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  • Jennifer M Mueller-Phillips
    Reflections on a Decade of SOX 404(b) Audit...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Reflections on a Decade of SOX 404(b) Audit Production and Alternatives
    Practical Implications:

    Public interest demands more transparency and analysis about how control audits are conducted, how they might be improved, and what might be better alternatives for the future. Thus investors, auditors, standard setters, academics, auditing students and U.S. markets could all benefit in the long run, from more transparency about the current U.S. audit production process and from informed debate about the best mechanism design for balancing the needs of all parties interested in internal control quality disclosure.

    For more information on this study, please contact William R. Kinney Jr.

    Citation:

    Kinney Jr, W. R., R. D. Martin, and M. L. Shepardson. 2013. Reflections on a Decade of SOX 404 (b) Audit Production and Alternatives. Accounting Horizons 27(4): 799-813.

    Keywords:
    Sarbanes-Oxley Act of 2002; regulation alternatives; internal control audits; 404(b).
    Purpose of the Study:

    Since the passage Sarbanes-Oxley Act during July 2002, audit production in the U.S. has been substantially expanded by mandated internal control audits. The control audit mandate is unique to the U.S. and costly to apply, yet little is known about the conduct of control audits or the efficacy of lower-cost alternatives. Hence, this paper reflects the authors overall knowledge about control audit production and observation of a consistent message across public and limited non-public archival data. 

    Design/Method/ Approach:

    The authors have followed 404(b) audit implementation from perspectives as auditing educators, academic fellows at the Securities and Exchange Commission (SEC), advisor to the Public Company Accounting Oversight Board (PCAOB), standards setter as an International Auditing and Assurance Standards Board (IAASB) member, and a Big 4 audit manager applying 404(b).

    Other methods include: research projects; theoretical, archival, and behavioral research of others; and numerous control audit conversations regarding implementation with U.S. and foreign regulators, standards setters, practitioners, directors, corporate officers, and investors.

    Findings:

    Main observations

    • Audits of internal control processes are fundamentally different from audits of financial statements as to objective, value, and approach, although they share some attributes.
    • The three sources of control audit evidence required by PCAOB standards differ substantially in incremental costs, audit expertise required, and ability to identify material weaknesses so that:
      • Relative to design evaluation and implementation testing, auditors are effective and efficient at identifying control weaknesses that have resulted in known accounting misstatements—even if the misstatements are immaterial.
      • Absent knowledge of accounting misstatements, identification of weaknesses in control process design is difficult.
      • The appropriate scope of operating effectiveness testing remains unclear, as does when entity-level control tests can substitute for process-level control tests.

    Alternatives to mandated control audits:

    • No other country or auditing standards-setting body has adopted the U.S. control audit legislated mandate, even though it has been considered in multiple countries.
    • Some other countries have developed alternatives that partially apply the U.S. requirements and provide some control information to investors, but at less cost of production.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of SOX
  • Jennifer M Mueller-Phillips
    Internal Control Reporting and Audit Report Lags: Further...
    research summary posted March 9, 2015 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Control Reporting and Audit Report Lags: Further Evidence
    Practical Implications:
    • This study’s results, “provide empirical evidence about the extent of additional audit effort associated with clients’ internal control problems and the benefits of reduced audit report lag from remediation of such problems.
    • This study suggests, “that there are significant differences in the market for audit services for accelerated and non-accelerated firms, and underscores the need to separately analyze the two types of firms.”

    For more information on this study, please contact Vishal Munsif K.

    Citation:

    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.

    Keywords:
    audit report lag; Section 404; internal control.
    Purpose of the Study:

    This study was performed as an examination of, “the association between internal control weaknesses and audit report lags for (1) a later time period; specifically, the fifth and sixth years of Section 404 reporting, and (2) both accelerated and non-accelerated filers.”

    As stated in its introduction, this study was motivated by several factors:

    • Additional evidence from future years would be useful to determine the extent to which audit report lag is higher for clients with different types of Section 404 reports, particularly since report lags are strongly related to the extent of the auditor’s work.
    • There have been many changes in the audit environment since the first year of internal control audits. It is not clear how these changes could have impacted the audit lag for firms with material weaknesses.
    • Study constitutes an important extension of [prior literature], since the requirements of Section 404(a) for non-accelerated filers were not in place during the sample period of prior literature.
    • While many studies have examined issues related to internal control problems, research related to the remediation of discovered problems is relatively sparse
    Design/Method/ Approach:

    This study used a regression model to examine three research questions:

    • RQ1: What is the audit report lag associated with material weaknesses in internal control in years five and six of Section 404 reporting?
    • RQ2: Is the audit report lag associated with material weaknesses in internal control shorter for non-accelerated filers than for accelerated filers?
    • RQ3: Is the audit report lag for clients that remediated material internal control weaknesses:
    • (a) lower than for clients that did not remediate such weaknesses? (b) higher than for clients that did not report such problems in the prior year?

