How do audit fees change? Effects of firm size and section 404(b) compliance

The purpose of this paper is to investigate the effect of the size of the audit firm and compliance with Section 404(b) on how audit fees change over time.

This study uses panel data and an OLS regression to examine the relationship between audit fee changes, firms’ size and Section 404(b) compliance.

Section 404(b)-compliant companies experience a larger change in audit fees if they are audited by Big 4 firms than second-tier firms. Second-tier audit firms increase the fees primarily for the companies which do not comply with Section 404(b).

Regulators have been concerned with the Big 4 fee premium for four decades. This study informs regulators that the Big 4 continue increasing their fees at a higher rate than second-tier firms for their Section 404(b)-compliant clients (even though recent research shows that second-tier firms have increased quality to match the Big 4). This suggests that the Big 4 fee premium increases for this subset of clients, adding to the regulatory concerns.

While prior research has established the existence of the Big 4 fee premium, little is known about how this premium changes over time. Prior research shows that audit fees increase when internal controls are weak; however, little is known about how Section 404(b) compliance (once control effectiveness is controlled) affects fee changes. This paper addresses these voids in research.