later your firm is slapped with a lawsuit. It seems the auditee was playing loose with the numbers, intentionally inflating numbers to satisfy the debt covenants (on the $25 million loan). The company did not make loan payments and the bank called the loan. The owners just walked away from their business leaving the keys with the bank—and you with a lawsuit. The bank believes it will suffer a loss of $7 million, and they are now looking to you to make up the difference.
Price for Risk Regardless
Always increase risk-adjust your price—even if you don’t get the work. You need sufficient time to address the increased risks. Alternatively, walk away from the work. It may be the better part of wisdom.
Rating New Work
Consider risk rating for all new work. You can use a scale as simple as one to five with five being high. Your firm might decide to never seek five-rated work, for example. If you decide to go after the high-risk work, consider adding a pricing premium. For five-rated engagements, you may choose to add 20%—for example—to your estimated time budget.
Think about your existing portfolio of work. Do you have any five-rated engagements? Might it be prudent to let one or two of those go? The continuance decision is just as important as acceptance. For more information about continuance decisions, click here.
For more information about this topic, see Why Higher Risk Should Result in Higher Priced Audits.