    Data was procured from the Audit Analytics database for information about Section 404 reports, auditor information, and audit report date for years 2008 and 2009. 

    Findings:
    • In 2008, the increase in audit report lag in the presence of material weaknesses in internal control is lower for non-accelerated filers as compared to accelerated filers
    • While the effect of a material internal control weakness on audit report lag is significantly lower in 2009 than in 2008 for accelerated filers, there is no such change for non-accelerated filers.
    • For firms remediating previously disclosed internal control problems, there is a significant decline in audit report lag; yet, the remediating firms continue to have higher reporting lags than firms that had clean Section404 opinions in both years.
    • At least with respect to the effect of internal control problems on audit report lag, the ‘‘small accelerated filers’’ (defined as those with market capitalization less than $250 million) are treated by the auditors as being (1) substantively similar to other accelerated filers, and (2) quite distinct from non-accelerated filers.
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Was Dodd-Frank Justified in Exempting Small Firms from...
    research summary posted November 26, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 08.06 Earnings Management – Detection and Response, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance?
    Practical Implications:

    Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

    We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

    For more information on this study, please contact

    Anthony D. Holder, PhD, CPA

    Assistant Professor, Department of Accounting - MS 103

    University of Toledo

    Toledo, OH 43606-3390

    Email: Anthony.Holder@utoledo.edu

    Web:    http://homepages.utoledo.edu/aholder4/

    Phone: 1.419.530.2560

    Fax: 1.419.530.2873 

    Citation:

    Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

    Keywords:
    Sarbanes-Oxley; Dodd-Frank; earnings management; exempt filers
    Purpose of the Study:

    A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

    Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

    The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

    Design/Method/ Approach:

    Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

    The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

    • Post-SOX reporting gains achieved by large firms (accelerated filers).
    • Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.
    Findings:

    We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters, Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluating Accruals/Detection of Abnormal Accruals, Impact of 404 on Fees and Financial Reporting Quality, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Auditor Attestation under SOX Section 404 and Earnings...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Attestation under SOX Section 404 and Earnings Informativeness
    Practical Implications:

    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. 

    Citation:

    Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).

    Keywords:
    earnings informativeness; internal control; Sarbanes-Oxley; Section 302; Section 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act (SOX) requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). This policy is intended to enhance the credibility of firms’ financial statements. Prior research suggests that audit characteristics that enhance the credibility of financial reporting are associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. This study examines the SEC’s and PCAOB’s expectation about the increased quality and reliability of financial reporting resulting from Section 404. By using a difference-in-differences approach, the authors compare the change in earnings informativeness for the test sample used with that for a control sample of non-accelerated filers. 

    Design/Method/ Approach:

    The authors used previous research and policy makers’ expectations to develop the following hypothesis for testing:

     

    H1: Earnings accompanied by the first-time clean SOX404 ICFR reports are more informative that the previous annual earnings that were not accompanied by ICFR.

     

    This hypothesis was tested by comparing earnings informativeness for the annual filings containing the first-time ICFR reports and the annual filings of the previous year. The sample consisted of two types of firms (1) accelerated filers with clean Section 404 reports for the current year and clean Section 302 management reports for the seven preceding quarters, and (2) non-accelerated filers with clean Section 302 management reports throughout the sample period. The sample period included firm year-ends between November 15, 2003 and November 15, 2005. The final sample consisted of 381 firms. 

    Findings:
    • Firms with first-time clean ICFR reports have higher earnings informativeness in SOX years than in the pre-SOX years when they received only financial statement audit reports.
    • The firms that benefited the most are those with higher likelihood of material weaknesses.
    • Firms with both low and high costs of compliance experience an increase in earnings informativeness. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
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  • Jennifer M Mueller-Phillips
    The Effectiveness of SOX Regulation: An Interview Study of...
    research summary posted April 15, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effectiveness of SOX Regulation: An Interview Study of Corporate Directors
    Practical Implications:

    A large majority of the directors interviewed for the purpose of this study maintained that, costs aside, SOX had positively impacted the quality of financial reporting. This can be supported by the decline in major frauds since the passage of the Act. On the downside, several directors also noted that SOX had negatively impacted corporate risk taking. Overall, corporate directors were by and large supportive of the SOX regulation. This conclusion runs counter to the typical opposition that corporate America has to any additional regulation.

