Is your company in trouble? Audit fees can be an early clue

— -- Sometimes, it's easy to tell if a company is in trouble. Earnings plunge. The stock falls. A SWAT team takes out the CEO.

But most people would like to be out of a stock before the company's lobby is filled with angry villagers, barking dogs and flaming torches. A recent study found that tracking a company's auditing fees can give you an early warning.

The auditor's job is to examine a company's books and make sure that all the information presented in its reports conforms to generally accepted accounting principles.

Normally, an auditor simply states whether the company's books are in order. As a rule of thumb, you never want to see a note like this one, from the auditor of American Sierra Gold (formerly C.E. Entertainment, which is a caution in itself):

"As discussed in Note 2, the company's significant operating losses, working capital deficiency and need for new capital raise substantial doubt about its ability to continue as a going concern."

By the time you get a note like that, however, it's usually too late. American Sierra Gold trades for a penny a share.

From time to time, companies will change auditors, but you can't read too much into that, unless the auditor was fired or fled the country. Companies often change auditors because they get a better offer from another accounting firm.

Starting in 2001, however, the Securities and Exchange Commission has required companies to disclose audit fees on the company's annual report. Few paid much attention to it.

Enron's collapse gave professor Jonathan Stanley of Auburn University the inspiration to pay more attention to auditing fees.

Just as everyone points to the Hindenburg when talking about zeppelin safety, Enron is the poster child for corporate implosion. But very few people realized that Enron was going belly up until it was too late.

But there was a warning: The year before the stock collapsed, Enron paid $25 million in auditing fees, more than all but one company in the Dow Jones industrial average. Intrigued, professor Stanley looked to see if there was any correlation between big auditor fees and stock performance.

Looking over Securities and Exchange Commission filings from 2000 to 2007, Stanley found that there is, indeed a correlation between the two. The higher the audit fees, the more likely the company is in trouble. His findings are in the August edition of the American Accounting Association's Auditing: A Journal of Practice & Theory.

Auditors get a highly detailed look at a company's finances, professor Stanley says. Fees could go up for two reasons:

•The auditors find something that needs more accounting attention, which is rarely a good thing.

•The auditors are pricing in potential legal fees. When a company collapses, enraged investors often sue the auditor, claiming it overlooked problems with the company's report. When Enron struck out, it sent its auditor, Arthur Andersen, to the minor leagues of accounting.

The SEC requires companies to disclose both their auditing fees and their audit-related fees, which are charges reasonably related to the audit. Stanley's paper focused purely on auditing fees.