Ghosh_Pawlewicz_AJPT_2009(1)

171

AUDITING: A JOURNAL OF PRACTICE & THEORY American Accounting AssociationVol. 28, No. 2 DOI: 10.2308/aud.2009.28.2.171November 2009pp. 171–197

The Impact of Regulation onAuditor Fees: Evidence from the

Sarbanes-Oxley ActAloke Ghosh and Robert Pawlewicz

SUMMARY: We examine changes in auditor fees around the Sarbanes-Oxley Act(SOX). Audit fees are expected to increase after SOX due to an increase in both auditeffort and auditors’ expected legal liability. Our results indicate an economically largeincrease in audit fees following the enactment of SOX. Controlling for audit and clientcharacteristics, we find that audit fee levels rose approximately 74 percent in the post-SOX period. Nonaudit fees fell significantly over the same period, but total fees paidto auditors rose because the increase in audit fees more than offset the decline innonaudit fees. Additionally, we find that the Big 4 audit firms increased audit fees by42 percent more than their smaller counterparts. Finally, we find that while small andlarge audit firms discount fees on initial engagements to attract new clients in the pre-SOX period, only small audit firms continue to offer fee discounts for the post-SOXyears. Our findings are robust to a host of sensitivity tests.

Keywords: Sarbanes-Oxley Act; audit pricing; auditor fees; Big 4 premium; fee dis-counting; lowballing.

Data Availability: Contact the first author about availability of the data.

INTRODUCTION

While several studies investigate the cross-sectional determinants of audit fees (e.g.,Simunic 1980; Palmrose 1986; Craswell et al. 1995; Bell et al. 2001; Ghosh andLustgarten 2006), relatively few academic studies examine the intertemporal var-

iation in audit fees. Anecdotal evidence, media coverage, and the popular press take forgranted that the additional audit work imposed by the Sarbanes-Oxley Act of 2002 (SOX;U.S. House of Representatives 2002) spurred an increase in audit fees (Ciesielski andWeirich 2006; Wilcox 2007). Drawing heavily on Simunic’s (1980) audit fee model, weempirically examine the impact of SOX on audit fees.

Aloke Ghosh is a Professor and Robert Pawlewicz is a Ph.D. Student, both at BaruchCollege–CUNY.

We thank Dan Simunic, Jeong-Bon Kim (the discussant), John Elliot, Douglas Carmichael, Donal Byard, CarolMarquardt, Lale Guler, Jianming Ye, Steven Lustgarten, Diana D’Amico, two anonymous reviewers, the participantsof the 2008 JCAE/AJPT Joint Symposium, and the research seminar at Baruch College, City University of NewYork, for their helpful comments.

Editor’s note: Accepted by Dan Simunic.

Submitted: August 2007Accepted: March 2009

Printed Online: November 2009

172 Ghosh and Pawlewicz

Auditing: A Journal of Practice & Theory November 2009American Accounting Association

SOX redefines the relationship between public companies and their auditors throughthe formation of a new regulatory body for the public accounting industry. The creationof the Public Company Accounting Oversight Board (PCAOB) has increased both oversightand penalties for audit-related violations. Additionally, several other provisions of SOX areexpected to increase audit effort. For example, Section 103 requires audit workpaper reten-tion for a minimum of seven years, Section 203 expands the required communicationsbetween the auditor and audit committee, and Section 404 requires that auditors attest tomanagement’s assessment of their internal controls.1

In the academic literature, audit fees are frequently modeled as a function of the costof the audit effort and the auditor’s expected legal liability (Simunic 1980). Because somekey SOX provisions involve substantial increases in audit effort, a growing consensus hasemerged among academics and practitioners that audit fees are expected to increase follow-ing SOX (e.g., Financial Executives International [FEI] 2004; Griffin and Lont 2007; Iliev2007). Audit fee increases after SOX could also be driven by a corresponding increase inauditors’ expected legal liability.

Expected legal liability depends on several key factors, including the probability ofmaterial misstatements in financial reports, the probability that the audit would fail to detecta misstatement, and the probability that the auditor would incur a legal liability due to anaudit failure (Choi et al. 2008). While the likelihood of material misstatements and auditfailure might have declined for the post-SOX period because of enhanced financial reportingand increased audit effort, expected legal liability may have increased. SOX empowersfederal courts and the Securities and Exchange Commission (SEC) to impose equitableremedies for violations of federal securities laws; this suggests the potential for increasingcivil monetary penalties levied against the auditor following SOX (Rashkover and Winter2005). In addition, the creation of a new regulatory body (i.e., the PCAOB) could alsoincrease auditors’ exposure to legal liability vis-a-vis penalties for audit-related violations.2

In summary, audit fees are expected to increase after SOX because of (1) increased auditeffort and (2) greater exposure to legal liability.

Prior studies conclude that large auditors charge a premium for providing a superiorlevel of audit assurance (e.g., Craswell et al. 1995; Simunic and Stein 1996; Choi et al.2008). Since SOX is widely expected to increase the audit workload, large auditors pro-viding a higher level of audit assurance are expected to increase audit fees more than smallaudit firms. The premium associated with large auditors could also increase following SOXif, as some believe, large auditors have a disproportionately greater exposure to litigationrisk for the post-SOX period.3

We also examine whether the practice of fee discounting or ‘‘lowballing’’ on initialaudit engagements, documented by prior studies, changed subsequent to SOX (e.g., Simonand Francis 1988; Chan 1999; Craswell and Francis 1999; Ghosh and Lustgarten 2006).Because voluntary auditor switching—a key determinant of fee discounting (Ghosh and

1 Similarly, Section 401 of the Act requires the Financial Accounting Standards Board (FASB) and the SEC toissue new regulations regarding off-balance-sheet activities, including the use of special-purpose entities andpro-forma figures in earnings announcements. These new regulations, including FIN No. 46 and Regulation G,increased required disclosures and the corresponding audit work.

2 SOX §105(c)(4) established monetary penalties of up to $15,000,000 ($750,000) for a public accounting firm(individual) in addition to other sanctions for intentionally violating the act. Further, Cornerstone Research findsthat damages claimed by plaintiffs in securities class action lawsuits are trending upward, which is an importantexplanation for the increase in the average size of the settlements (Cummings 2005).

3 Refer to a discussion of the speech by Conrad Hewitt, the Chief Accountant of the SEC, at the NorthwesternUniversity Legal Conference in San Diego on January 25, 2007 in Burns (2007).

The Impact of Regulation on Auditor Fees 173


Lustgarten 2006)—is expected to decline for the post-SOX years from higher switchingcosts (Asthana et al. 2004), we posit that fee discounting is lower for the post-SOX years.

Using a large sample between fiscal years 2000 and 2005, we document a significantincrease in audit fees around the time of SOX. Prior to SOX, mean audit fees were$533,360, but this number increased to $1,185,322 in the years following enactment. Thus,audit fees increased more than 122 percent between the pre- and post-SOX years. At thesame time, average nonaudit fees declined from $1,259,634 to $671,364. Total fees in-creased concurrently because the increase in audit fees offset the decline in nonaudit fees.

While these results provide preliminary insights into the trends in audit fees, we needto consider several other factors that might explain the results, including changes in clientcharacteristics and sample composition associated with audit fees. Therefore, similar to theapproach taken by prior studies (e.g., Craswell and Francis 1999; Ghosh and Lustgarten2006), we estimate the impact of SOX on audit fees using a regression specification thatcontrols for cross-sectional variation in audit fees. Controlling for the size of the auditor;auditor’s opinion; market concentration in the audit industry; and client characteristics suchas size, risk, and complexity, our results suggest that audit fees rose by approximately 74percent for the years subsequent to SOX. We also estimate audit fee regressions using arestricted sample that includes firms with available data for all of the relevant years. Ourresults using the constant sample indicate similar increases in audit fees for the post-SOXperiod.

Because large (i.e., Big 4) auditors, with so-called deep pockets, have more to losewhen litigation risk increases, the increase in audit fees for the post-SOX period is expectedto be larger for brand-name auditors. Consistent with our predictions, we find that theaverage increase in audit fees is 42 percent higher for clients of large audit firms than forclients of small audit firms.

We find that the extent of fee discounts on audit fees for new engagements declinedover the post-SOX period. Ghosh and Lustgarten (2006) hypothesize that fee discountingis confined to the audit market segment consisting of small auditors. Because competitionamong small auditors is high, they are more likely than large auditors to reduce fees toattract new clients. In contrast, because competition for new clients among large auditorsis low, client turnover for large auditors is relatively low. Consistent with the findings ofGhosh and Lustgarten (2006), we find that small and large auditors discounted fees for newengagements during the pre-SOX years. However, there is no evidence of lowballing amonglarge auditors after enactment. Small auditors give price discounts to new clients for boththe pre- and post-SOX years. There are two possible explanations for our results. First, ahigher workload might preclude large auditors from fee discounting to attract new clientsfor the post-SOX years. Second, the increased threat of litigation could also limit largeauditors from offering price discounts to new clients on initial engagements for post-SOXyears.4

Our study is one of the first to provide evidence on audit fees around SOX using arigorous empirical research design. In a recent study, Griffin and Lont (2007) also examineaudit fees around SOX, but several key features distinguish our contribution from theirs.First, they focus on residual audit fees, while we analyze audit, nonaudit, and total fees

4 Our results are robust to several added sensitivity analyses, including using levels and changes specifications,conducting yearly regressions, excluding the forced switching of former Andersen clients from our sample,including additional controls for client business complexity, deflating audit fees to constant 2000 dollars,and including an indicator variable for high-litigation industries.



paid. Second, their data are limited to large auditors, while we compare the differences inaudit fees between large and small auditors around SOX. Finally, we are the first study toexamine fee discounting associated with new engagements and how this phenomenonchanged following the act’s passage.

The remainder of this paper is organized as follows. First we review the related liter-ature on regulation and audit fees. Next we explain the empirical methods and researchdesign, discuss our data, and present descriptive statistics. Finally, we discuss our mainresults and our sensitivity analyses, and conclude.

REGULATION AND AUDIT FEESBackground

The bulk of the audit fee literature employs some variation of the audit fee modelproposed by Simunic (1980) which expresses audit fees (or the cost of an audit) as the sumof the cost of audit effort (c � q) and an expected liability loss component (E[L] � E[�]):

E[C] � c � q � E[L] � E[�] (1)

where E[�] represents the expectation operator, C is the total cost of the audit to an auditor,c is the per unit cost of an audit including all normal profits, q is the quantity or effortsupplied by an auditor, � is the ex post fraction of the losses from lawsuits borne by theauditor, E[L] is the present value of future losses from lawsuits, and E[�] is the expectedfraction of the legal losses borne by the auditor. Therefore, E[L] � E[�] is the presentvalue of future losses expected to be incurred by the auditor if the engagement results inlawsuits. In equilibrium, the total cost of the audit (E[C]) is equal to audit fees.