    For more information on this study, please contact Jeffrey R. Cohen.
     

    Citation:

    Cohen, J. R., C. Hayes, G. Krishnamoorthy, G. S. Monroe, and A. M. Wright. 2013. The Effectiveness of SOX Regulation: An Interview Study of Corporate Directors. Behavioral Research in Accounting 25 (1).

    Keywords:
    audit process; corporate governance; qualitative research; risk management; Sarbanes-Oxley Act.
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was enacted in July 2002 in response to a number of significant financial reporting failures. This legislation significantly expanded the authority and responsibilities of the audit committee and board in overseeing financial reporting and internal controls. This study was conducted to provide insights into the effectiveness of SOX regulation from the perspective of corporate directors. By examining these director’s experiences of the impact of SOX, the authors aimed to discover how public corporations have responded to the legislation. Specifically, this study attempts to analyze the effectiveness of SOX with respect to achieving high-quality financial reporting.

    Design/Method/ Approach:

    The authors interviewed 22 experienced public company directors in 4 cities: Boston, Los Angeles, Chicago, and New York. The directors were chosen with a view to capture a cross-section of corporate governance experience, industries, and company size. The interviews were conducted over a 5 week period in 2007 just before the financial crisis of late 2007. The interviews varied in length from 30 to 60 minutes. All interviews were conducted by a single person in the offices of the participants, with the exception of one interview that was conducted by telephone. The interviews were guided by a pre-determined set of interview questions based on Cohen et al (2010), with additional questions added regarding SOX provisions and other SOX-related academic literature.

    Findings:
    • Directors have experienced enhanced expertise, attitude, process, and power and authority of the audit committee.
    • Post-SOX internal scope, level of responsibility, and status of internal audit functions have seen substantial improvement.
    • Compliance with SOX has led to greater empowerment of the audit committee.
    • CEO/CFO certification has increased CEO ownership of the integrity of financial disclosure and has been pushed down through the organization.
    • Management is still actively involved in the decision management process, including such matters as the appointment of the auditor.  
       
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Impact of 404 on Fees and Financial Reporting Quality, Impact of SOX
  • Jennifer M Mueller-Phillips
    Internal Controls and Conditional Conservatism
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Controls and Conditional Conservatism
    Practical Implications:

    This study provides insights to regulators given potentially conflicting perspectives as to the benefits of financial reporting conservatism. Regulators view conservatism as allowing the deliberate understatement of assets or income and/or the deliberate overstatement of liabilities or expenses, rendering financial statements not neutral and, therefore, jeopardizing the quality of reliability and unbiasedness desired by the conceptual framework. In contrast, the benefits of conservatism lie in the agency conflict conservatism whereby it reduces managers’ ability and incentives to overstate earnings and net assets by requiring higher verification standards for gain recognition and reduces managers’ ability to withhold information on expected losses. As the results suggest that strong internal controls facilitate conservatism, this may increase concern among regulators opposed to accounting conservatism.

    For more information on this study, please contact Beng Wee Goh.
     

    Citation:

    Goh, B. W. and D. Li. 2011. Internal Controls and Conditional Conservatism.  The Accounting Review 86 (3):  975-1005. 

    Keywords:
    internal controls; conservatism; material weaknesses; Sarbanes-Oxley Act.
    Purpose of the Study:

    In 2002, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) to improve the quality of financial reporting and to restore investor confidence in the reliability of financial statements. An important aspect of SOX is its internal control reporting requirements, which allow investors to be informed about the quality of a firm’s internal controls. Given the importance of the internal control provisions as a means to improve the governance of firms, this study extends the literature on the reporting effects of strong versus weak internal controls by examining how the quality of internal controls is related to conservatism in financial reporting. Specifically, the authors examine whether material weakness (MW) firms that subsequently remediate their weaknesses exhibit different levels of conservatism from MW firms that continue to have these weaknesses. The authors define conservatism as the higher degree of verification to recognize good news as gains than to recognize bad news as losses and place emphasis here because it has been argued to provide several governance benefits, such as reducing agency conflicts and improving managerial investment decisions, enhancing the efficiency of debt contracts, and reducing litigation costs.

