Pervasiveness, severity, and remediation of internal control material weaknesses under SOX Section 404 and audit fees

Purpose – The purpose of this paper is to examine the association between pervasiveness, severity, and remediation of internal control material weakness (ICMW) reported by the SEC registrants pursuant to SOX Section 404 and audit fees. Design/methodology/approach – The paper employs multivariate regression models for a sample of 854 firms that disclosed ICMW for the first time in 2004, 2005, or 2006, to investigate the empirical relationship of pervasiveness and severity of ICMW and its subsequent remediation with audit fees. Findings – The analyses demonstrate that audit fees are significantly positively related to the severity (and pervasiveness) of ICMW in the years of ICMW disclosures and are significantly negatively related to the remediation of internal control weaknesses in the years when ICMW remediation took place. The test results further demonstrate that the remediation of systematic control weaknesses has a greater effect on reduction of audit fees compared to the remediation of nonsystematic (transaction/account related) control weaknesses, though the remediation of both systematic and nonsystematic control weaknesses is accompanied by audit fee declines. Research limitations/implications – The study produces evidence on pricing audit services by incumbent auditors in response to the severity of internal material control weaknesses and their remediation in subsequent fiscal periods. Its results shed light on certain new aspects of audit fee determinants in the post‐SOX period by virtue of their implications that the pervasiveness and severity of internal control problems induce auditors to make an upward fee adjustment while their remediation has a moderating effect on pricing audit services. Originality/value – The study's finding is a useful addition to the existing fee literature and is relevant for the post‐SOX world which experienced a structural change in financial accounting and auditing environment.