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Past control risk and current
Past control risk
Thomas G. Calderon, Li Wang and Thomas Klenotic
George W. Daverio School of Accountancy, The University of Akron, Akron, Ohio, USA
Purpose – The authors posit that audit fees are driven by historical risk factors and risk encountered in the current period. The purpose of this paper is to focus on historical risk by examining the incremental effect of material weakness in internal control (MW) identiﬁed in prior periods on current audit fees, after current risk factors are controlled for.
Design/methodology/approach – The paper uses multiple regression as the main research method, where the authors regress current audit fees on MW in prior periods, current MW, and a vector of other contemporaneous variables as proxies for current risk factors. Findings – The authors ﬁnd that past MW incrementally affects current audit fees beyond MW and other risk factors identiﬁed in the current period. The effect of past MW on audit fees generally last at least for three years. In addition, companies with persistent past MW incurred substantially higher audit fees. The paper also ﬁnds that past MW continues to be positively and signiﬁcantly associated with current audit fees even after the MW is remediated and there are no subsequent reports of MW. Moreover, the number of MW dominates existence of MW in explaining audit fees in the current and the previous year.
Research limitations/implications – This study does not attempt to distinguish between fee adjustments that are attributable to audit effort and adjustments that are attributable to risk premiums. Nonetheless, it is clear that organizations can expect to incur signiﬁcant incremental costs over multiple years whenever they fail to maintain effective internal control systems. Originality/value – The ﬁndings of this study contribute to the audit fees literature by explicitly incorporating risks from multiple prior periods into the audit fee model. The results suggest that it is important to consider historical risk factors in examining current period audit fees. Keywords Audit fees, Control risk, Lagged material weakness, Risk assessment, Auditing Paper type Research paper
This study examines the intertemporal association between material weakness (MW) in internal control identiﬁed in prior periods and current period audit fees. The Sarbanes-Oxley Act (SOX) of 2002 and US auditing standards (AICPA, 1983; PCAOB, 2004, 2008) recognize the importance of internal control over ﬁnancial reporting (ICFR). Auditing Standard (AS) No. 5 (PCAOB, 2008) requires auditors of public companies to perform an integrated audit of ﬁnancial statements and ICFR. Auditors have to obtain sufﬁcient evidence to provide a separate opinion on the effectiveness of ICFR. In addition, AS No. 9 (PCAOB, 2010a, b, c, d, e, f, g, h, paragraph 7) requires auditors to assess whether prior internal control deﬁciencies (ICDs) would affect current ﬁnancial statements and ICFR and, if so, how the deﬁciencies will affect current period audit procedures. Similarly, AS No. 12 (PCAOB, 2010a, b, c, d, e, f, g, h, The authors would like to thank Diane Jules and the participants at the 2010 American Accounting Association Ohio Region meeting for their helpful comments and suggestions.
Managerial Auditing Journal
Vol. 27 No. 7, 2012
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paragraph 18) requires auditors to evaluate whether signiﬁcant changes from prior periods, including changes in ICFR, affect the risk of material misstatement in the current period.
Generally accepted auditing standards suggest that engagement effort should be adjusted based on the auditors’ risk assessment of ICFR to efﬁciently allocate resources. More speciﬁcally, AS...
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