The Effect of Internal Control Weakness under Section 404 of the Sarbanes-Oxley Act on Audit Fees

In this paper, we investigate the effect of the enactment of the Sarbanes-Oxley Act (SOX) in 2002 on audit pricing, using a sample of 252 firms that received an "Ineffective audit opinion on the effectiveness of the internal control over financial reporting under Section 404 of SOX. Our analyses show the following. First, we find that auditors charge significantly higher audit fees in the post-SOX period than in the pre-SOX period. Second, we find that auditors' opinions on the weakness in internal control (WIC) are positively associated with audit fees, and that the positive association between the two is pronounced primarily in the post-SOX period, but not in the pre-SOX period. Third, we find that highly levered clients and/or loss-making clients with WIC problems pay incrementally higher audit fees during the post-SOX period. We also find that Big 4 audit fee premiums increase significantly for all clients during the post-SOX period, regardless of whether the clients have WIC or not. Finally, we provide evidence suggesting that during the post-SOX period, both clients with firm-level and account-level WIC problems pay significantly higher audit fees than clients without WIC problems. Overall, our results suggest that auditors, in terms of their behavior and pricing mechanism, responded to an upward shift in the strength of the legal liability regime caused by the SOX enactment.