Corporate Governance and Audit Fees:

Evidence of Countervailing Relations

Paul A. G r i f f i n a * , David H. L o n t b * and Yuan S u n b *

“University of California
’University o f o t a g o
Received August 2007; Accepted May 2008

Abstract

This study documents that audit fees, and hence audit quality, and governance reflect two
countervailing relations, namely, a fee increase because of exogenous changes in expected liability
that require greater auditing and other mechanisms to attain better governance, and a fee reduction
because auditors reduce the price of risk to reflect the benefits of better governance. The study
period provides an interesting setting to test these relations because it covers the passage of the
Sarbanes-Oxley legislation, which imposed a substantial cost on many companies to strengthen
governance, including increased auditing and internal control spending. Yet, after controlling for
such increased spending, our results also suggest that better governance reduces the cost of
auditing.

JEL Classijications: C30, G34, K22, M42, M48

Keywords: auditing, audit fees, corporate governance, Sarbanes-Oxley

1. introduction

This study suggests that audit fees, and hence audit quality, and corporate governance
are jointly determined. To show this, we derive and test a framework that reflects two

‘ We thank an anonymous JCAE reviewer, Sandra Chamberlain, Jong-Hag Choi, Elizabeth Demers, Steve
Hillegeist, Michael Maher, Prasad Naik, Ramanan Venkataraman, and Ning Zhu for their useful comments and
suggestions. We thank Sanjai Bhagat for data on median director’s holdings. We also thank participants at the
following presentations of earlier versions: The 4IhAnnual Corporate Governance and Financial Reporting
Seminar, Irvine, California, September 2007, INSEAD, France, October 2007, the 5IhAnnual Australasian Audit
Research Forum, Canberra, November 2007, the Joint JCAEIAJFT Symposium, Hong Kong, January 2008, and
the Leon Recanati Graduate School of Management, Tel Aviv, January 2008.
 Paul A . GrifJin,David H . Lont and Yuan Sun 19
Journal of Contemporary Accounting & Economics Vol4, No I (June 2008) 18-49

countervailing relations between governance and audit fees, namely, a fee increase
because of exogenous changes in expected liability that require greater auditing and other
mechanisms to attain better governance, and a fee reduction because auditors reduce the
price of risk to reflect the benefits of such better governance.’
Most archival studies on this topic (explained further in Section 2) draw conclusions
based on audit fee models that assume, in effect, that governance affects auditing but not
the reverse. For example, Carcello et al. (2002) document a positive relation between audit
fees and board characteristics and conclude that stronger boards purchase more auditing
services, which increases fees. Tsui et al. (2001) find a negative relation between audit
fees and board characteristics and conclude that better governance reduces control risk,
which decreases fees. They also find that company growth opportunities moderate the
reduction in control risk.
The implied modeling assumption in these studies - that governance affects audit fees but
not the reverse - seems unrealistic, however. Company boards often purchase additional or
higher quality auditing services (outside or internal) to effect better corporate governance,
which in turn influences how auditors audit. If governance choices affect auditing and
vice versa, that is, they are co-determined variables, traditional regression methods can
misrepresent what may be jointly determined positive and negative relations. Bedard and
Johnstone (2004), for example, find that auditors’ planned billing rates and chargeable
hours vary positively with assessed earnings management risk and negatively with the
interaction of assessed earnings management risk and reduced governance risk. This is
prima facie evidence of a joint determination. But it is unclear from the models in that
study whether audit fees are determined by auditors’ independent or joint (endogenous)
assessments of earnings management risk and corporate governance. Such assessments
are endogenously determined if, for example, auditors’ views of corporate governance
derive in part from the planning and conduct of the audit and vice versa. Assuming this
is a most likely and logical situation, additional structure is required for a most accurate
representation of the relation between audit fees and governance. This paper offers one
such structure or framework?
The potential for misrepresentation may also be important practically because regulators
and others need accurate assessments of the consequences of their actions. For instance,
some commentators (e.g., Butler and Ribstein, 2006) have expressed concern about the
high growth and cost of auditing and internal control in recent years, in part as a result
of the Sarbanes-Oxley Act of 2002 (hereafter, SOX). Better knowledge of the benejits of

