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    An Intertemporal Analysis of Audit Fees and Section 404...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
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    Title:
    An Intertemporal Analysis of Audit Fees and Section 404 Material Weaknesses
    Practical Implications:

    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.

    Citation:

    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

    Keywords:
    SOX Section 404, internal control opinion, remediation of a material weakness, audit fees
    Purpose of the Study:

    In 2002, the Sarbanes-Oxley Act (“SOX”) was passed, which dramatically changed the financial reporting landscape following a wave of high-profile corporate frauds. Section 404 of SOX was perhaps the most significant reform, requiring that company management report on the effectiveness of internal control over financial reporting (404a), and requiring that the company’s external auditor complete a comprehensive evaluation of the internal controls and render an opinion on their effectiveness (404b). The mandated evaluation(s) of internal controls come at a significant cost to filers, as the initial evidence evaluated post-SOX pointed to a significant increase in audit fees for those companies subject to the provisions of SOX 404. These findings fueled criticism of Section 404 by opponents who argue the costs imposed an overwhelming burden on companies.

    This study investigates the impact of Section 404 on audit fees beyond the initial years of implementation. Specifically, it entails a longitudinal empirical examination of audit fees post-SOX within the theoretical context of the audit risk model. Audit fees should reflect both audit risk and audit effort. Using information provided through the newly mandated internal control opinions, this study tests how audit fees respond following either (1) the remediation of or (2) the failure to remediate internal control weaknesses by a company. The findings presented in this study should be of interest to audit industry regulators, academics performing audit fee research post-SOX, and to audit practitioners.

    Design/Method/ Approach:

    The sample is comprised from the population of accelerated filers subject to the provisions of SOX Section 404 spanning 2004 through 2007. The final sample consists of more than 13,500 company-year observations obtained from the Audit Analytics and Compustat databases with non-missing data necessary to perform the hypotheses tests. These tests employ OLS regression using a traditional audit fee model commonly used in audit pricing research and the test variables for varying types of Section 404 internal control opinions.

    Findings:
    • Using a levels model, audit fees are found to be consistently and significantly higher both in the presence of a material weakness in internal control and for companies that remediate a previous material weakness.
    • In a changes model, the findings suggest that audit fees decline significantly in each of the first two years after the remediation of a material weakness. Thus, the remediation of a material weakness leads to lower audit fees, but the corresponding decline does not occur immediately.
    • Three years after remediating a material weakness in internal control, a company still pays a 19 percent audit fee premium as compared to a company that never reported a material weakness. However, this premium does not differ significantly from the premium paid by these same companies in the year prior to the implementation of SOX 404, suggesting that auditors recognized these companies entailed heightened audit risk even prior to performing the internal control evaluation.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality