Past control risk and current audit fees

Abstract

PurposeThe authors posit that audit fees are driven by historical risk factors and risk encountered in the current period. The purpose of this paper is to focus on historical risk by examining the incremental effect of material weakness in internal control (MW) identified in prior periods on current audit fees, after current risk factors are controlled for.Design/methodology/approachThe paper uses multiple regression as the main research method, where the authors regress current audit fees on MW in prior periods, current MW, and a vector of other contemporaneous variables as proxies for current risk factors.FindingsThe authors find that past MW incrementally affects current audit fees beyond MW and other risk factors identified in the current period. The effect of past MW on audit fees generally last at least for three years. In addition, companies with persistent past MW incurred substantially higher audit fees. The paper also finds that past MW continues to be positively and significantly associated with current audit fees even after the MW is remediated and there are no subsequent reports of MW. Moreover, the number of MW dominates existence of MW in explaining audit fees in the current and the previous year.Research limitations/implicationsThis study does not attempt to distinguish between fee adjustments that are attributable to audit effort and adjustments that are attributable to risk premiums. Nonetheless, it is clear that organizations can expect to incur significant incremental costs over multiple years whenever they fail to maintain effective internal control systems.Originality/valueThe findings of this study contribute to the audit fees literature by explicitly incorporating risks from multiple prior periods into the audit fee model. The results suggest that it is important to consider historical risk factors in examining current period audit fees.