In the Simunic (1980) model, the present value of future losses is a function of thequantity of resources utilized directly by the client firm in operating the internal accountingsystem (a) and the quantity of resources used by the auditor in performing the audit (q),that is:

E[L] � F(a, q) (2)

where F denotes a functional form. Much of the audit fee literature uses firm characteristicsincluding size, complexity of operations, and business risk to proxy for the cost of auditeffort (Simunic and Stein 1996).

Prior audit fee research based on variations of Simunic’s (1980) audit fee model in-cludes studies that examine how audit fees change with client losses (Simunic 1980), firmsswitching auditors (e.g., Craswell and Francis 1999; Ghosh and Lustgarten 2006),firms listing on a public exchange (Palmrose 1986), auditors’ perception of their client’srisk (Bell et al. 2001), and audit services for financial institutions (Fields et al. 2004).Menon and Williams (2001), one the few studies to analyze long-term trends in audit fees,examine whether audit fees changed from 1980 to 1997. Hence, their study does not addresswhether audit fees changed around SOX.

In the following subsections, we analyze the impact of the Sarbanes-Oxley Act on auditfees, the Big 4 premium, fee discounting, and nonaudit fees.

Audit Fees: The Sarbanes-Oxley Act and Audit EffortAssuming that the per-unit cost of an audit (c) has remained unchanged over the recent

years, audit fees are determined by audit effort (q) and the expected litigation costs for the



auditor (E[L] � E[�]). Ceteris paribus, several requirements of the Sarbanes-Oxley Acthave increased the audit workload, which is expected to lead to higher audit fees. Amongothers:

● Section 101 created the PCAOB to regulate the public accounting industry. Greateroversight of the accounting profession suggests that auditors are likely to be morediligent in their audit work. Consequently, audit effort is expected to increase asauditors spend more time conducting their audits and maintaining extensive recordsof their audit work for PCAOB examinations.

● Section 103 requires that audit firms retain audit workpapers for at least seven years,provide a second partner review of the audit report, and describe the extent of testingof the internal control structure of the company.

● Sections 202 and 204 require audit committee preapproval for services provided bythe external auditor, and greater communication between the auditor and audit com-mittee. Preapproval and increased communication, both written and verbal, requiregreater effort on the auditor’s part.

● Section 401 introduces new rules regarding reporting for off-balance-sheet transac-tions, pro forma financial reporting, and special-purpose entities.5 These disclosuresare expected to increase the effort necessary to both produce and audit financialstatements.

● Section 404 requires the external audit firm to attest to management’s assessment ofinternal controls as part of the annual audit engagement.

In summary, each of these provisions requires more effort during the financial statementaudit, which is expected to increase audit fees.

Audit Fees: The Sarbanes-Oxley Act and Legal LiabilityIn addition to audit effort, in the Simunic (1980) model, the auditor’s legal liability

also plays a crucial role in determining the level of audit fees. In general, an auditor’s legalliability cost is a function of (1) the probability of a material misstatement, (2) the proba-bility of an audit failure, and (3) the probability of incurring legal costs associated with thefailure (Choi et al. 2008). As the quality of financial statements improves from the enhancedreporting requirements of SOX, maintenance and testing of internal controls, managementcertification of financial reports, oversight of the accounting profession by the PCAOB, andenhanced oversight by audit committees, the probability of material misstatements is ex-pected to decline. The incidence of audit failure is also expected to fall subsequent to SOXas auditors exert greater effort to produce their audit opinion and attest to management’sassessment of internal controls.

Despite an expected decrease in the probability of material misstatements in financialstatements and in the incidence of audit failures, many believe that auditors’ legal liabilitymight have risen with the passage of SOX due to an increase in legal costs associated withaudit failures (Griffin and Lont 2007). In a recent study, PricewaterhouseCoopers (PwC2008) finds that the average accounting-related settlement (excluding outliers) increased

5 The SEC requires all companies to disclose material financial results, commitments, transactions, relationshipswith entities, and uncertainties as part of disclosures with financial statements. Regulation G, released by theSEC in January 2003, requires non-GAAP- and GAAP-based financial results to be reconciled in accordancewith this section of the act. Additionally, the FASB produced multiple new rules governing the reporting of off-balance-sheet transactions (FASB Interpretation Nos. 45 and 46R).



steadily after SOX until peaking in 2005.6 In a related study, Cornerstone Research con-cludes that the damages claimed by plaintiffs in securities class action lawsuits are trendingupward, thereby driving average settlements even higher (Cummings 2005). Although thesestudies examine securities lawsuits, not specifically public accounting lawsuits, the generalincreasing trend in securities class action settlements suggests an increase in legal liabilityfor auditors.7

Several provisions of SOX are also expected to increase auditors’ exposure to legalliability. First, the act significantly expanded the SEC’s enforcement powers related toaccounting matters, especially those involving allegations of accounting fraud and manage-ment misconduct (Rashkover and Winter 2005). For example, the ‘‘Fair Funds’’ provisionallows the SEC to direct civil monetary penalties to aggrieved investors rather than to theU.S. Treasury. Further, SOX codifies case law empowering federal district courts to imposeequitable remedies to benefit victims in SEC enforcement actions. While SOX does notchange the way civil penalties are determined, it affords the SEC greater discretion to seeklarger civil penalties in enforcement actions (Heffes 2005). Additionally, SOX may haveled to greater legal liability costs because of new penalties imposed by the PCAOB in casesof audit failure.

Collectively, the higher level of penalties for fraud and audit failure under SOX mayhave led to a perception that auditors’ legal liability changed after its enactment. Therefore,we expect audit fees to increase subsequent to SOX due to an increase in audit effort andan increase in auditors’ exposure to legal liability from lawsuits and fines imposed byregulatory bodies.

Big 4 Premium and the Sarbanes-Oxley ActPrior studies document that large (Big 4) audit firms charge a fee premium both in the

U.S. and around the world (e.g., DeAngelo 1981; Palmrose 1986; Craswell et al. 1995;Choi et al. 2008). We examine whether SOX had any significant impact on the fee premiumcharged by large auditors.

In a recent study, Choi et al. (2008) provide links among audit pricing, legal liabilityand the Big 4 fee premium. They find that audit fees increase monotonically as the strengthof a country’s legal liability improves. Since an auditor’s legal liability is expected toincrease with the quality of the legal regime, auditors charge a higher fee as compensation.Further, for a given legal liability regime, Choi et al. (2008) find that large auditors chargea fee premium. Because legal liability costs are higher for large auditors, they have greaterincentives to increase audit effort compared with small auditors, which suggests higherfees. Finally, Choi et al. (2008) argue that the Big 4 fee premium decreases as the legalregime becomes stronger. They reason that because small auditors have a higher auditfailure rate than Big 4 auditors, smaller auditors increase audit fees significantly more tocompensate for their increase in legal liability costs. Assuming that SOX ushered in astricter legal regime, the Choi et al. (2008) findings suggest a decline in the Big 4 auditfee premium for the post-SOX period.

6 The PwC (2008) study also documents that the average number of cases filed post-SOX is lower than the pre-SOX level. This may indicate a less litigious environment for the post-SOX years, but the size of accounting-related settlements indicates otherwise.

7 Most of the assertions on perceived changes in auditor’s litigation risk around SOX are casual observations orclaims based on anecdotal evidence. Although a rigorous study examining the influence of SOX on changes inauditor’s legal liability is beyond the scope of this paper, we believe such a study is likely to provide valuableinsights.



While Choi et al. (2008) model the Big 4 premium as a function of a country’s legalregime and the audit failure rate, in many countries, such as the United States, the strictnessof the legal regime varies by audit firm size. Section 104 of the act directs the PCAOB toconduct annual reviews of all audit firms that audit more than 100 SEC registrants. Con-sequently, the PCAOB has made public its annual reviews of the Big 4 firms, drawingadded scrutiny to their work (Reilly 2007). Additionally, the Big 4 firms audit a dispro-portionate number of large firms, thereby exposing them to a greater number of largelawsuits (Choi et al. 2008). Consistent with this expectation, in a 2007 speech, SEC ChiefAccountant Conrad Hewitt commented that auditor legal liability is worrisome for regula-tors because the Big 4 accounting firms audit most U.S. public companies. An extensionof the Choi et al. (2008) model is that the legal environment may be relatively stricter forthe Big 4 auditors after SOX, allowing Big 4 auditors to potentially increase their premium.We empirically test the impact of SOX on the Big 4 premium.

Fee Discounting and the Sarbanes-Oxley ActPrior literature finds evidence of fee discounting by audit firms to attract new audit

clients (e.g., Simon and Francis 1988; Chan 1999; Craswell and Francis 1999). Ghosh andLustgarten (2006) hypothesize that fee discounting is more intense among small audit firmsthan among large audit firms. The audit market can be grouped into two broad categories:a large number of small auditors offering similar products, and a small number of largeauditors offering specialized audit services. Since audit quality is considered similar acrosssmall auditors, they are expected to compete solely on price and to offer fee discounts toattract new clients. Conversely, large auditors with specialized audit services (the Big 4)are less likely to compete on price because of the fear of price retaliation from rivals. Thus,differences in the degree of competition in the two types of audit markets are consideredas a key explanation for fee discounting in Ghosh and Lustgarten (2006).

One implication of their study is that fee discounting is expected to continue for smallauditors for the post-SOX period because SOX did change the degree of competition amongsmall auditors. While the demise of Andersen reduced the level of competition within largeauditors (i.e., the oligopolistic sector), competition within the non-Big 4 audit market (i.e.,atomistic sector) remained virtually unchanged. In contrast, fee discounting is expected todiminish for large auditors because the downfall of Andersen in June of 2002 increased theconcentration in the market for large auditors. Asthana et al. (2004) find that there is adecline in the frequency of voluntary auditor switches among the Big 4 auditors becauseof an increase in switching costs due to the loss of Andersen. Both these arguments suggestfewer incentives for Big 4 auditors to offer fee discounts to attract new clients after SOX.

EMPIRICAL METHODSLevels Specifications

Researchers analyzing fees paid to external auditors typically regress audit fees onvariables that proxy for the unobservable audit production function and the auditor’s liti-gation risk (e.g., Simon and Francis 1988; Craswell and Francis 1999; Ghosh and Lustgarten2006). The adjusted R2s from these models are quite high, which indicates a low likelihoodthat the experimental variables do not proxy for correlated omitted variables (Craswell etal. 1995). We estimate the following multivariate regression model to estimate the influenceof regulation on audit fees.



Audit fees � � � � SOX � � Auditor � � Herfindahl � � Assets0 1 2 3 4

� � Currentassets � � Currentratio � � Receivableratio5 6 7

� � Inventoryratio � � Leverage � � Profitability � � Loss8 9 10 11

� � Merger � � Opinion � � Segments � � Foreign � ε.12 13 14 15 (3)

Audit fees is the natural logarithm of fees paid to the external audit firm for the fiscalyear’s financial statement audit (from Audit Analytics), and SOX is an indicator variablethat equals 1 if the fiscal year-ends after July 30, 2002, 0 otherwise.8 A positive coefficienton SOX (�1) indicates that, controlling for other factors, average audit fees increased afterSOX.