’ We define corporate governance as a portfolio of mechanisms, procedures, standards, and other activities
that control the conflicts of interest that can occur when contracting parties seek outcomes that differ from those
sought by the company. Many conflicts occur and create agency costs because investors and creditors provide
capital to the company as principals and delegate some aspects of the operating, investing, and financing deci-
sions to others in the company as agents or managers. Auditing is one mechanism companies use to control
agency costs (Watts and Zimmerman, 1983).
’ The need to pay greater attention to the structure of how corporate governance interacts with economic
variables has been leveled at the governance literature generally; most often at the empirical studies of the rela-
tion between governance and company performance. For instance, Shleifer and Vishny (1997). Hermalin and
Weisbach (2003),and Gillan (2006) all call for greater attention to structural models that reflect how governance
and company performance may be jointly determined. DeFond and Francis (2005) also comment on the issue
of jointly determined variables in the context of “difficult” research design issues in auditing research.
20 Paul A . Grifln. David H . Lont and YLiun Sun
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such increased auditing and control spending to improve corporate governance such as an
offset to higher audit fees may help mitigate these concerns.
We first state an economic framework that adds further structure to Simunic (1 980)
by assuming that auditing is one of several mechanisms available to a company board to
achieve optimal corporate governance,and that the auditor shares in the costs and benefits of
changes in governance as a change in the equilibrium quantity or price of auditing relative
to the use of other resources for governance.We then test an audit fee model consistent with
this framework.’ Our model regresses audit fees on governance (more specifically,proxies
that suggest a need or demand for governance), audit risk, and other variables, adjusts for
the joint relation between audit fees and governance, and includes interaction variables
to capture possible joint governance-auditing effects. We test for a positive coefficient
on measures of governance and a negative coefficient on the interaction between such
measures and the audit risk determinants in an audit fee model.
Consistent with our framework, we find a significant positive relation between audit
fees and several measures of governance because, in effect, auditing is one mechanism
of governance and/or is positively correlated with similar mechanisms. We also find a
significant negative relation between governance and audit fees, not because auditing
affects governance (a positive relation), but because auditing as a governance mechanism
affects the interaction of governance and audit risk (a negative relation). We base our
results mostly on an instrumental variable derived from the components of the corporate
governance G-index, as outlined in Gompers et al. (2003). We draw similar conclusions
when we test our hypotheses based on governance alternatives such as board or audit
committee independence.
Our results cover audit fee and financial and governance data from 2000 to 2006. The
period after the passage of SOX in July 2002 is especially interesting in that the legislation
may have created a “natural” experiment to study the impact of increased corporate
governance. SOX forced many companies to incur substantial resources on governance,
including increased fees for auditing and internal control that they might not otherwise
have incurred (Hartman, 2007). Such audit fee increases have been partly explained in
terms of increased effort and risk sharing by the auditor as a result of additional liability
under SOX (Dyck et al., 2007; Griffin and Lont, 2007). Yet, after controlling for differences
in effort and risk sharing, we document two further possible influential factors, namely,
that the audit fee increases following the passage of SOX vary positively with proxies for
corporate governance and negatively with the interaction of such governance proxies and
audit risk.
Our study contributesto the literature in two principal ways. First, we state aframework
that unifies the joint relation between audit fees, and hence audit quality, and corporate
governance. Second, we conduct tests that show results consistent with this framework,
wherein increased audit fees create a mechanism for better governance, which in turn leads

’We acknowledge that ours is not the only framework to explain the interaction of corporate governance
and auditing. Others include models based on an auditor’s decision to accept a client (e.g.,Johnstone and Bedard.
2003) or agency theory (e.g.,Hermalin, 2008). We adapt the Simunic (1980) model, in part, because it offers a
structure wherein auditors and companies interact in a competitive market setting to establish optimal prices and
quantities of the alternative governance mechanisms. including auditing. We comment on this further when we
introduce the model in Section 2.
 Paul A. GrifJin, David H . Lont and Yuan Sun 21
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to an offset in audit fees through a reduction in the price of risk. Our estimate of this audit
fee offset appears to be economically relevant.
Section 2 reviews the literature and states the framework and hypotheses. Section
3 describes the data and sample. Section 4 states the empirical models and summarizes
the regression results. Section 5 discusses additional tests to check the consistency and
reliability of the results. The final section summarizes the study and suggests areas for
future research.

