The Effect of Internal Control Weakness Under Section 404 of the Sarbanes-Oxley Act on Audit Fees

Abstract

In this paper, we investigate the effect of the enactment of the Sarbanes-

Oxley Act (SOX) in 2002 on audit pricing, using a sample of 252 firms that received an Ineffective audit opinion and other firms that received clean

audit opinion on the effectiveness of the internal control over financial reporting

under Section 404 of SOX. Our analyses show the following. First,

we find that auditors charge significantly higher audit fees for all firms in

the post-SOX period than in the pre-SOX period. Second, we find that auditors

opinions on the weakness in internal control (WIC) are positively associated

with audit fees, and that the positive association between the two

is pronounced primarily in the post-SOX period, but not in the pre-SOX

period. Third, we find that clients with WIC problems that are highly levered

and/or report losses pay incrementally higher audit fees during the post-

SOX period. We also find that Big 4 audit fee premiums increase significantly

for all clients during the post-SOX period, regardless of whether the

clients have WIC or not. Overall, our results suggest that auditors, in terms

of their behavior and pricing mechanism, responded to an upward shift in

the strength of the legal liability regime caused by the SOX enactment.