The control variables are defined as follows: Auditor is an indicator variable that equals1 when the external auditor is a Big 4 or a Big 5 auditing firm (auditor information isobtained from Audit Analytics), 0 otherwise; Herfindahl is the normalized Herfindahl-Hirschman Index (HHI) within each two-digit standard industry classification (SIC) codefor each fiscal year;9 Assets is the natural logarithm of total assets (Compustat item #6);Currentassets is the ratio of current assets (Compustat item #4) to total assets; Currentratiois the ratio of current assets to current liabilities (Compustat item #5); Receivableratio isthe ratio of total receivables (Compustat item #2) to total assets; Inventoryratio is the ratioof inventory (Compustat item #3) to total assets; Leverage is the ratio of total debt (Com-pustat items #9 and #34) to total assets; Profitability is the ratio of income before extraor-dinary items (Compustat item #18) to total assets; Loss is an indicator variable that equals1 for firms with negative income before extraordinary items, 0 otherwise; Merger is anindicator variable that equals 1 if the firm has a nonzero number in the Acquisition/MergerPretax field (Compustat item #360), 0 otherwise; Opinion is an indicator variable that equals1 if the audit opinion (Compustat item #149) is not listed as unqualified, 0 otherwise;Segments is the number of business segments reported in the Compustat Segments file; andForeign is the ratio of sales revenue generated outside of the U.S. to total reported revenuein the Compustat Segments file.10 All the variables are measured as of the end of the fiscalyear.

Because large audit firms charge a premium for providing higher quality audits (e.g.,DeAngelo 1981; Palmrose 1986; Craswell et al. 1995; Choi et al. 2008), we expect apositive relationship between Auditor and Audit fees. We include Herfindahl to control forthe concentration in the audit industry; we expect a positive relationship between Herfindahland Audit fees. We control for client firm size (Assets) because firm size is positivelyassociated with Audit fees (Simunic 1980). We use Currentassets, Currentratio, Leverage,Profitability, Loss, and Opinion as proxies for audit risk, which are also positively correlatedwith audit fees (Simunic 1980; Craswell et al. 1995; Seetharaman et al. 2002). Finally, weinclude Receivableratio, Inventoryratio, Merger, Segments, and Foreign as proxies for auditcomplexity (Ghosh and Lustgarten 2006).

8 We use July 30, 2002, as the cutoff date because President George W. Bush signed the bill into law on thisdate, with the provisions of the act becoming effective after this date.

9 Herfindahl is computed as the sum of the market shares squared for each audit firm for each industry, which isthen normalized by subtracting 1 /n and dividing the difference by 1 � (1 /n), where n is the number of auditfirms in the industry. Refer to the U.S. Department of Justice website (http: / /www.usdoj.gov /atr /public /testimony /hhi.htm) for further details.

10 Segment information is only available for a subsample of 11,257 observations. Therefore, all the tests usingthese variables are confined to the smaller subsample.

http://www.usdoj.gov/atr/public/testimony/hhi.htm

http://www.usdoj.gov/atr/public/testimony/hhi.htm



Because large audit firms with brand-name concerns are potentially more likely to beaffected by the SOX provisions, we also interact SOX with Auditor (SOX * Auditor) toinvestigate whether the increase in audit fees for the post-SOX period is bigger for largeaudit firms. Specifically, we estimate the following augmented model.

Audit fees � � � � SOX � � SOX * Auditor � � Auditor � � Herfindahl0 1 2 3 4

� � Assets � � Currentassets � � Currentratio5 6 7

� � Receivableratio � � Inventoryratio � � Leverage8 9 10

� � Profitability � � Loss � � Merger � � Opinion11 12 13 14

� � Segments � � Foreign � ε. (4)15 16

A positive coefficient on SOX * Auditor (�2) indicates that, controlling for other factors,the average increase in audit fees is larger for the post-SOX period for Big 4 audit firmscompared with small audit firms.

To further investigate the impact of SOX on nonaudit fees and total fees, we modifyEquation (4) by replacing Audit fees with Nonaudit fees and Total fees (both logarithmictransformations).

Nonaudit fees � � � � SOX � � SOX * Auditor � � Auditor � � Herfindahl0 1 2 3 4




� � Segments � � Foreign � ε.15 16 (4a)

Total fees � � � � SOX � � SOX * Auditor � � Auditor � � Herfindahl0 1 2 3 4




� � Segments � � Foreign � ε.15 16 (4b)

Because changes in fees around SOX could reflect changes in sample composition, weconstruct a restricted sample with relevant data for all the years from 2000 through 2005.

Changes SpecificationsAs in Ghosh and Lustgarten (2006), we analyze audit fees for new engagements using

a changes specification rather than a levels specification because Switch is inherently achange variable. Another advantage of using a changes specification is that it mitigatesbiases related to omitted correlated variables. Assuming that the omitted correlated variablesare firm-specific and constant over time, using a changes specification reduces some of thebias problem in cross-sectional regressions (Ghosh and Lustgarten 2006). We estimatethe following change in audit fees model to examine fee discounting.



�Audit fees � � � � SOX � � SOX * Switch � � Switch � � �Herfindahl0 1 2 3 4

� � �Assets � � �Currentassets � � �Currentratio5 6 7

� � �Receivaleratio � � �Inventoryratio � � �Leverage8 9 10

� � �Profitability � � Loss-to-Noloss � � Noloss-to-Loss11 12 13

� � Nomerger-to-Merger � � Merger-to-Nomerger14 15

� � Qualified � � Unqualified � ε16 17 (5)

where Switch is an indicator variable that equals 1 if the external audit firm for the currentyear is not the same as the prior year, 0 otherwise; Loss-to-Noloss (Noloss-to-Loss) is anindicator variable that equals 1 for firms with negative income before extraordinary itemsfor the prior (current) year but not for the current (prior) fiscal year, 0 otherwise; Nomerger-to-Merger (Merger-to-Nomerger) is an indicator variable that equals 1 if the Acquisition/Merger Pretax number is nonzero (zero) for the current fiscal year but not for the prior(current) year, 0 otherwise; Qualified (Unqualified) is an indicator that equals 1 if the auditorissues a qualified (unqualified) opinion for the current year but not for the prior year, 0otherwise; and � represents a change operator defined (difference between the current yearand the prior year). All other variables are as previously defined.

A negative coefficient on Switch (�3) is consistent with fee discounting for the pre-SOX years. A positive (negative) coefficient on SOX * Switch (�2) indicates whether thereis a decline (increase) in fee discounting for the post-SOX period compared with the pre-SOX period.

Because Ghosh and Lustgarten (2006) find that fee discounting varies according toAuditor, we analyze whether fee discounting associated with initial audit engagementschanged following SOX by partitioning the auditor switch sample into two broad groups:(1) when the incoming audit firm is small and (2) when the incoming audit firm is large.11

Therefore, we modify Equation (5) as follows.

�Audit fees � � � � SOX � � SOX * Switch � � SOX * Switch0 1 2 Atomistic 3 Oligopolistic

� � Switch � � Switch � � �Herfindahl4 Atomistic 5 Oligopolistic 6

� � �Assets � � �Currentassets � � �Currentratio7 8 9

� � �Receivableratio � � �Inventoryratio � � �Leverage10 11 12

� � �Profitability � � Loss-to-Noloss � � Noloss-to-Loss13 14 15

� � Merger-to-Nomerger � � Nomerger-to-Merger16 17

� � Qualified � � Unqualified � ε.18 19 (6)

A negative coefficient on SwitchAtomistic (�4) is consistent with fee discounting in the at-omistic market (i.e., when the incoming auditor is small) for the pre-SOX years. Similarly,a negative coefficient on SwitchOligopolistic (�5) indicates fee discounting in the oligopolisticmarket (i.e., when the incoming auditor is large) for the pre-SOX years. A positive (neg-ative) coefficient on SOX * Switch (for �2 or �3) indicates whether there is a decline

11 Ghosh and Lustgarten (2006) partition auditor switches into four categories: (1) prior auditor was large but thecurrent auditor is small, (2) prior auditor was small but the current auditor is large, (3) both the prior and currentauditors are large, and (4) both the prior and current auditors are small. Because we have a small number ofobservations in two of these categories, we focus on the incoming auditor.



(increase) in fee discounting in the post-SOX period compared with those in the pre-SOXperiod for the different market segments.

DATA AND STATISTICSSample Selection

We obtain fee information for 2000 through 2005 from the Audit Analytics database,which compiles audit fee information based on proxy statements filed with the SEC. Wealso obtain the name of the audit firm and the audit opinion (Opinion) from Audit Analytics.Financial data are obtained from the Compustat Annual and Segments files.

The full sample consists of 23,273 firm-year observations from 2000 through 2005 withthe necessary data. For additional tests, we compile two separate subsamples. In the constantsubsample, we require a firm to have data for all six years to be included; in the seg-ments subsample, we require firms to have segment data. The constant subsample includes11,763 firm-year observations; the segments subsample includes 11,257 firm-year obser-vations. Because our analysis also includes auditor switching, which requires two consec-utive years of audit fee data, we create a third subsample to analyze audit fees for firmsswitching auditors after deleting the initial observation for each company. The subsampleanalyzing auditor switching or audit fee changes consists of 17,602 observations. We win-sorize all continuous variables at the 1 and 99 percent levels to reduce the influence ofextreme observations.

Descriptive StatisticsWe report the descriptive statistics in Table 1. For the full sample (Panel A), the average

(median) client firm pays just under $1,765,138 ($550,000) in Total fees to the audit firm.The mean (median) Audit fees are $1,007,155 ($321,200), and Nonaudit fees are $832,125($143,000). The average (median) firm in our sample operates in an industry where theaudit firms have Herfindahl of 0.23 (0.22); owns $2.89 billion ($248 million) in assets; andholds Currentasset of 0.49 (0.49), Currentratio of 2.81 (1.83), Receivableratio of 0.15(0.12), Inventoryratio of 0.10 (0.05), and Leverage of 0.26 (0.19). The average (median)Profitability is �0.14 (0.02), with approximately 40 percent of the observations showing aloss for the fiscal year. The median firm is U.S.-based, did not engage in merger activityfor the fiscal year, did not switch auditors from the previous fiscal year, employs a Big 4(or Big 5) auditor and received an unqualified audit opinion.

In our constant sample (Table 1, Panel B), we find that the average (median) clientfirm pays just under $1,968,020 ($645,000) in Total fees to the audit firm. The mean(median) Audit fees are $1,091,414 ($362,000) and Nonaudit fees are $985,704 ($177,500).The average (median) firm in our constant subsample operates in an industry where theaudit firms have Herfindahl of 0.23 (0.22); owns $2.87 billion ($296 million) in assets; andholds Currentasset of 0.49 (0.48), Currentratio of 2.86 (1.88), Receivableratio of 0.15(0.13), Inventoryratio of 0.10 (0.05), and Leverage of 0.25 (0.20). The average (mean)Profitability is �0.11 (0.02), with approximately 39 percent of the observations showing aloss for the fiscal year. Again, the median firm is U.S.-based, did not engage in mergeractivity for the fiscal year, did not switch auditors from the previous fiscal year, employsa Big 4 (or Big 5) auditor and received an unqualified audit opinion.

