Evidence on the Impact of Internal Control over Financial Reporting on Audit Fees

Abstract

Introduction: Circa 1992, the dot.com sector created an irrational stock-trading market where the usual “financial” profiles of: Liquidity, Cash Flow from Operations, and Revenue Ggeneration were replaced by Ponzi-esque mayhem. To stabilize the markets, the Public Company Accounting Oversight Board [PCOAOB] required a second audit opinion: the COSO Opinion on the adequacy of management’s system of Internal Control over Financial Reporting: [ICoFR]. Study Focus: Three COSO-[ICoFR] designations are now required as public information: (i) A “clean” opinion [Is Effective], (ii) Deficiencies are noted, and (iii) Weaknesses reported. Our research interest is to determine, for a panel of randomly selected firms traded on the S&P500 for a eleventen-year period: 2005 to 2015, the nature of the effect that the COSO deficiency reporting protocol has on (i) Audit Fees and (ii) the Market Cap of traded firms. Method: To this end we collected, using the Audit Analytics [WRDS] database, various categories of reported Audit Fees and also Market Cap information. This random sample was classified into two sets: the first group: Is Effective SEC 302 Designation and No COSO issues & the second group: Is Not 100% Effective for which there were SEC 302 Deficiencies or Weaknesses noted. Results: Inferential testing indicates that failure to attend to the PCAOB-COSO imperatives results in a relational where there are higher Audit Fees and a slippage of the firm’s Market Cap compared to the Is Effective Group. The PCAOB’s protocol to require the Audit of the firm’s ICoFR system and make that evaluation public information seems to be an excellent corrective “Carrot and Stick”.