2. Literature, Economic Framework, and Empirical Models

2 .I Related literature

The literature on relations between governance and company activities and events
has grown considerably in recent years, spurred in part by SOX and related legislation in
response to perceived breakdowns of corporate governance. Several papers examine the
notion that better governance leads to better operating or stock market performance! A
smaller set of papers addresses the relation between corporate governance and auditing,
premised on the idea that superior governance may impact the amount and quality of
auditing. For example, Carcello et al. (2002),Abbott et al. (2003), Fan and Wong (2005),
and Goodwin-Stewart and Kent (2006) adopt a board or shareholder perspective. They
propose and find a positive relation between governance and auditing, because the demand
for stronger corporate governance induces a company to apply more or better quality
resources to auditing and control.
Others suggest and document a negative relation between governance and auditing.They
contend that better governance reduces control risk and ensures higher quality reporting,
which enables a reduction in audit risk and fees. Cohen and Hanno (2000) interview subjects
and conclude that superior governance enables auditors to reduce substantive testing. Tsui
et al. (2001) find a negative relation between board independence and audit fees, which
they suggest arises because of the effect of governance on audit risk. Cohen et al. (2002)
use an experiment to show that auditors consider governance factors, especially the role
of management, in planning and executing an audit. Bedard and Johnstone (2004) rely
on partners’ assessments of risk in planning and pricing decisions and find that planned
audit fees vary positively with earnings management risk and the interaction of earnings
management risk and governance risk. Finally, Mitra et al. (2007) test relations between
institutional ownership characteristics and audit fees. They report a positive relation when

For example, Gompers et al. (2003), Bebchuk at al. (2004), Brown and Caylor (2006), and Larcker et al.
(2007) find positive relations between company performance and indexes of corporate governance (appropri-
ately signed). Masulis et al. (2007) further explain the company performance-governance link by documenting
that companies with more anti-takeover provisions experience negative stock returns around acquisition an-
nouncements. Other studies select a smaller number of governance features such as board or committee inde-
pendence and insider or board ownership to test their empirical propositions. Bhagat and Bolton (2008) propose
and test a simple measure of governance - dollar ownership of board members - which they find correlates well
with future operating performance and disciplinary actions by the board for poor performance. It is not our inten-
tion to review the literature in finance, however, which is extensive. For a recent review of the finance literature,
see Gillan (2006).
22 Paul A. GrifJin, David H . Lont and Yuan Sun
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institutional ownership is diffused because such investors need better governance, which
induces boards to purchase higher quality auditing. They also report a negative relation
when institutional ownership is more concentrated because concentrated (block) owners
monitor better, which reduces audit risk.

2.2 Economic framework

Optimal Corporate Governance:Our framework extends Simunic’s (1980) audit fee

model by assuming that a company derives its optimal governance portfolio by choosing
appropriate quantities of external and internal governance mechanisms, in this case,
independent auditing and internal control, to equate the total cost of governance with
the total benefit of governance. We assume two determinants of governance at this stage
for simplicity; we include additional determinants later (Section 2.3). Using Simunic’s
(1980) notation, the company selects an optimal governance portfolio by choosing a pair
of internal control and auditing resources ( d , Q )at prices v and c , respectively, conditional
on the expected liability from bad financial statements, E(dld, Q),such that the total cost
equals the total benefit of governance.
In this setting, internal control and auditing resources are acquired to the point where
the marginal reduction in expected liability E(dla, q ) from internal control u equals v and
the marginal reduction in E(dla, q) from q equals c. The company is assumed to trade
off a and q , such that da/dq < 0.5Simunic (1980) also assumes that the company’s cost
minimization problem to derive the pair (a, $) does not depend of how E(dld, $) is shared
between the auditor and the company; in other words, the fee always fully price-protects
the auditor for expected company liability.
Given expected liability E(dl6, Q),optimal corporate governance then simplifies to the
choice of d and $. But d and Q are conditional on the price of internal control, v , and the
price of auditing, c. As such, if prices v and c change, the company trades off a resources
for q resources and vice versa. For example, if c decreases relative to v , we should observe
an increase in auditing, q, and a decrease in internal control, a , to the point that the total
cost equals the total benefit of governance.
An Exogenous Change in Corporate Governance:Whether defined as a reduction in
expected liability E(dld, Q) or, more generally, as any exogenous shift to improve corporate
governance, the benefits of stronger governance do not occur without cost. Legislators and
regulators may impose new standards of internal control, stronger and more qualified boards,
greater transparency of accounting and disclosure, tougher rules and stiffer penalties, and
greater liability on those not in compliance with such improved corporate practices.

