Audit Fees and Pricing Strategy: Do Restatements of Internal Control Reports and Earnings matter?

Abstract

Under Sarbanes-Oxley (SOX) Act Section 302, management should, from one hand, certify and disclose in reports the effectiveness of internal controls applied to processes and procedures followed by a listed entity and, on the other, highlight potential deficiencies and provide information on potential frauds or sources of risk that could negatively impact on the effectiveness of the internal controls in place. Building on the above, SOX Act Section 404 requires that management should report information in its annual reports regarding the adequacy and effectiveness of the system of internal controls, which affects the procedures of financial reporting. These internal control reports, as part of the internal audit system within an organization, they undergo a review initially by the internal audit department and then by external auditors. The external auditors’ comments may dictate certain changes to be made, which could inevitably lead to refinements, which are then depicted to the adjusted internal control reports. The need for restatements of internal control reports is definitely associated with additional work from the side of the external auditor and may initiate more extensive audit work. Hence, the aim of the particular study is to investigate to what extent the audit fees paid to external auditors (i.e. the audit firm) are affected by such restatements to the internal control reports and whether the entity’s earnings and book value of equity have a mediating role to the above relationship. The innovativeness of the current research lies at the fact that it is the first time that a research focuses on “Restatements of Internal Control Reports” (RICR) and “Firm’s Earnings” (FE) as significant determinants of “Audit Fees” (AF) paid to external auditors, providing materially useful evidence about the behavioral profile of audit firms concerning their pricing strategy. Employing a dataset that captures the period before and during the global financial crisis of 2007-2008, we use RICR as control variable to assess not only the effectiveness of internal controls, but also the performance of the selected financial institutions and to what extent do the above influence the pricing strategy adopted by audit firms. In methodological terms, we apply Multiple Regression Analysis to a data set that consists of 2.878 observations, which stem from 300 US financial institutions and are recorded for a period of seven years that range from 2004 to 2010. The selection of the specific period facilitates comparisons between the period before and during global financial crisis. These findings are then contrasted with the results that cover the whole 2004-2010 period.

Keywords: Audit Fees, Restatements of Internal Control Report, Earnings, Book Value, Banking Sector, Financial Institutions, Pricing Strategy