SOX 404, Auditor Effort, and the Prevention of Financial Report Misstatements
52 Pages Posted: 22 Nov 2015 Last revised: 25 Jan 2017
Date Written: 2017
Prior research shows that the Sarbanes Oxley (SOX) Section 404(b) integrated audit is associated with lower incidence of misstatements. We predict that under 404(b), the auditor’s ability to detect misstatements increases relative to other internal control regimes when greater resources are exerted during the engagement. Supporting this prediction, we find that the benefits of 404(b) vs. other regimes (including SOX 404(a)) in reducing misstatements increase with incremental audit effort (proxied by abnormal audit fees). We find no benefit of 404(b) in misstatement reduction when abnormal audit effort is low. This implies that the value of 404(b) testing is not uniform, but rather is greater when sufficient resources are available to thoroughly understand client controls. In contrast, we find no benefit of abnormal audit effort under other regulatory regimes. We further examine the conditions under which knowledge gained from auditor internal control testing is more valuable. We find that the benefits of increased audit effort under 404(b) do not vary across internal control regimes under AS2 vs. AS5, and are more pronounced for engagements with shorter auditor tenure, non-Big 4 auditors, and industry specialist auditors.
Keywords: Audit quality, internal controls, SOX 404(b), restatements, material weakness
JEL Classification: M49
Suggested Citation: Suggested Citation