Raghunandan2006MYMPaper - SOX Section 404 Material Weakness...

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SOX Section 404 Material Weakness Disclosures and Audit Fees K. Raghunandan and Dasaratha Rama November 2005 Contact Author: K. Raghunandan School of Accounting Florida International University 11200 S.W. 8 th Street Miami, FL 33199 raghu@fiu.edu K. Raghunandan and Dasaratha Rama are Professors at Florida International University.
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SOX Section 404 Material Weakness Disclosures and Audit Fees Abstract Section 404 of the Sarbanes-Oxley Act, and the ensuing Auditing Standard No. 2 (PCAOB 2004), requires management and the auditor to report on internal controls over financial reporting. Section 404 is arguably the most controversial element of SOX, and much of the debate around the costs of implementing section 404 has focused on auditors’ fees (Ernst & Young 2005). In this paper, we examine the association between audit fees and internal control disclosures made pursuant to section 404. Our sample includes all of the 731 manufacturing firms that (a) have a December 31, 2004 fiscal year end, and (b) filed the section 404 report by May 15, 2005. We find that the mean (median) audit fees for the firms in our sample for fiscal 2004 is 86 (127) percent higher than the corresponding fees for fiscal 2003. Audit fees for fiscal 2004 are 59 percent higher for clients with a material weakness disclosure compared to clients without such disclosure; however, audit fees for fiscal 2003 are not associated an internal control material weakness disclosure (in the 10-K filed following fiscal 2004). We also find that the association between audit fees and the presence of a material weakness disclosure does not vary depending on the type of disclosure (systemic problem vs. account or transaction specific problem). 2
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SOX Section 404 Material Weakness Disclosures and Audit Fees In this paper we examine the association between material weakness disclosures made pursuant to section 404 of the Sarbanes-Oxley Act (SOX 2002) and audit fees. Section 404 and the subsequent PCAOB standards relating to this section (PCAOB 2004) require (a) a management report on internal control over financial reporting, (b) auditor attestation of such a management report, and (c) an auditor’s report on internal control. The internal control reporting requirements have been the most controversial elements of SOX. Many SEC registrants and others have complained about the high-costs associated with the new requirements (SEC 2005b) and audit fees account for a significant part of section 404 implementation costs (ABA 2005; FEI Our analysis focuses on audit fees paid by all of the 731 manufacturing firms with a December 31, 2004 fiscal year end that filed their 404 reports by May 15, 2005. Not surprisingly, we find that the audit fees are higher for the 76 firms that disclosed material weaknesses in internal controls over financial reporting pursuant to section 404 of SOX. Of greater interest are our results related to the magnitude of the higher fees, the effects on prior
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This note was uploaded on 11/30/2011 for the course ACCOUNTING 655 taught by Professor Lee during the Spring '11 term at Prince George's Community College, Largo.

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Raghunandan2006MYMPaper - SOX Section 404 Material Weakness...

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