The findings suggest that audit fees respond to audit risk changes in the post-SOX environment, however this response is not immediate. These findings have important practical implications for audit regulators and for practicing auditors. These findings imply that audit firms are slow to reduce audit fees in the wake of remediation, which may be due to the documentation requirements imposed by PCAOB Auditing Standard No. 2 (“AS 2”). Notably, the PCAOB issued Auditing Standard No. 5 (“AS 5”) to supersede AS 2 in 2007 in an effort to improve implementation of the internal control requirements. In particular, AS 5 provided refinements to AS 2 meant to make the audit more scalable to a particular client and their corresponding risks. The findings presented in this study could be used as a baseline for evaluating whether AS 5 increased the responsiveness between audit fees and the underlying client risks. Audit practitioners must balance engagement risk management with public perceptions in order to maintain their reputations in the market for audit services. The findings presented here imply that audit fees are the most persistent in the presence of more severe material internal control weaknesses, consistent with predictions extending from the audit risk model.
For more information on this study, please contact Matthew Hoag.
Hoag, M. L. and C. W. Hollingsworth. 2011. An intertemporal analysis of audit fees and section 404 material weaknesses. Auditing: A Journal of Practice and Theory 30 (2): 173-200
The results of this study are important for companies and regulators that are trying to understand the true costs for firms with an adverse report on internal control. It further informs the continuing debate regarding Section 404 of SOX and provides some evidence that these premiums can be as high as 30 (20) percent in the first(second) year after remediation when compared to firms that only have clean Section 404 reports. Lastly, this provides opportunities for future research investigating how long it takes audit fees to return the level of companies that only receive clean opinions and whether or not this premium relates to additional audit work or a risk premium.
Munsif, V., K. Raghunandan, D. V. Rama, and M. Singhvi. 2011. Audit Fees after Remediation of Internal Control Weaknesses. Accounting Horizons 25 (1): 87-105.
Section 404 is one of the most controversial provisions of the Sarbanes-Oxley Act. Many studies have examined the negative consequences of adverse reports on internal control issued by the auditor. Other studies have looked at the cost of compliance of Section 404 and find that it is burdensome, disproportionately so for small companies. This study focuses on the benefits of internal control audits. Regulators have argued that the benefits of Section 404 are hard to measure because of the difficulty in quantifying the benefits. This study contributes to the debate on the benefits of Section 404 by documenting evidence that although compliance with Section 404’s requirements has been reported to be associated with high costs, the first-time internal control reports seem to have increased earnings informativeness.
Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).
The results of this study are important for showing the impact of SOX requirements on the audit environment. The evidence suggests that ICFR opinions provide clients with information to assess the effectiveness of auditors. After adverse internal control opinions, clients dismiss auditors in order to obtain higher quality audits, measured by switches to Big 4 and industry specialist auditors. However, only industry specialist auditors are associated with remediation of adverse reports.
Ettredge, M., J. Heintz, C. Li, and S. Scholz. 2011. Auditor realignments accompanying implementation of SOX 404 ICFR reporting requirements. Accounting Horizons 25 (1): 17-39.
The uncertainties surrounding material weaknesses, the difficulty of auditing around some types of weaknesses, and the fact that the auditor must explain why it issued a clean report on the financial statements when it had issued a MWO, may cause the auditor to become conservative in its GCO decision, which is fairly ambiguous to start with. The study has particular relevance for policy makers and a need for a broader evaluation of the effects of SOX 404.
Goh, B. W., Krishnan, J., & Li, D. 2013. Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions. Contemporary Accounting Research 30 (3): 970-995.
The authors’ findings are important because they indicate that AS5 may be less effective at improving ICQ than AS2 and provides some evidence that declining material weakness rates under AS5 do not indicate improving ICQ. The findings also suggest that SOX 404(a) management assessments are not an acceptable substitute to ICFR audits for improving ICQ. The results suggest that more rigorous SOX 404(b) audits under Auditing Standard No. 2 had real benefits in terms of improved overall internal control system quality and unaudited accruals quality; however, attempts to reduce ICFR audit costs via reduced requirements of Auditing Standard No. 5 may have resulted in lower material weakness disclosure rates and lower overall internal control system quality.
Schroeder, J. H. and M. L. Shepardson. 2016. Do Sox 404 Control Audits and Management Assessments Improve Overall Control System Quality? The Accounting Review 91 (5): 1513-1541.
This is first paper to examine the broad effect of ineffective ICFR on firm operations, and to establish a more direct link between MWIC over inventory and managers’ inventory management decisions. These results provide strong evidence that despite being largely unremarked upon as a potential benefit by managers or regulators, maintaining effective ICFR can provide an economically meaningful benefit to their firms’ operations. To the extent that there is a disconnect between actual and perceived benefits to maintaining effective ICFR, the recent regulatory move to exempt certain firms from internal control disclosure regulation may be premature. For a large sample of publicly traded firms, the authors provide evidence that the lack of proper inventory acquisition, tracking, or valuation systems has a direct impact on firms’ operating performance.
Feng, Mei, Li, C., McVay, S. E., & Skaife, H. 2015. Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management. Accounting Review 90 (2): 529-557.
The evidence showing that, all else equal, SEC sanctions following restatements are no more likely for firms that previously claimed to have effective internal controls (and, in some cases, are less likely) suggests that public enforcement of SOX 404 is unlikely to provide strong incentives to detect and disclose existing weaknesses. Also, the results showing that penalties stemming from various private mechanisms are more likely for firms that report their internal control weaknesses in advance of restatements suggests the existence of possible disincentives to detect and disclose existing weaknesses. Together, these results offer a potential explanation for why the majority of restatements occur at firms that previously claimed to have effective controls.
Rice, S. C., Weber, D. P., & Wu, Biyu. 2015. Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses. Accounting Review 90 (3): 1169-1200.
The results carry important implications for regulators, investors, and researchers. The findings suggest both firm-level corporate governance and home country investor protection still matter in explaining the disclosure behavior of cross-listed firms. Hence, it may be warranted for U.S. securities regulators to devote more resources to monitoring the financial disclosure quality of CONTROL_WEDGE firms from weak investor protection countries. The results suggest that U.S. investors should pay closer attention to the financial disclosure quality of cross-listed firms, especially CONTROL_WEDGE firms from weak investor protection countries. This is important because the recent accounting frauds involving cross-listed firms suggest that U.S. investors might not have paid sufficient attention to the disclosure quality, and as a result suffered significant economic losses after the revelation of the accounting frauds.
Gong, G., Ke, B., & Yu, Y. 2013. Home Country Investor Protection, Ownership Structure and Cross-Listed Firms' Compliance with SOX-Mandated Internal Control Deficiency Disclosures. Contemporary Accounting Research 30 (4): 1490-1523.
For more information on this study, please contact Vishal Munsif K.
Vishal Munsif,K. Raghunandan,Dasaratha V. Rama (2012) Internal Control Reporting and Audit Report Lags: Further Evidence. AUDITING: A Journal of Practice & Theory: August 2012, Vol. 31, No. 3, pp. 203-218.