The results reported in Panel C for the subsample with segment data are very similarto those in Panels A and B. Thus, the summary statistics do not indicate substantial dif-ferences among the three subsamples.



TABLE 1Summary Statistics

Panel A: Full Samplea

Variable Q1 Median Mean Q3

FeesAudit fees $127,000 $321,200 $1,007,155 $915,000Nonaudit fees $38,550 $143,000 $832,125 $517,000Total fees $199,810 $550,000 $1,765,138 $1,531,000

Firm CharacteristicsAuditor 1.0000 1.0000 0.7974 1.0000Herfindahl 0.1961 0.2217 0.2315 0.2589Assets (millions) $46.506 $248.06 $2,890.3 $1,203.5Currentassets 0.2863 0.4910 0.4940 0.6976Currentratio 1.1482 1.8321 2.8066 3.1590Receivableratio 0.0575 0.1236 0.1492 0.2043Inventoryratio 0.0033 0.0540 0.1029 0.1594Leverage 0.0192 0.1916 0.2605 0.3694Profitability �0.0883 0.0216 �0.1431 0.0647Loss 0.0000 0.0000 0.3960 1.0000Merger 0.0000 0.0000 0.0379 0.0000Opinion 0.0000 0.0000 0.0007 0.0000

Observations 23,273

Panel B: Constant Subsamplea


FeesAudit fees $151,932 $362,000 $1,091,414 $1,023,280Nonaudit fees $52,400 $177,500 $985,704 $611,000Total fees $247,400 $645,000 $1,968,020 $1,757,000

Firm CharacteristicsAuditor 1.0000 1.0000 0.8466 1.0000Herfindahl 0.1904 0.2199 0.2266 0.2544Assets (millions) $67.474 $296.38 $2,873.6 $1,336.0Currentassets 0.2837 0.4785 0.4881 0.6904Currentratio 1.1973 1.8781 2.8615 3.2693Receivableratio 0.0626 0.1253 0.1491 0.2020Inventoryratio 0.0035 0.0491 0.0963 0.1493Leverage 0.0231 0.1966 0.2478 0.3636Profitability �0.0818 0.0219 �0.1088 0.0634Loss 0.0000 0.0000 0.3899 1.0000Merger 0.0000 0.0000 0.0378 0.0000Opinion 0.0000 0.0000 0.0004 0.0000

Observations 11,766

Panel C: Segments Subsamplea


FeesAudit fees $205,436 $526,000 $1,462,664 $1,512,000Nonaudit fees $75,766 $275,000 $1,278,614 $916,000Total fees $346,000 $938,200 $2,609,435 $2,619,000

(continued on next page)



TABLE 1 (continued)


Firm CharacteristicsAuditor 1.0000 1.0000 0.8769 1.0000Herfindahl 0.2008 0.2217 0.2316 0.2575Assets (millions) $98.986 $464.15 $4,089.3 $2,148.2Currentassets 0.3425 0.5073 0.5157 0.6912Currentratio 1.3172 1.9675 2.8073 3.2213Receivableratio 0.0839 0.1438 0.1613 0.2118Inventoryratio 0.0127 0.0834 0.1098 0.1668Leverage 0.0168 0.1766 0.2233 0.3318Profitability �0.0475 0.0278 �0.0625 0.0706Loss 0.0000 0.0000 0.3580 1.0000Merger 0.0000 0.0000 0.0452 0.0000Opinion 0.0000 0.0000 0.0003 0.0000Segments 1.0000 3.0000 3.3468 5.0000Foreign 0.1784 0.4474 0.4993 0.8811

Observations 11,257

a Audit fees are fees paid to the external audit firm for the fiscal year’s financial statement audit, Nonaudit feesare fees paid to the external audit firm for services not related to the audit, and Total fees are the amount offees paid to the external audit firm for the fiscal year. Audit, Nonaudit and Total fees are obtained from AuditAnalytics. Auditor is an indicator variable that equals 1 when the external auditor is one of the Big 4 or Big 5auditing firms, 0 otherwise. Herfindahl is the normalized Herfindahl Index within each two-digit standardindustry classification (SIC) code. Assets is total assets (in millions). Currentassets is the ratio of current assetsto total assets. Currentratio is the ratio of current assets to current liabilities. Receivableratio is the ratio oftotal receivables to total assets. Inventoryratio is the ratio of inventory to total assets. Profitability is incomebefore extraordinary items divided by total assets. Leverage is the ratio of total debt to total assets. Loss is anindicator variable that equals 1 for firms with negative income before extraordinary items, 0 otherwise. Mergeris an indicator variable that equals 1 if the Acquisition /Merger Pretax number is non-zero, 0 otherwise.Opinion is an indicator variable that equals 1 if the audit opinion is not listed as unqualified, 0 otherwise.Segments is the number of business segments reported. Foreign is the ratio of sales revenue generated outsideof the United States to total reported segment revenue. All variables are measured as of the fiscal year-end. Thefull sample (Panel A) consists of 23,273 observations, the constant subsample (Panel B) consists of 11,766observations, and the segments subsample (Panel C) consists of 11,257 observations over the years 2000 to2005.

RESULTSUnivariate Tests

Figure 1 presents the trends in average fees for the years 2000 through 2005. The graphillustrates that audit fees increased monotonically over the sample period. While the in-crease in audit fees between 2000 and 2001 is small, there is a substantial rise in audit feesin each of the subsequent years.12 The monotonic increase in audit fees suggests that thecosts of implementing the various requirements of the Sarbanes-Oxley Act were incurredover multiple years. Costs related to many sections of the act, including those associatedwith audit workpaper retention and review (Section 103), preparing audit workpapers forPCAOB review (Section 101), audit partner rotation (Section 203), and audit committeepreapproval and communication (Sections 202 and 204), are ongoing costs likely to increaseaudit fees every year after SOX. Also, new reporting requirements under Section 401,

12 Studies examining the relationship between audit fees and SOX may suffer from biases because of changes inaudit fee definitions from 2003 (SEC 2003). However, we believe that such a change is unlikely to bias ourresults. The mean increase in audit fees from 2001 to 2002 and from 2002 to 2003, which coincides withchanges in the audit fee definition, is very modest. The largest audit fee increases for our sample occurs between2003 and 2005, after the 2003 rule had already taken effect.



FIGURE 1Trends in Fees Paid to Auditors from 2000 through 2005

Mean Fees Paid to Auditors

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

2000 (n=2,202) 2001 (n=3,409) 2002 (n=4,258) 2003 (n=4,773) 2004 (n=4,799) 2005 (n=3,832)

Fiscal Year

Fee

s P

aid

Total FeesAudit FeesNonaudit Fees

including off-balance-sheet liability reporting under FIN45 (effective December 31, 2002)and special-purpose entity reporting under FIN46R (effective December 31, 2003), demandgreater audit effort from their effective dates forward. Finally, Section 404 became effectiveon November 30, 2004, for large accelerated filers. Firms and their auditors were incurringcosts up to and beyond that date preparing for the internal control documentation and testingrequirements.

In contrast, nonaudit fees declined monotonically over the same period. The decline innonaudit fees is steeper for the years after 2001, which is consistent with the regulatoryrestrictions imposed on audit firms providing nonaudit services.13 Total fees (the sum ofaudit and nonaudit fees) declined from 2000 to 2002, with a slight increase in 2003, butlarge gains subsequent to 2003 (the post-SOX period).

In Table 2 we report the magnitude of the levels and changes in audit fees aroundSOX. For the full sample (Panel A), average Audit fees increased from $533,360 for thepre-SOX period to $1,185,322 for the post-SOX period. The increase in Audit fees of$651,962 (122 percent) over the two periods is statistically significant. In contrast, Nonauditfees decreased from $1,259,634 to $671,364 for the same periods. The decline in Non-

13 Auditors are forbidden from providing the following services to their audit clients: bookkeeping or financialstatement preparation; financial information system design and implementation; appraisal or valuation services,fairness opinions, or contribution in-kind reports; actuarial services; management or human resources functions;broker /dealer, investment advisor, or investment banking services; and legal services or expert services relatedto the audit.



TABLE 2Audit Fees around the Sarbanes-Oxley Act

Panel A: Full Sample

OverallMean

Pre-SOXMean

Post-SOXMean Difference

Audit fees $1,007,155 $533,360 $1,185,322 $651,962**Nonaudit fees $832,125 $1,259,634 $671,364 �$588,270**Total fees $1,765,138 $1,595,982 $1,828,747 $232,765**Observations 23,273 6,360 16,913

Panel B: Big 4 Auditors

OverallMean

Pre-SOXMean


Audit fees $1,216,517 $596,081 $1,478,905 $882,824**Nonaudit fees $1,025,730 $1,438,447 $851,189 �$587,258**Total fees $2,149,264 $1,807,372 $2,293,853 $486,480**Observations 18,559 5,516 13,043

Panel C: Non-Big 4 Auditors

OverallMean

Pre-SOXMean


Audit fees $182,896 $123,443 $195,862 $72,419**Nonaudit fees $69,904 $90,994 $65,305 �$25,689*Total fees $252,834 $214,432 $261,209 $46,777*Observations 4,714 844 3,870

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.Audit fees are fees paid to the external audit firm for the fiscal year’s financial statement audit, Nonaudit fees arefees paid to the external audit firm for services not related to the audit, and Total fees are the amount of feespaid to the external audit firm for the fiscal year. Audit, Nonaudit, and Total fees are obtained from AuditAnalytics.

audit fees of $588,270 (�47 percent) between the two periods is also significant. Total feesincreased from $1,595,982 to $1,828,747 over the two periods, which is a 15 percentincrease.

For firms using large auditors (Table 2, Panel B), these increases are even more dra-matic. We find that average Audit fees increased from $596,081 over the pre-SOX periodto $1,478,905 over the post-SOX period, an increase of 148 percent. In contrast, Nonauditfees decreased from $1,438,447 to $851,189, a decline of 41 percent. Total fees increasedfrom $1,807,372 to $2,293,853 around SOX, which translates to a 27 percent increase.

For firms using small auditors, the increases in Audit fees are much less pronounced.In Table 2, Panel C we find that average Audit fees increased from $123,443 over the pre-SOX period to $195,862 over the post-SOX period. Thus, Audit fees increased by 59 percentbetween the two periods. In contrast, Nonaudit fees decreased from $90,994 to $65,305,which translates to a 28 percent decline between the two periods. Total fees increased from$214,432 to $261,209 (22 percent) over the two periods.

Overall, the univariate results indicate that Audit fees increased while Nonaudit feesdecreased following SOX for both large and small auditors.



