Sarbanes-Oxley Section Effect on Audit Fees

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Isolating Sarbanes-Oxley Section 404(b) effect on audit fees and market liquidity: a natural experiment.

 

Premalata Sundaram* PDBP 2010 University of Florida

August 23, 2010

Abstract
Since the passage of the Sarbanes-Oxley Act (SOX) of 2002, a large body of evidence has accumulated on the costs this legislation has imposed on public companies in the United States. Estimates of the direct costs of the law have been fairly straightforward to measure, but the indirect costs of the legislation like incremental audit and non-audit fees, additional audit effort and additional internal control audit expenses like payroll and technology are harder to estimate due to lack of detailed data on these expenses. Since audit fees had been rising prior to 2002 due to a riskier auditing climate and due to the demise of Arthur Anderson in the Enron debacle, it is difficult to isolate the effect of SOX on audit fees in the U.S. Some studies have looked at the effect of SOX on audit fees and have documented an increase in the same, including a Big 4 premium. However, the portion of the increase attributable specifically to the 404(b) auditor attestation requirement is unobservable (Coates 2007) . This study aims to fill this critical gap in the literature by estimating the portion of the incremental audit fees that is the result of the auditor attestation requirement of Section 404 by using a unique dataset of Indian companies. Clause 49 of the exchange listing requirements for companies in India required CEO/CFO certifications on internal controls and financial statements since 2003. Some of these companies are also cross-listed on US exchanges and have to comply with Section 404 from fiscal year-end Dec 2009. This provides a natural experiment to isolate the incremental compliance costs due to Section 404 for the cross-listed firms. The results of this study have important implications for policy makers and regulators in the U.S. who are concerned about the competitiveness of US capital markets going forward. In many cases, this audit fee premium may make the costs of listing in the US too high and incentivize the firm to de-list or cancel its ADR program and go dark, calling into question the global competitiveness of US stock exchanges. *Address all correspondence to premalatas@ufl.edu I would like to thank Dr. Stephen Asare for providing valuable feedback for this paper and the faculty in the bridge program for their support and encouragement.

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I.

Introduction

Section 404 of the Sarbanes-Oxley Act (SOX) of 2002 requires management to present a signed report on the effectiveness of the internal controls in the firm. Section 404(b) further requires that the external auditor issue a report (attest to) on the internal controls of the client and on management’s assessment of such controls.1 The Act therefore imposed additional costs on public companies that included additional audit fees, internal labor costs for added staff, and external consulting/technology expenses. SOX Section 404 costs have arguably been a matter of great controversy and undue hardship on smaller public companies (Scannell 2007). These costs have also increased the total costs to foreign companies of having their stocks listed and traded on a US exchange. The increase in audit fees attributable to auditor attestation requirement is composed of two parts; (1) increased audit fees for higher audit effort and/or higher auditor liability risk and (2) increased internal audit staff requirements including payroll and technology/consulting services. Based on disclosures of audit fees required for US companies, it is difficult to separate the audit fee into these two components. In a recent study by Raghunandan and Rama(2006), the authors use voluntary disclosure data made by some small companies to separate out the Section 404 compliance costs, but their sample is mostly smaller companies that disclose internal control weaknesses. Due to...
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