Audit Fee

Topics: Auditing, Audit, Internal control Pages: 50 (6626 words) Published: December 21, 2013
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Past control risk and current
audit fees

Past control risk

Thomas G. Calderon, Li Wang and Thomas Klenotic
George W. Daverio School of Accountancy, The University of Akron, Akron, Ohio, USA

693

Abstract
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

1. Introduction
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
pp. 693-708
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686901211246813

MAJ
27,7

694

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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AICPA (1997), Consideration of Fraud in a Financial Statement Audit. Statement on Auditing
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AICPA (2002), Audit Documentation. Statement on Auditing Standards No. 96, American
Institute of Certified Public Accountants, New York, NY.
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