TABLE 3Audit Fees and SOX

Independent Variables Coefficient (t-stat)Regression 1

Coefficient (t-stat)Regression 2

Coefficient (t-stat)Regression 3

Intercept 8.86 (317.88)** 9.11 (280.04)** 8.98 (143.92)**SOX 0.55 (54.95)** 0.25 (10.63)** 0.35 (6.89)**SOX * Auditor 0.35 (13.50)** 0.25 (4.86)**Control Variables

Auditor 0.21 (14.45)** �0.07 (�3.02)** �0.01 (�0.12)Herfindahl �0.12 (�1.87) �0.12 (�2.00)* �0.02 (�0.18)Assets 0.54 (180.17)** 0.54 (179.34)** 0.54 (120.38)**Currentassets 0.79 (27.00)** 0.80 (27.34)** 0.80 (17.08)**Currentratio �0.05 (�26.04)** �0.05 (�26.18)** �0.06 (�17.19)**Receivableratio 0.71 (14.66)** 0.70 (14.58)** 0.66 (8.18)**Inventoryratio �0.28 (�7.11)** �0.30 (�7.46)** �0.25 (�3.91)**Leverage 0.02 (1.02) 0.02 (1.23) 0.03 (1.12)Profitability �0.20 (�21.20)** �0.20 (�21.72)** �0.29 (�12.03)**Loss 0.17 (15.31)** 0.17 (15.43)** 0.11 (6.89)**Merger 0.16 (6.61)** 0.16 (6.77)** 0.11 (3.76)**Opinion �0.20 (�1.22) �0.18 (�1.13) �0.79 (�2.20)Segments 0.04 (15.22)**Foreign 0.05 (2.69)**

Adjusted R2 (%) 75.43 75.58 75.28Observations 23,273 23,273 11,257

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The dependent variable is Audit Fees. Audit fees is the natural logarithm of fees paid to the external audit firmfor the fiscal year’s financial statement audit. The explanatory variables are defined as follows. SOX is anindicator variable that equals 1 if the fiscal year-ends after July 30, 2002, 0 otherwise. Auditor is an indicatorvariable that equals 1 when the external auditor is one of the Big 4 or Big 5 auditing firms, 0 otherwise.Herfindahl is the normalized Herfindahl Index within each two-digit standard industry classification (SIC) code.Assets is the natural logarithm of total assets. Currentassets is the ratio of current assets to total assets.Currentratio is the ratio of current assets to current liabilities. Receivableratio is the ratio of total receivables tototal assets. Inventoryratio is the ratio of inventory to total assets. Profitability is income before extraordinaryitems divided by total assets. Leverage is the ratio of total debt to total assets. Loss is an indicator variable thatequals 1 for firms with negative income before extraordinary items, 0 otherwise. Merger is an indicator variablethat equals 1 if the Acquisition /Merger Pretax number is non-zero, 0 otherwise. Opinion is an indicator variablethat equals 1 if the audit opinion is not listed as unqualified, 0 otherwise. Segments is the number of businesssegments reported. Foreign is the ratio of sales revenue generated outside of the United States to total reportedsegment revenue. All variables are measured as of the fiscal year-end. t-statistics are calculated using White(1980)-corrected standard errors. The full sample consists of 23,273 observations and the segments subsampleconsists of 11,257 observations over the years 2000 to 2005.

Multivariate TestsLevels Specifications

We examine whether the increase in audit fees subsequent to SOX remains significantafter controlling for other factors that also influence audit fees, including firm size, auditorsize, and audit complexity. Regression 1 results of Table 3 are consistent with those ofprior studies. The parameter estimates for Assets, Currentassets, Receivableratio, Loss, andMerger are positive and significant at the 5 percent level, while the estimates for Current-ratio, Inventoryratio, and Profitability are negative and significant. Similar to prior studies,the adjusted R2 is high (above 75 percent). More importantly, the parameter estimate ofSOX (�1) is 0.55 (t-stat � 54.95), implying that audit fees are approximately 74 percent



higher for the average firm after SOX.14 Thus, our results are consistent with the hypothesisthat audit fees increased subsequent to the Sarbanes-Oxley Act.

In Regression 2, we interact SOX with Auditor. The coefficient on SOX indicates themagnitude of the increase in audit fees over the post-SOX period for small auditors.The coefficient on SOX * Auditor (�2) indicates the incremental increase in audit fees forlarge audit firms over the same period. A positive coefficient suggests that the fee increasesfor large auditors over the post-SOX period exceeded those of small audit firms.

As before, the coefficient on SOX in Regression 2 continues to be positive and signif-icant (�1 � 0.25, t-stat � 10.63), indicating that even small auditors charged higher feesafter SOX (fees were 28 percent higher). Further, the increase in audit fees for the post-SOX period is significantly higher for large audit firms. The coefficient on SOX * Auditoris positive and significant (�2 � 0.35, t-stat � 13.50). The coefficient estimates indicatethat, after controlling for other factors (including the market concentration for audit ser-vices), large audit firms on average charge 42 percent higher audit fees than small auditfirms in the post-SOX period. Our results indicate that large auditors are more likely to beaffected by the SOX provisions than small auditors.

In Regression 3, we include additional controls for firm complexity which are expectedto be positively related to Audit fees. The results using the segment data are similar to thosefrom the full sample. Both the coefficients on SOX (�1 � 0.35, t-stat � 6.89) and SOX* Auditor (�2 � 0.25, t-stat � 4.86) remain positive and significant. By truncating thesample and including additional controls for firm complexity, the variables for Auditor andHerfindahl lose their significance. The coefficients for the additional complexity measuresare positive and significant, as expected.

In Table 4 we present the results for Total fees and Nonaudit fees for both the fullsample and the subsample including. The results for Nonaudit fees provide consistent ev-idence of a significant decrease in nonaudit fees for the post-SOX period for both smalland large audit firms.15 These results indicate that while, on average, audit firms lost non-audit services from their audit clients, large (Big 4) auditors lost significantly largeramounts.

The coefficient for SOX is positive and significant in the regressions when we use Totalfees as the dependent variable. For both the full sample (�1 � 0.15, t-stat � 6.47) and thesegments data subsample (�1 � 0.22, t-stat � 4.40), only the SOX variable is positive andsignificant at the 0.05 level. The results from these regressions indicate that total feescollected are greater for large auditors (Auditor, �3) and that total fees increased signifi-cantly after SOX (SOX, �1). The coefficients on SOX * Auditor suggest that the gap in totalfees between large and small auditors did not widen after SOX.

We also report the results using a restricted constant sample in Table 5 to mitigate theconcern that a shift in sample composition might drive our results. Consistent with ourprior results, both for the full sample and for the segments sample, we find that (1) thecoefficients on SOX are positive and significant for Audit fees and Total fees regressions,but negative for the Nonaudit fees regression, and (2) the coefficients on SOX * Auditor

14 For a regression where the dependent variable is the logarithmic transformation, the coefficient on a binaryexplanatory variable (such as SOX) needs to be transformed as e� � 1 to calculate a percentage change in thebase dependent variables (audit fees) when the binary variable changes from 0 to 1 (see Kennedy 1992, 223).All regression t-statistics are calculated using White (1980) heteroscedasticity-corrected standard errors.

15 In the regression using the full sample, the coefficients on SOX and SOX * Auditor type are both negative andstatistically significant (�1 � �0.19, t-stat � �4.46; �2 � �0.39, t-stat � �8.44). For the regression based onthe sample with segments data, both coefficients of interest are again negative and statistically significant at the0.01 level (�1 � �0.19, t-stat � �2.08; �2 � �0.42, t-stat � �4.50).



TABLE 4Nonaudit Fees, Total Fees, and SOX

IndependentVariables

Dependent VariableNonaudit Fees

Coefficient (t-stat)Total Fees

Coefficient (t-stat)

Intercept 7.59 (132.70)** 7.60 (70.72)** 9.36 (296.29)** 9.30 (157.08)**SOX �0.19 (�4.46)** �0.19 (�2.08)** 0.15 (6.47)** 0.22 (4.40)**SOX * Auditor type �0.39 (�8.44)** �0.42 (�4.50)** 0.01 (0.41) �0.08 (�1.55)Control Variables

Auditor 0.63 (14.68)** 0.82 (9.38)** 0.22 (9.29)** 0.34 (6.90)Herfindahl �0.07 (�0.65) �0.04 (�0.21) �0.10 (�1.75) 0.02 (0.19)Assets 0.66 (138.27)** 0.64 (90.61)** 0.58 (207.47)** 0.57 (139.05)**Currentassets 1.01 (20.96)** 0.91 (12.20)** 0.88 (31.77)** 0.86 (19.13)**Currentratio �0.04 (�13.72)** �0.05 (�10.08)** �0.05 (�26.11)** �0.05 (�17.53)**Receivableratio 0.75 (9.22)** 0.41 (3.16)** 0.64 (14.06)** 0.53 (6.97)**Inventoryratio �0.53 (�7.68)** �0.50 (�4.57)** �0.44 (�11.53)** �0.42 (�7.02)**Leverage 0.05 (1.83) 0.18 (3.79)** 0.04 (2.51)* 0.08 (2.88)*Profitability �0.24 (�15.45)** �0.26 (�8.15)** �0.22 (�25.19)** �0.25 (�12.54)**Loss 0.13 (7.35)** 0.07 (2.52)* 0.16 (15.25)** 0.10 (6.49)**Merger 0.39 (10.32)** 0.34 (7.34)** 0.24 (11.35)** 0.21 (7.63)**Opinion 0.31 (1.94) �0.53 (�0.47) 0.02 (0.07) �0.66 (�1.14)Segments 0.04 (9.84)** 0.04 (14.08)**Foreign 0.11 (3.55)** 0.06 (3.05)**

Adjusted R2 (%) 61.97 62.71 78.61 78.38Observations 23,273 11,257 23,273 11,257

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The dependent variables are Nonaudit Fees and Total Fees. Nonaudit fees is the natural logarithm of fees paid tothe external audit firm for services not related to the audit. Total fees is the natural logarithm of total amount offees paid to the external audit firm for the fiscal year. The explanatory variables are defined as follows. SOX isan indicator variable that equals 1 if the fiscal year-ends after July 30, 2002, 0 otherwise. Auditor is an indicatorvariable that equals 1 when the external auditor is one of the Big 4 or Big 5 auditing firms, 0 otherwise. Auditoris an indicator variable that equals 1 when the external auditor is one of the Big 4 or Big 5 auditing firms, 0otherwise. Herfindahl is the normalized Herfindahl Index within each two-digit standard industry classification(SIC) code. Assets is the natural logarithm of total assets. Currentassets is the ratio of current assets to totalassets. Currentratio is the ratio of current assets to current liabilities. Receivableratio is the ratio of totalreceivables to total assets. Inventoryratio is the ratio of inventory to total assets. Profitability is income beforeextraordinary items divided by total assets. Leverage is the ratio of total debt to total assets. Loss is an indicatorvariable that equals 1 for firms with negative income before extraordinary items, 0 otherwise. Merger is anindicator variable that equals 1 if the Acquisition /Merger Pretax number is non-zero, 0 otherwise. Opinion isan indicator variable that equals 1 if the audit opinion is not listed as unqualified, 0 otherwise. Segments is thenumber of business segments reported. Foreign is the ratio of sales revenue generated outside of the UnitedStates to total reported segment revenue. All variables are measured as of the fiscal year-end. t-statistics arecalculated using White (1980)-corrected standard errors. The full sample consists of 23,273 observations and thesegments subsample consists of 11,257 observations over the years 2000 to 2005.

are positive (negative) for the Audit fees (Nonaudit fees) regressions, but insignificant forthe Total fees regression. Thus, our results using the restricted sample are very similar tothose using the full sample.