    Design/Method/ Approach:

    The authors identify 1,098 firms that, under either SOX 302 or SOX 404, disclose at least one MW from January 2003 to November 2005 and focus on firms that disclosed MWs because the reporting of MWs is mandatory, whereas the reporting of significant deficiencies and control deficiencies is not. The authors examine the fiscal years 2000 and 2001 to test whether there is a relationship between internal control quality and conservatism because these years just precede the enactment of SOX and, hence, avoid any confounding effects due to SOX. Therefore, the authors rely on the assumption that MWs exist within the firm even before their disclosures from January 2003 to November 2005. The authors utilize three measures of conservatism that are commonly used in the literature to capture the asymmetric timeliness in the recognition of economic losses: (1) persistence of earnings changes, (2) accrual-based loss recognition, and (3) the timeliness of earnings to news. In their second analysis the authors focus solely on the MW sample of firms because remediation is required in their test of whether remediating firms exhibit a difference in conservatism when compared to those that fail to remediate.

    Findings:
    • The results using all three measures of conservatism noted above are consistent with a positive relation between internal control quality and conservatism. Specifically, the authors find that MW firms exhibit lower conservatism than control firms without such weaknesses. Results using all three measures of conservatism are consistent with a positive relation between internal control quality and conservatism.
    • Furthermore, the authors show that MW firms that subsequently remediate their weaknesses (i.e., show an improvement in internal control quality) exhibit greater conservatism than MW firms that continue to have these weaknesses.

    Therefore, the authors’ results are consistent with strong internal controls serving as a mechanism that facilitates conservatism.

    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Impact of PCAOB Auditing Standard No. 5 on Audit Fees...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of PCAOB Auditing Standard No. 5 on Audit Fees and Audit Quality
    Practical Implications:

    This study provides an analysis of the effect of PCAOB Auditing Standard No. 5 (AS5) on internal control audit efficiency. The authors interpret their results as indicating that AS5 improved internal control audit efficiency by reducing audit fees without harming audit quality. The results of this study provide insight into the consequences of PCAOB standard setting, which is of interest to standard setters and businesses subject to their rules.


    For more information on this study, please contact Dechun Wang.
     

    Citation:

    Wang, D. and J. Zhou. 2012. The Impact of PCAOB Auditing Standard No. 5 on Audit Fees and Audit Quality. Accounting Horizons 26 (3): 493-511.

    Keywords:
    PCAOB Auditing Standard No. 5, audit fee, audit quality, internal control.
    Purpose of the Study:

    Due to strong complaints to the SEC and PCAOB about high audit costs associated with PCAOB Auditing Standard No. 2 (AS2) which governed internal controls audits, the PCAOB amended AS2 and proposed Auditing Standard No. 5 (AS5) in 2007. AS5 was aimed at reducing unnecessary costs and providing a more efficient audit of internal controls. It provides auditors a “top-down, risk-based” approach which allows them to tailor the audit to client size, complexity and specific critical risk areas. Furthermore, it provides auditors more flexibility in relying on the work of management and internal auditors.
        This study’s aim is to understand whether the PCAOB has accomplished its goal of making internal audits more efficient. The authors make a point to say that this requires not only audit fee reduction but also no drop in audit quality. The authors make and test the following hypotheses:

    H1: Audit fees are significantly lower after the adoption of AS5 for accelerated filers, but not non-accelerated filers (Note: AS5 does not apply to non-accelerated filers because the requirement of an audit of internal controls for these firms was initially deferred and eventually exempted by the Dodd-Frank Act of 2010)

    H2: Ceterus Paribus, audit quality does not change after the adoption of AS5
     

    Design/Method/ Approach:

    The authors utilize data on public companies around the 2007 implementation of AS5. They classify accelerated filers that had FYEs between November 15, 2007 (the AS5 implementation date) and November 14, 2008 as AS5 firms. They compare changes in audit fees for these firms to changes in audit fees in the previous year. They then compare changes in audit fees for AS5 firms to changes in audit fees for firms not subject to AS5 during the same period (non-accelerated filers). Finally they compare audit quality for AS5 firms in the year after AS5 implementation to the year immediately preceding AS5 implementation.

