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The accounting scandals of the beginning of the 21st century caused dramatic changes in the field of accounting. Among the direct effects of the Enron scandal are the demise of the fifth largest accounting company in the United States – Arthur Andersen (AA) – and the enactment of the Sarbanes-Oxley Act (SOX), which limits accounting practice, and puts heavy fines on the auditing industry. While the dissolution of Arthur-Andersen mostly affected its former clients, SOX affected the entire field of accounting. Both events, however, allowed researchers in the field to observe firms’ reaction to the changes in the audit industry, which produced a vast empirical literature (Agrawal and Cooper, 2017; Diermeier et al., 2017).
Despite the plethora of empirical findings, there is very little theory that ties between auditing fees, internal auditing practices and legal costs. In this research, it is proposed to fill this gap by providing a game-theoretic multi-period model that captures empirical observations that were made in these recent years. Specifically, the paper presents a model that ties between government penalties and legal costs associated with auditing, auditing fees and firms’ internal auditing practices. In this paper’s principal-agent setting the players are the auditing firm (AF) and the client firm (CF). Client firms are characterized by their credibility, i.e. the reputation of their internal accounting practices. Firms with good reputation are believed to have better internal control practices than firms with bad reputation. The auditing fee depends on the costs that auditor incurs, namely, the auditing cost and the legal costs in case there are errors in the audit. The client firm, on its part, can choose to invest in improving its internal auditing practices and thus, improve its credibility. By improving its credibility, it can reduce the legal costs incurred by the auditor and hence the fees it has to pay the auditor.
The findings of this paper are that in equilibrium there is a threshold level of credibility that firms must meet. This threshold level is positively tied with the expected legal costs and thus, explains why firms adapted to SOX with increasing accounting conservatism. Moreover, firms who are considered to be less credible will pay increased auditing fees. This paper’s model, however, predicts that these firms will align themselves to the new threshold level sooner rather than later, and that in consecutive periods auditing fees for these firms will align themselves with the rest of the industry.