Auditors’ Fee Premiums and Low Quality Internal Controls

Abstract

We examine the relation between low quality internal controls and audit fee premiums. Using a novel dataset of audit hours and audit fees we find, consistent with the audit risk model, that auditors increase their effort (hours) due to low internal control quality. We find that auditors also charge a significant fee premium to clients with internal control weaknesses. This premium is observed for severe internal control weaknesses and companies with low quality alternative governance mechanisms. The results are robust to multiple methods to address endogeneity including company-fixed effects, difference-in-differences design, and a propensity-score matched sample. Taken as a whole, low internal control quality leads to fee premiums, which are a deadweight loss to client companies.

Keywords: Internal control, Audit fees, Auditor effort, Risk premium, Korea

JEL Classification: M4, M42