The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier, and small audit firms

Abstract

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller firms.