When Does SOX 404 Benefit Financial Reporting Quality?

Abstract

Prior research shows that the Sarbanes Oxley (SOX) Section 404(b) integrated audit is associated with lower incidence of misstatements. We predict that the knowledge gained from internal control testing under 404(b) should improve the auditor’s ability to detect misstatements relative to other internal control regimes that do not require control testing, and that this benefit will vary with the incremental effort applied to the engagement. Our baseline tests show that the association between incremental audit effort (proxied by abnormal audit fees) and misstatement reduction is greater under SOX 404(b) vs. other regimes (including SOX 404(a)). These findings imply that the value of incremental audit effort is not uniform, but is greater when control testing is required and sufficient resources are available to thoroughly understand client controls. We further examine the conditions under which knowledge gained from auditor control testing is more valuable. We find that the benefits from control testing 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, firms disclosing material weakness in internal controls, and firms misstating core accounts.