    Findings:
    • The authors provide evidence of a decrease in audit fees for the AS5 sample while audit fees increased for the pre-AS5 sample and the contemporaneous non-accelerated filing sample. 
    • The authors do not find a significant change in audit quality for the AS5 sample. This failure to find a significant result is robust to different measures of audit quality (Abnormal accruals, meeting or beating earnings forecasts and the probability of issuing an internal control weakness opinion).

    Taken together, the authors claim that these results are indicative of AS5 providing more efficient audits of internal controls. They argue that this result is confirmation that AS5 has accomplished the PCAOB’s objective of providing the same benefits of Sarbanes Oxley at a more reasonable cost to companies.

    Category:
    Internal Control, Standard Setting
    Sub-category:
    Changes in Audit Standards, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Audit Fees after Remediation of Internal Control Weaknesses
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit Fees after Remediation of Internal Control Weaknesses
    Practical Implications:

    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.

    Citation:

    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. 

    Keywords:
    internal controls; audit fees; material weakness; remediation
    Purpose of the Study:

    Firms that receive an adverse report on internal control under Section 404 of SOX typically experience significant costs, such as a higher cost of capital. Additionally, these companies reporting material weaknesses also tend pay higher audit fees which is consistent with the belief that ineffective internal controls leads to a higher propensity for misstatements. Conversely, it is logical to expect that these higher fees will return to normalized levels if the weakness is remediated; however, recent evidence in regards to control problems disclosed pursuant to Section 302 of SOX has been contrary to this belief. This study attempts to provide clarification to these findings and investigates whether audit fees return to previous levels after the remediation of material weaknesses disclosed under Section 404 of SOX. It is important to recognize that in contrast to prior research which examines fees in the year of (or year prior to) remediation, this study examines the audit fees in the years following the remediation  in order to determine if the higher fees that the company pays in year of disclosure remain at a premium even two or three years after remediation.

    Design/Method/ Approach:

    The authors use data on SEC registrants and collect information on audit fees and Section 404 disclosures for the first four years of internal control reporting (2004-2007). The authors exclude financial sector companies, as well as, foreign firms and compare audit fees over the four year period of analysis for SEC registrants with fiscal year-ends from November 15 through May 31 of the following calendar year. The authors examine audit fees in years subsequent to the remediation of internal control weaknesses in order to determine whether auditors continue to view firms that had ever received an adverse Section 404 opinion as being “tainted,” such that even after remediating the problem, firms continue to pay an audit fee premium.

    Findings:

    The authors find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years of internal control reporting. The authors also show that general weaknesses have a higher effect on audit fees than only account-specific internal control weaknesses.

    Category:
    Internal Control, Accountants' Reporting
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Consequences of Adverse 404 Opinions
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  • Jennifer M Mueller-Phillips
    Auditor Realignments Accompanying Implementation of SOX 404...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements
    Practical Implications:

    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. 

    Citation:

    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.

    Keywords:
    auditor realignments; dismissals; internal control; SOX Section 404; remediation
    Purpose of the Study:

    This study was motivated by the increased frequency of client dismissals of auditors since the implementation of SOX in 2002.  The added requirement that auditors opine on the client’s internal control over financial reporting (ICFR) brought concern among financial statement users that clients would seek more compliant auditors decreasing the quality of the audit.  This paper studies the impact of adverse auditors’ opinions on clients’ internal controls to determine whether:

    • Clients dismiss auditors after receiving an adverse SOX 404 ICFR opinion.
    • Clients dismiss auditors to improve financial reporting by obtaining a higher-quality auditor.
    • Dismissals and hiring a new auditor are associated with subsequent improved ICFR opinions.
    Design/Method/ Approach:

    The authors study accelerated filers from November 2004 through December 2007 and obtain data on ICFR opinions, auditor dismissals, and auditor switches.  Higher audit quality is measured as changes to Big 4 and industry specialist auditors. 

    Findings:
    • Companies receiving adverse ICFR opinions are more likely to dismiss their auditor in the subsequent year.
    • Companies that dismiss their auditor after an adverse ICFR opinion are more likely to hire Big 4 and industry specialist auditors.
    • Remediation of adverse reports is only associated with clients that switch to an industry specialist auditor.
    Category:
    Standard Setting, Internal Control
    Sub-category:
    Impact of 404, Impact of SOX, Impact of 404 on Fees and Financial Reporting Quality
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