Several sources of evidence support this assumption. Wallace (1984). Felix et al. (2001). and Jensen and
Payne (2003) provide empirical evidence consistent with a trade-off between auditing and internal control costs.
A trade-off is also implied by US auditing standards, most recently,Auditing Standard No. 5 (Public Company
Accounting Oversight Board, 2007), which advocates a “top down” approach for the auditor to understand the
risks inherent in a company’s internal controls and to test those controls commensurate with such risks. Some
studies report a positive relation, however, although many of those examine audit fees in non-US environments.
notably in Australia, where the auditing regulations are different. Other studies find that the positive relation
disappears when external audit and internal audit costs are adjusted for common variables such as company size
and complexity (e.g., Carcello et al., 2005).
 Paul A . GrifJin, David H. Lont and Yuan Sun 23
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Consider an exogenous change in corporate governance as a change from E(dla, q ) to

E(d*la, q ) ,where d* reflects a portfolio of governance mechanisms with lower expected
liability. Ford* < d, the company will use more of a and q such that the marginal reduction
in E(d*l a , q ) from a equals v and the marginal reduction in E(d*l a , q) from q equals c.
4).
Assume the ( a ,q ) pair for cost minimization given d* is (a*, 4
For a^ > li and > 4, assuming
prices are unchanged, internal control and auditing costs increase. In other words, in this
setting, stronger corporate governance from d to d* is achieved partly by an increase in
audit fees.
Audit Risk and the Price of Auditing: How might auditors price the increased auditing
resources, 4, needed to achieve the lower expected liability? The auditor in Simunic
(1980) is always fully price-protected by the audit fee, and so there is no reason to re-
price auditing resources given lower expected liability. This is not realistic, however, so
we relax this assumption such that the price of auditing, c, varies positively with expected
liability. This changes the minimum cost of auditing resources for expected liability d*.
For example, if the price of auditing, c, decreases due to lower expected liability, a higher
level of governance is achieved at a lower total cost by substituting auditing resources, q,
for internal control resources, a. Figure 1 explains this further.
Optimal corporate governance is achieved in Figure 1 at the point of tangency of the cost
lines C, ,C,, or C, and the governance output functions G I ,G,, or G,. Thus, for an assumed
initial level of governance, G I ,an optimal quantity of auditing is achieved at q , , where C,
intersects with G ,. We assume that q , exceeds qo,the minimum level of auditing required
by law or regulation. If a higher level of governance, G,, is required, this is achieved with
higher auditing resources, q2,Assuming no change in the price of auditing, that is, the slopes
of C, and C, are equal, this leads to an unambiguous increase in audit fees. However, if we
assume that an increase in governance also reduces the price of auditing, but not internal
control, this flattens the cost lines, C, or C,.
Figure I also explains the likely empirical effects on audit fees of a change in
governance. Assuming no change in the price of auditing, we should observe an increase
in audit fees as auditing resources increase from q, to q2(or q , to 4,). Stronger governance,
however, moderates the audit fee increase because the price of auditing falls. One such
level of stronger governance, G,, is achieved at a total cost C, < C,, which uses fewer
auditing resources q, < q,. Findings consistent with these predictions would, therefore,
demonstrate two relations. First, we should observe that audit fees vary positively with
a change in corporate governance (e.g., a shift from G, to G , or G,) and, second, audit
fees should vary negatively with the interaction of corporate governance and audit risk (a
shift in the slope of C, or C, to the slope of C,). This second relation occurs because the
reduction in the price of audit risk that occurs endogenously with the auditing response to
stronger governance also decreases audit fees.

2.3 Models

We first specify a general governance relation (how auditing services affect governance)
and a general auditing relation (how governance affects auditing). Our functional form of
the governance relation is:
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Journal oj'contemporary Accounting & Economics ViA 4 , No I (June 2008) 18-49

Figure 1

Internal Control, Auditing, and Optimal Corporate Governance

Internal
control, a

%I 4, 9, 4? Auditing, 4

In this figure, u and 4 represent the quantities of internal control and auditing resources used by a company with
relative costs C , ,Cz,or C,. G , ,Gz,or G, each represent levels of equal governance for various combinations of (1
and y.The profit-maximizing amounts of auditing, 4. are at 4 , ,4?,and q, for the costigovernance combinations,
K,,Gl). (CzG,), and (C3,GJ.respectively.

where G is a measure of governance, a and q are proxies for internal control and auditing,
respectively, and x is a vector of all other determinants of G. We include x in Model 1
because it is unrealistic to assume governance is determined by internal control and auditing
alone, as we assumed earlier. We also state an auditing relation in the form of

q = f ( e ,r , G , r G ) ,

where q measures auditing, e and r are vector measures of audit effort and audit risk,
 Paul A. Grzfin, David H . Lont and Yuan Sun 25
Journal of Contemporary Accounting & Economics Vol4, No 1 (June 2008) 18-49

respectively, G measures governance, and r . G reflects the interaction of governance

