Does the 404 Audit Increase the Effectiveness of Additional Substantive Procedures for Clients with Ineffective ICFR?

• In Event: Client Risk and Internal Controls

Abstract

In this study, we examine two related research questions in the context of the audit risk model. For clients with ineffective internal controls over financial reporting (ICFR), first, are additional substantive procedures (additional audit effort) effective in lowering the likelihood of a material misstatement in the financial statements? Second, is the increased audit effort more effective during the current 404 audit regime than during the pre-404 (but post-SOX) time period? Using observations for a two year pre-404 time period and a four year 404 time period, we show that abnormal audit fees (as a proxy for additional audit effort) in the presence of ineffective internal controls lowers the likelihood of a material misstatement in the financial statements during the 404 time period but not in the pre-404 (but post-SOX) time period. Collectively, our findings suggest that the 404 audit adds value by improving the effectiveness of additional substantive procedures in the presence of ineffective controls. Further, the added value is more pronounced for clients with company-level (vs. account-level) control material weaknesses, intentional (vs. unintentional) financial statement misstatements, and for larger (vs. smaller) clients.

Authors

• Chan Li, University of Pittsburgh

• K K Raman, The University of Texas at San Antonio

• Lili Sun, University of North Texas