Changes SpecificationsSimilar to Ghosh and Lustgarten (2006), we employ a changes specification to inves-

tigate whether auditors on initial engagements discount audit fees. We report the regressionresults of changes in audit fees around SOX for firms switching auditors in Table 6. We



TABLE 5Audit Fees, Nonaudit Fees, Total Fees, and SOX: Constant Subsample

Dependent Variable

Audit Fees Nonaudit Fees Total Fees

Independent Variables Coefficient (t-stat) Coefficient (t-stat) Coefficient (t-stat)

Intercept 9.08 (208.87)** 7.49 (95.84)** 9.29 (215.39)**SOX 0.39 (11.40)** �0.12 (�1.89)** 0.26 (6.20)**SOX * Auditor type 0.32 (8.68)** �0.50 (�7.58)** �0.04 (�0.97)Control Variables

Auditor �0.09 (�2.78)** 0.58 (9.92)** 0.19 (5.81)**Herfindahl �0.10 (�1.28) 0.14 (0.95) �0.04 (�0.49)Assets 0.55 (130.96)** 0.69 (102.24)** 0.60 (155.41)**Currentassets 0.74 (18.14)** 0.92 (13.55)** 0.83 (20.80)**Currentratio �0.05 (�19.88)** �0.04 (�8.88)** �0.05 (�18.51)**Receivableratio 0.74 (10.84)** 0.79 (6.85)** 0.69 (10.33)**Inventoryratio �0.04 (�0.73)** �0.33 (�3.29)** �0.20 (�3.54)**Leverage �0.05 (�1.84) �0.02 (�0.49) �0.05 (�1.99)*Profitability �0.26 (�16.65)** �0.35 (�14.54)** �0.28 (�18.91)**Loss 0.13 (8.57)** 0.07 (2.64)** 0.12 (8.49)**Merger 0.19 (5.83)** 0.34 (6.41)** 0.23 (7.82)**Opinion �0.34 (1.64) 1.26 (3.44)* 0.90 (3.08)**

Adjusted R2 (%) 75.80 60.84 78.30Observations 11,763 11,763 11,763

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The dependent variables are Audit Fees, Nonaudit Fees, or Total Fees. Audit fees is the natural logarithm of feespaid to the external audit firm for the fiscal year’s financial statement audit. Nonaudit fees is the naturallogarithm of fees paid to the external audit firm for services not related to the audit. Total fees is the naturallogarithm of total amount of fees paid to the external audit firm for the fiscal year. Audit, Nonaudit and Totalfees are obtained from Audit Analytics. Auditor is an indicator variable that equals 1 when the external auditoris one of the Big 4 or Big 5 auditing firms, 0 otherwise. Herfindahl is the normalized Herfindahl Index withineach two-digit standard industry classification (SIC) code. Assets is the natural logarithm of total assets.Currentassets is the ratio of current assets to total assets. Currentratio is the ratio of current assets to currentliabilities. Receivableratio is the ratio of total receivables to total assets. Inventoryratio is the ratio of inventoryto total assets. Profitability is income before extraordinary items divided by total assets. Leverage is the ratio oftotal debt to total assets. Loss is an indicator variable that equals 1 for firms with negative income beforeextraordinary items, 0 otherwise. Merger is an indicator variable that equals 1 if the Acquisition /Merger Pretaxnumber is non-zero, 0 otherwise. Opinion is an indicator variable that equals 1 if the audit opinion is not listedas unqualified, 0 otherwise. All variables are measured as of the fiscal year-end. t-statistics are calculated usingWhite (1980)-corrected standard errors. The constant subsample consists of 11,766 observations for thecompanies that remained in our sample every year from 2000 to 2005.

report the results without including the segment data to maximize the number ofobservations.

In Regression 1, SOX (�1 � 0.18, t-stat � 21.50) continues to be positive and significantat the 1 percent level. Our results suggest that controlling for changes in client character-istics, audit fees for continuing engagements increase an additional 18 percent in the post-SOX period. The coefficient for Switch is negative and significant (�3 � �0.12, t-stat ��7.13), indicating fee discounting of approximately 12 percent for companies that switchedauditors. These results are similar to those reported in Ghosh and Lustgarten (2006).

In Regression 2, we investigate whether the extent of lowballing changed followingSOX. The coefficient on Switch (�3) is negative (�3 � �0.21, t-stat � �5.16), but the



TABLE 6Audit Fee Changes and SOX

Independent Variables Coefficient (t-stat) Coefficient (t-stat)

Regression 1 Regression 2

Intercept 0.09 (12.81)** 0.09 (13.56)**SOX 0.18 (21.50)** 0.18 (20.70)**SOX * Switch 0.10 (2.71)**Control Variables

Switch �0.12 (�7.13)** �0.21 (�5.16)**�Herfindahl �0.01 (�0.21) �0.01 (�0.23)�Assets 0.33 (22.57)** 0.33 (22.60)**�Currentassest �0.09 (�1.90)* �0.09 (�1.90)**�Currentratio �0.00 (�1.45) �0.00 (�1.46)*�Receivableratio 0.09 (1.16) 0.09 (1.19)�Inventoryratio 0.25 (2.50)** 0.25 (2.51)**�Leverage 0.03 (1.06) 0.03 (1.05)�Profitability �0.10 (�9.67)** �0.10 (�9.68)**Loss-to-Noloss �0.03 (�2.26)* �0.03 (�2.27)*Noloss-to-Loss 0.01 (0.52) 0.01 (0.50)Nomerger-to-Merger 0.05 (2.21)* 0.05 (2.20)*Merger-to-NoMerger �0.00 (�0.03) �0.00 (�0.03)Qualified 0.01 (0.10) 0.01 (0.09)Unqualified 0.01 (0.12) 0.01 (0.11)

Adjusted R2 (%) 8.29 8.31Observations 17,602 17,602

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The dependent variable is the percentage change in Audit Fees between the current year and the prior year. Auditfees is obtained from Audit Analytics. The explanatory variables are defined as follows. SOX is an indicatorvariable that equals 1 when the fiscal year-end date is after July 30, 2002, 0 otherwise. SOX*Switch is aninteraction of the SOX and Switch variables. Switch is an indicator variable that equals 1 if the external auditfirm for the current year is not the same as the prior year, 0 otherwise. Herfindahl is the normalized HerfindahlIndex within each two-digit standard industry classification (SIC) code. Assets is the natural logarithm of totalassets. Currentassets is the ratio of current assets to total assets. Currentratio is the ratio of current assets tocurrent liabilities. Receivableratio is the ratio of total receivables to total assets. Inventoryratio is the ratio ofinventory to total assets. Profitability is income before extraordinary items divided by total assets. Leverage isthe ratio of total debt to total assets. Loss-to-Noloss is an indicator variable that equals 1 for firms with negative(positive) income before extraordinary items for the prior (current) fiscal year, 0 otherwise. Noloss-to-Loss is anindicator variable that equals 1 for firms with positive (negative) income before extraordinary items for the prior(current) fiscal year, 0 otherwise. Nomerger-to-Merger is an indicator variable that equals 1 if the Acquisition /Merger Pretax number is zero (non-zero) for the prior (current) fiscal year, 0 otherwise. Merger-to-NoMerger isan indicator variable that equals 1 if the Acquisition /Merger Pretax number is non-zero (zero) for the prior(current) fiscal year, 0 otherwise. Qualified (Unqualified ) is an indicator that equals 1 if the auditor issues aqualified (unqualified) opinion for the current year but not for the prior year, 0 otherwise. � is a change operatordefined as the difference between the number for the current year and those of the prior year. t-statistics arecalculated using White (1980)-corrected standard errors. The sample consists of 17,602 observations over theyears 2001 to 2005.

coefficient on SOX * Switch (�2) is positive (�2 � 0.10, t-stat � 2.71). Our results suggestthat while incoming auditors were discounting audit fees by 22 percent for the pre-SOXperiod relative to what the predecessor auditors were charging, the number declined to 11percent (� �0.21 � 0.10) for the post-SOX period. The coefficient on SOX (�1), whichcaptures the change in fees for continuing audit engagements after the act, continues to bepositive and significant (�1 � 0.18, t-stat � 20.70). Thus, controlling for other factors,



TABLE 7Audit Fee Changes, Fee Discounting, and SOX

Independent Variables Coefficient (t-stat) Coefficient (t-stat)

Regression 1 Regression 2

Intercept 0.09 (12.43)** 0.10 (13.62)**SOX 0.18 (21.82)** 0.17 (20.64)**SOX * SwitchAtomistic 0.01 (0.17)SOX * SwitchOligopolistic 0.23 (4.10)**Control Variables

SwitchAtomistic �0.28 (�11.40)** �0.29 (�3.67)**SwitchOligopolistic 0.01 (0.53) �0.19 (3.86)**�Herfindahl �0.05 (�0.77) �0.05 (�0.85)�Assets 0.33 (22.43)** 0.33 (22.47)**�Currentassets �0.08 (�1.80)* �0.08 (�1.80)*�Currentratio �0.00 (�1.49)* �0.00 (�1.48)*�Receivableratio 0.09 (1.17) 0.09 (1.19)�Inventoryratio 0.24 (2.48)** 0.24 (2.50)**�Leverage 0.04 (1.44) 0.03 (1.41)�Profitability �0.10 (�9.59)** �0.10 (�9.60)**Loss-to-Noloss �0.03 (�2.08)* �0.03 (�2.08)*Noloss-to-Loss 0.01 (0.69) 0.01 (0.69)Nomerger-to-Merger 0.05 (2.12)* 0.05 (2.11)*Merger-to-NoMerger �0.00 (�0.26) �0.00 (�0.26)Qualified 0.01 (0.10) 0.01 (0.10)Unqualified 0.03 (0.23) 0.02 (0.22)

Adjusted R2 (%) 9.12 9.20Observations 17,602 17,602

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The dependent variable is the percentage change in Audit Fees between the current year and the prior year. Auditfees is obtained from Audit Analytics. The explanatory variables are defined as follows. SOX is an indicatorvariable that equals 1 when the fiscal year-end date is after July 30, 2002, 0 otherwise. SwitchAtomistic

(SwitchOligopolistic) is an indicator variable that equals 1 if an auditor switch is in the atomistic (oligopolistic)sector, and 0 otherwise. Auditor is an indicator variable that equals 1 when the external auditor is one of the Big4 or Big 5 auditing firms, 0 otherwise. Herfindahl is the normalized Herfindahl Index within each two-digitstandard industry classification (SIC) code. Assets is the natural logarithm of total assets. Currentassets is theratio of current assets to total assets. Currentratio is the ratio of current assets to current liabilities.Receivableratio is the ratio of total receivables to total assets. Inventoryratio is the ratio of inventory to totalassets. Profitability is income before extraordinary items divided by total assets. Leverage is the ratio oftotal debt to total assets. Loss-to-Noloss is an indicator variable that equals 1 for firms with negative (positive)income before extraordinary items for the prior (current) fiscal year, 0 otherwise. Noloss-to-Loss is an indicatorvariable that equals 1 for firms with positive (negative) income before extraordinary items for the prior (current)fiscal year, 0 otherwise. Nomerger-to-Merger is an indicator variable that equals 1 if the Acquisition /MergerPretax number is zero (non-zero) for the prior (current) fiscal year, 0 otherwise. Merger-to-NoMerger is anindicator variable that equals 1 if the Acquisition /Merger Pretax number is non-zero (zero) for the prior(current) fiscal year, 0 otherwise. Qualified (Unqualified ) is an indicator that equals 1 if the auditor issues aqualified (unqualified) opinion for the current year but not for the prior year, 0 otherwise. � is a change operatordefined as the difference between the number for the current year and those of the prior year. t-statistics arecalculated using White (1980)-corrected standard errors. The sample consists of 17,602 observations over theyears 2001 to 2005.

auditors increased audit fees by an additional 18 percent per year for continuing engage-ments after SOX.

The results in Table 7 provide further insights on the impact of SOX on fee discountingwithin the two market segments (large and small audit firms). In Regression 1, only the



coefficient on SwitchAtomistic is significant (�4 � �0.28, t-stat � �11.40), while that onSwitchOligopolistic is insignificant (�5 � 0.01, t-stat � 0.53). More importantly, the coefficienton SOX continues to be positive and significant, suggesting that audit fees increased for thepost-SOX period. Our results suggest that small audit firms discount audit fees to attractnew clients, while large audit firms do not.

In Regression 2, we interact SwitchAtomistic and SwitchOligopolistic with SOX to investigatewhether fee discounting changed after SOX. We find that the coefficients on SwitchAtomistic

and SwitchOligopolistic are both negative and significant, which suggests evidence of lowballingby large and small audit firms to attract new clients in the pre-SOX period. When weinteract the two indicator variables with SOX, we find that only SOX * SwitchOligopolistic issignificant (�3 � 0.23, t-stat � 4.10). Thus, while large audit firms might have discountedaudit fees for the pre-SOX period, there is no evidence of lowballing in the post-SOXperiod (�3 � �5 � 0.04). The coefficient on SOX * SwitchAtomistic is insignificant (�2 � 0.01,t-stat � 0.17), which suggests that small audit firms were discounting audit fees for newclients during the pre-SOX period and that this phenomenon did not change for the post-SOX period. However, the results on the SwitchAtomistic and SwitchOligopolistic (pre-SOX esti-mates) need to be interpreted with caution because of the small sample size.

Because of econometric concerns from estimating a pooled regression where the errorterm might be serially correlated, we also estimate Regression 1 of Table 7 (without theSOX variable) for each of the years from 2001 to 2005 (untabulated). Consistent with thepooled results, we find that SwitchOligopolistic is only negative and significant (t-stat � �4.86)in 2001 but insignificant for all of the subsequent years, indicating that large auditors wereoffering fee discounts in 2001 only. In contrast, the coefficient on SwitchAtomistic is negativeand significant at less than the 1 percent level for all six years, indicating that small auditorswere offering fee discounts for the entire sample period (both pre- and post-SOX).

Overall, our regression results provide compelling evidence to indicate that audit feesincreased following SOX. This increase in fees is independent of the number of controlvariables included in the regression and does not depend on whether we use a levels orchanges specification. Further, we find strong evidence of fee discounting in the pre-SOXperiod, but this phenomenon declined after SOX. Finally, most of our results suggest thatonly small audit firms discount fees to attract new clients while large audit firms do not.

Explanations for Audit Fee IncreasesOne possible explanation for the increase in audit fees for the post-SOX years is linked

to a stricter legal environment. Related and important questions are whether (1) auditorsincreased audit fees by the same quantity for all clients for the post-SOX years because ofa stringent legal environment and/or (2) the increase in audit fees resulted from a structuralshift in the audit fee structure at the firm level (i.e., client attributes including size, com-plexity, and risk have become relatively more important determinants of audit fees for post-SOX years).

We test these related conjectures by estimating Regression 1 from Table 3 separatelyfor the pre- and post-SOX years.16 We then compare the estimated coefficients between thetwo periods. A larger intercept term (�0) for the post-SOX years, compared with that ofthe pre-SOX years, indicates that all clients are equally affected by the provisions of SOXand are paying higher audit fees during this period. In contrast, larger slope coefficients (�1

16 To maximize the number of observations, we estimate the regression using the unrestricted sample. Becausethere are no observations with a qualified audit opinion for the pre-SOX years, we do not include Opinion inthe regression.



TABLE 8Abnormal Audit Fees and SOX

Panel A: Estimated Regression Coefficients for Pre-SOX and Post-SOX Years

Independent Variables Coefficient (t-stat) Coefficient (t-stat) Difference (t-stat)

Pre-SOX Post-SOX

Intercept �0 9.31 (211.12)** 9.28 (262.72)** �0.03 (�52.87)**Auditor �1 0.08 (3.14)** 0.21 (12.76)** 0.14 (409.46)**Herfindahl �2 �0.01 (.0.17) �0.21 (�2.41)* �0.19 (�149.99)**Assets �3 0.49 (94.06)** 0.56 (154.62)** 0.07 (1,112.22)**Currentassets �4 0.51 (10.38)** 0.92 (25.96)** 0.41 (627.47)**Currentratio �5 �0.05 (�17.38)** �0.05 (�19.97)** 0.00 (49.94)**Receivableratio �6 0.87 (11.38)** 0.64 (10.84)** �0.23 (�219.97)**Inventoryratio �7 0.03 (0.44) �0.43 (�8.68)** �0.45 (�506.88)**Leverage �8 0.03 (0.84) 0.03 (1.88) 0.01 (17.01)**Profitability �9 �0.24 (�13.44)** �0.19 (�17.79)** 0.04 (203.77)**Loss �10 0.15 (8.81)** 0.18 (12.94)** 0.03 (104.21)**Merger �11 0.11 (2.51)* 0.02 (6.59)** �0.09 (�151.43)**Adjusted R2 (%) 74.68 75.07Observations 6,360 16,913

Panel B: Abnormal Audit Fees for Post-SOX Years

Post-SOXMean Median

Reported 12.94 12.90Predicted 12.40 12.42

Abnormal 0.54 (90.59)** 0.48 (25.30)**

*, ** Indicate significance at the 0.05 percent and 0.01 percent levels, respectively.The Pre-SOX (Post-SOX) regression includes all observations from the full sample where the fiscal year-ends onor before (after) July 30, 2002. The dependent variable Audit fees is the natural logarithm of fees paid to theexternal audit firm for the fiscal year’s financial statement audit. The explanatory variables are defined asfollows. Auditor is an indicator variable that equals 1 when the external auditor is one of the Big 4 or Big 5auditing firms, 0 otherwise. Herfindahl is the normalized Herfindahl Index within each two-digit standardindustry classification (SIC) code. Assets is the natural logarithm of total assets. Currentassets is the ratio ofcurrent assets to total assets. Currentratio is the ratio of current assets to current liabilities. Receivableratio isthe ratio of total receivables to total assets. Inventoryratio is the ratio of inventory to total assets. Profitability isincome before extraordinary items divided by total assets. Leverage is the ratio of total debt to total assets. Lossis an indicator variable that equals 1 for firms with negative income before extraordinary items, 0 otherwise.Merger is an indicator variable that equals 1 if the Acquisition /Merger Pretax number is non-zero, 0 otherwise.All variables are measured as of the fiscal year-end and regression t-statistics are calculated using White(1980)-corrected standard errors.In Panel B we compute predicted or counterfactual audit fees for the post-SOX years by interacting theestimated coefficients from the pre-SOX period with all the firm-year specific values for the post-SOX years.

to �11) for the post-SOX years, compared with those of the pre-SOX years, are consistentwith the premise that there is a structural change in audit pricing at the firm level followingSOX.

Panel A of Table 8 presents the audit fee regression results for the pre- and post-SOXyears. In the Difference column, we test whether the estimated coefficients are statistically



different for the post-SOX years. Our results suggest that although the intercept coefficientdeclined for the post-SOX years, the decline is less than 0.5 percent (� �0.03 / 9.31),which is economically insignificant. In contrast, seven of the 11 slope coefficients are largerfor the post-SOX years. Other than Auditor, the variables with larger estimated coefficients(Assets, Currentassets, Inventoryratio, Leverage, Profitability, and Loss) are generally con-sidered various constructs for audit risk. Thus, the relative importance of audit risk ininfluencing audit pricing increased significantly following SOX. Further, Big 4 auditorswere charging higher audit fees during this period.

To assess the aggregate impact of the structural shifts in the estimated coefficients onaudit fees, we compute abnormal audit fees for the post-SOX years using the counterfactualapproach as in Chaney et al. (2004). The counterfactual approach estimates what audit feesfor the post-SOX years would have been had the audit fee pricing environment not changed.Specifically, we compute predicted audit fees for the post-SOX years by interacting theestimated coefficients from the pre-SOX years with the firm-specific values from the post-SOX years. Abnormal audit fees for the post-SOX years are defined as the differencebetween the reported and predicted audit fees.

Panel B of Table 8 presents reported audit fees, predicted audit fees, and abnormalaudit fees. We find that mean and median abnormal audit fees are positive and highlysignificant, where abnormal audit fees are the difference between reported audit fees andpredicted fees. Our results suggest that structural shifts in the audit fee structure at the firmlevel, especially from changes in the pricing of audit risk, resulted in abnormally high auditfees for the post-SOX years.

SENSITIVITY TESTSIn this section we conduct several sensitivity tests. For brevity, we discuss the results

of the tests without reporting them in separate tables.

Audit Fees for Large Auditors from Yearly RegressionsA more refined test for increases in audit fees is to perform yearly regressions (i.e.,

estimate Equation (3) without SOX) and focus on the intertemporal variations in the esti-mated coefficients on Auditor over the sample period. If auditor fees increased followingSOX, we expect the magnitude of the coefficient on Auditor to increase over successiveyears. Consistent with our expectations, we find that the coefficients on Auditor are 0.09,0.10, 0.18, 0.38, and 0.47 for the years 2001 to 2005, respectively. The yearly regressionsindicate that audit fees for large auditors increased monotonically but that the biggest in-creases began in 2002.

Former Andersen ClientsAndersen officially exited the market for audit services after its conviction for obstruc-

tion of justice on June 13, 2002, which is very close to the date used to partition our sampleinto two groups (pre- and post-SOX). The exit of Andersen might confound our fee dis-counting results because it occurred concurrently with the enactment of SOX. To controlfor the effect of ‘‘forced’’ auditor switches, we exclude the switches of former Andersenclients that happened after the firm’s conviction from our sample and reestimate Regression2 from Table 7.

When we eliminate former Andersen client switches, our results remain qualitativelyunchanged. The coefficient for SOX * SwitchAtomistic remains insignificant (�2 � �0.05,t-stat � �0.61), while the coefficient for SOX * SwitchOligopolistic is positive and significant(�3 � 0.22, t-stat � 3.77). The coefficients for SwitchAtomistic (�4 � �0.24, t-stat � �2.95)



and SwitchOligopolistic (�5 � �0.20, t-stat � �3.71) remain negative and significant. By elim-inating clients ‘‘forced’’ to hire new auditors after Andersen’s conviction, we control forthe possibility that forced auditor switches might be an explanation for our findings.

Complexity/Audit Effort RelationshipTo ensure that the results for SOX in our levels regressions are not driven solely by the

complexity of the client’s business, we conduct two additional analyses. First, using asegment subsample, we construct an indicator variable (Complex) that equals 1 if a firmhas Receivableratio, Inventoryratio, Segments, and Foreign values above the median valuesfor each variable, 0 otherwise. We include Complex as an added explanatory variable andreestimate Regression 3 from Table 3; we find that the coefficients for Complex (� � 0.19,t-stat � 6.83), SOX (� � 0.39, t-stat � 7.79), and SOX * Auditor type (� � 0.27, t-stat� 5.15) are all positive and significant.

Second, we reestimate Regression 3 from Table 3 after including Complex and SOX *Complex; we find that only SOX * Complex remains significant. More importantly, SOX (�� 0.38, t-stat � 7.68) and SOX * Auditor (� � 0.27, t-stat � 5.10) remain positive andsignificant. These sensitivity results indicate that companies with more complex operationswere paying significantly higher fees and that the amount of additional fees charged forcomplexity has grown since SOX. Even controlling for the additional increase in audit feesfor complex businesses, we find additional evidence that SOX increased audit fees and theBig 4 premium.

Constant Dollar Audit Fee RegressionsBecause Audit Analytics presents audit fees directly from company disclosures, we

control for the possibility that the results for SOX are partially driven by general priceincreases over our sample period. We scale the audit fees by the GDP deflator publishedby the United Nations for each year and reestimate Regressions 1 and 2 from Table 3.17

For Regression 1, the coefficient for SOX remains positive and significant (�1 � 0.51,t-stat � 48.55) and for Regression 2, the coefficients for both SOX (�1 � 0.21, t-stat� 8.08) and SOX * Auditor type (�2 � 0.36, t-stat � 12.70) are also positive and significant.Our findings that SOX increased audit fees, as well as the Big 4 premium, remain robustwhen controlling for increases in general prices.

High-Litigation IndustriesSeveral studies find that firms in some industries are more likely to be sued than others

(e.g., PwC 2008). To examine whether the impact of SOX on audit fees is stronger forfirms in more litigious industries, we reestimate Regressions 2 and 3 from Tables 3 and 5by including an indicator variable for firms in high-litigation industries. As in prior research(e.g., Francis et al. 1994; Frankel et al. 2002; Ashbaugh et al. 2003), we define Litigationas equaling 1 when firms are from any one of the following industries: biotechnology (SICcodes 2833–2836 and 8731–8734), computers (SIC codes 3570–3577 and 7370–7374),electronics (SIC codes 3600–3674), and retailing (SIC codes 5200–5961); 0 otherwise.

The results show that the Litigation variable is insignificant in all regressions. However,the coefficients on SOX and SOX * Auditor continue to be positive and significant. Thus,our tests indicate that SOX did not alter the increase in audit fees differentially betweenhigh- and low-litigation industries.

17 Data obtained from the United Nations Statistics Division website (http: / /unstats.un.org / ): 2000 � 100; 2001� 102.4; 2002 � 104.1; 2003 � 106; 2004 � 108.8; 2005 � 111.8.

http://unstats.un.org/



CONCLUSIONThis paper studies fees paid to public accounting firms around the Sarbanes-Oxley Act.

Drawing heavily on the audit fee model developed by Simunic (1980), we hypothesize thatkey provisions of SOX increase audit effort, expected auditor legal liability, and, hence,fees. Using a large sample drawn from Audit Analytics between 2000 and 2005, we finda large increase in audit fees following SOX (i.e., for fiscal years ended after July 30,2002). Controlling for other auditor and client characteristics, our results suggest that av-erage audit fees increased by approximately 74 percent following SOX. We also find evi-dence that the post-SOX fee increase is even larger for the Big 4 audit firms. While auditfees increased sharply after SOX, there was a marked decline in nonaudit fees. Overall,total fees (the sum of audit and nonaudit fees) rose, indicating that the total revenue packagefrom the average audit client increased after SOX, even though public accountants wereprecluded from providing specific nonaudit services.

We also find that the fee discounting (lowballing) associated with initial engagementsdocumented by prior researchers (e.g., Craswell and Francis 1999, Ghosh and Lustgarten2006) abated in the post-SOX period. Similar to Ghosh and Lustgarten (2006), we findevidence of fee discounting in the atomistic market segment for the post-SOX years. Whilewe find some evidence of fee discounting by large audit firms in the pre-SOX years, wedocument no such evidence for the post-SOX years. Overall, we find that SOX not onlyincreased audit fees, but also enhanced the large auditor premium, while reducing feediscounts for new audit clients.

REFERENCESAshbaugh, H., R. LaFond, and B. Mayhew. 2003. Do nonaudit services compromise auditor indepen-

dence? Further evidence. The Accounting Review 78 (3): 611–639.Asthana, S., S. Balsam, and S. Kim. 2004. The effect of Enron, Andersen and Sarbanes-Oxley on the

market for audit services. Working paper, Temple University.Bell, T., W. Landsman, and D. Shackelford. 2001. Auditors’ perceived business risk and audit fees:

Analysis and evidence. Journal of Accounting Research 39 (1): 35–43.Burns, J. 2007. SEC’s top accountant favors limiting auditors’ liability, reduce complexity of rules.

Associated Press, January 25, San Diego, CA.Chan, D. 1999. Lowballing and efficiency in a two-period specialization model of auditing competi-

tion. Contemporary Accounting Research 16 (4): 51–72.Chaney, P., D. Jeter, and L. Shivakumar. 2004. Self-selection of auditors and audit pricing in private

firms. The Accounting Review 79 (1): 51.Choi, J., J. Kim, X. Liu, and D. Simunic. 2008. Audit pricing, legal liability regimes, and Big 4

premiums: Theory and cross-country evidence. Contemporary Accounting Research 25 (1): 55–99.

Ciesielski, J., and T. Weirich. 2006. Ups and downs of audit fees since the Sarbanes-Oxley Act. TheCPA Journal 76 (10): 28–35.

Craswell, A., J. Francis, and S. Taylor. 1995. Auditor brand name reputations and industry speciali-zations. Journal of Accounting and Economics 20: 297–322.

———, and ———. 1999. Pricing initial audit engagements: A test of competing theories. TheAccounting Review 74 (2): 201–216.

Cummings, J. 2005. Sarbanes-Oxley fails to slow fraud. Business Finance 11: 9.DeAngelo, L. 1981. Auditor size and audit quality. Journal of Accounting and Economics 3: 183–

199.Fields, L., D. Fraser, and M. Wilkins. 2004. An investigation of the pricing of audit services for

financial institutions. Journal of Accounting and Public Policy 23 (1): 53–77.



Financial Executives International (FEI) 2004. FEI Special Survey on Sarbanes-Oxley Section 404Implementation Executive Summary. Available at: http: / /www.404institute.com/docs/SOXSurveyJuly.pdf.

Francis, J., D. Philbrick, and K. Schipper. 1994. Shareholder litigation and corporate disclosures.Journal of Accounting Research 32 (2): 137–164.

Frankel, R., M. Johnson, and K. Nelson. 2002. The relation between auditors’ fees for nonauditservices and earnings management. The Accounting Review 77 (Supplement): 71–105.

Ghosh, A., and S. Lustgarten. 2006. Pricing of initial audit engagements by large and small auditfirms. Contemporary Accounting Research 23 (2): 333–368.

Griffin, P., and D. Lont. 2007. An analysis of audit fees following the passage of Sarbanes-Oxley.Asia-Pacific Journal of Accounting and Economics 14: 161–192.

Heffes, E. M. 2005. SEC enforcement division: Ratcheting up. Financial Executive 21: 14–16.Iliev, P. 2007. The effect of the Sarbanes-Oxley Act (Section 404) on audit fees, accruals and stock

returns. Working paper, Brown University.Kennedy, P. 1992. A Guide to Econometrics. 3rd edition. Cambridge, MA: MIT Press.Menon, K., and D. Williams. 2001. Long-term trends in audit fees. Auditing: A Journal of Practice

& Theory 20 (1): 115–136.Palmrose, Z.-V. 1986. Audit fees and auditor size: Further evidence. Journal of Accounting Research

24 (1): 97–110.PricewaterhouseCoopers LLP (PwC). 2008. 2007 Securities Litigation Study. New York, NY: PwC

Advisory Crisis Management.Rashkover, B., and C. Winter. 2005. The impact of Sarbanes-Oxley on SEC enforcement in public

company disclosure cases. International Journal of Disclosure and Governance 2: 312–324.Reilly, D. 2007. Audit watchdog report raps Ernst, KPMG. The Wall Street Journal (January 12): C3.Securities and Exchange Commission (SEC). 2003. Final Rule: Strengthening the Commission’s Re-

quirements Regarding Auditor Independence Requirements. Release No. 33-7919. Washington,D.C.: Government Printing Office.

Seetharaman, A., F. Gul, and S. Lynn. 2002. Litigation risk and audit fees: Evidence from U.K. firmscross-listed on U.S. markets. Journal of Accounting and Economics 33: 91–115.

Simon, D., and J. Francis. 1988. The effects of auditor change on audit fees: Tests of price cuttingand price recovery. The Accounting Review 63 (2): 255–269.

Simunic, D. 1980. The pricing of audit services: Theory and evidence. Journal of Accounting Research18 (1): 161–190.

———, and M. Stein. 1996. The impact of litigation risk on audit pricing: A review of the economicsand the evidence. Auditing: A Journal of Practice & Theory 15 (Supplement): 119–134.

U.S. House of Representatives. 2002. The Sarbanes-Oxley Act of 2002. Public Law 107-204 [H.R.3763]. Washington, D.C.: Government Printing Office.

White, H. 1980. A heteroskedasticity-consistent covariance matrix estimator and a direct test forheteroskedasticity. Econometrica 48: 817–838.

Wilcox, K. 2007. Dealing with Sarbox. The Wall Street Journal (June 1): A13.

http://www.404institute.com/docs/SOXSurveyJuly.pdf

http://www.404institute.com/docs/SOXSurveyJuly.pdf

Copyright of Auditing is the property of American Accounting Association and its content may not be copied or

emailed to multiple sites or posted to a listserv without the copyright holder's express written permission.

However, users may print, download, or email articles for individual use.

Ghosh_Pawlewicz_AJPT_2009(1)

Documents

Transcript of Ghosh_Pawlewicz_AJPT_2009(1)