and audit risk. Since G and q are co-determined variables given Models 1 and 2 , single-
equation estimation of the auditing relation can produce bias in the coefficients of G and
r.G and, possibly, misleading inferences based thereon. We, therefore, use a two-stage
approach, where the first stage derives an instrumental variable for G, namely, the fitted
value of a regression of G on a and x, which we denote in our auditing relation as G .
More specifically, we test the auditing relation as an audit fee model of the following
form:

where LAFE = log of audit fees (qc in terms of the economic framework), ei = audit effort
c
proxy i, rj = audit risk proxy j , = an instrumental variable for corporate governance, G,
and e = uncorrelated random error. We rely on the prior literature to select or develop the
proxies for audit effort, ei, audit risk, rj, and governance instrument, G.6
We assume in this specification that the audit fee determinants rj and instrument G
proxy reasonably for the amounts of audit risk and governance, respectively, assessed by
auditors in determining fees. As such, it is reasonable to interpret the coefficients in Model
3 for audit risk and the interaction of audit risk and governance as indicators of how those
determinants are priced into audit fees.

We use the coefficients from Model 3 to test the following hypotheses:

The governance hypothesis (H,): That audit fees vary positively with corporate
governance,i.e., that P, > 0 versus the null hypothesis
that P, 5 0.

The audit pricing hypothesis (H2): That audit fees vary negatively with the interaction of
audit risk and governance, i.e., that P, < 0 for audit
risk proxy j versus the null hypothesis that 6 , ~0.

Rejection of null hypotheses H, and H, would be consistent with our economic

framework, which reasons that even though better governance, including auditing, is costly
and, thus, we should expect a positive relation between auditing and governance (H,),better
governance also enhances financial statement quality and mitigates control risk, which
enables auditors to decrease the price of audit risk and, thus, reduce their fees (H2).

We define and motivate the audit effort, audit risk, and governance variables in Section 3. Briefly, when G
is defined in relation to the G-index, we expect a positive relation between G and q because higher G reflects
higher agency costs. Similarly, we expect a positive relation between G and q when G is defined in terms of
board and audit committee independence because independent committees may demand more and better audit-
ing to solve the agency problem.
26 Paul A . Grifln, David H . Lont and Yuan Sun
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3. Data, Governance Proxies, and Sample Characteristics

3.1 Data

We obtain data on audit fees and other aspects of the services provided by auditors from
data sets maintained by Audit Analytics, in particular, the Audit Analytics’ audit fee, audit
opinion, and auditor change files. These files extract data from SEC registrants’ DEF14-A
proxy statement filings (for audit and other fees) and Form 8-K and Form 10-K reports
(for information on reportable events, auditor changes, and disagreements), and relate
to fiscal years 2000 to 2005. We then merge these company-year audit fee observations
(approximately, 45,000) with those that have annual financial statement data available
on Cornpustat and analyst coverage data on the Institutional Brokers’ Estimate System
(ZBES) for at least some of those same fiscal years. This generates a sample of a maximum
of 18,923 company-year observations, comprising companies with fiscal year ends from
2000 to 2005, SEC filing dates from January 26,2001 to July 25,2006, and audit fee and
financial statement data for the audit effort, e , and audit risk, r , determinants in Model 3.
We obtain additional data on litigation risk from a securities class action database
maintained by ISS, Inc.7 Because ISS maintains comprehensive coverage of securities class
action litigation, we reasonably assume that the companies not in this database, at least
through July 25,2006, have not been sued in an earlier securities class action litigation.This
sample, hence, remains unchanged at a maximum of 18,923 company-year observations
when we combine it with the class action litigation data. We refer to this sample as the
“audit fee” sample.
We then merge the audit fee sample with the IRRC Governance database to obtain a
second sample of a maximum of 6,448 company-year observations over the filing date
period January 26,2001 to July 25,2006 (“governance” sample). Because IRRC produces
the governance data bi-annually, in January or February of each year, starting in 2000, we
assign each year of produced data to two years - the year of production and the succeeding
year, where a year is defined as the calendar year of the filing date.
We also use information on the board of directors and the audit committee to measure
aspects of governance. We obtain these data from the IRRC Directors’ database. Our sample
size drops to a maximum of 5,277 company-year observations for fiscal years 2000 to 2005
when we merge the governance sample with the Directors’ database (“directors”’ sample).
Note that the directors’ data are available annually from 2000 to 2005 and, so, we tag the
data by fiscal year (rather than calendar year of the SEC filing).
Our main tests, however, require governance proxies, which are only available for the
IRRC governance and directors’ samples. As we show later (Section 3.3), these samples
differ in their composition from the larger audit fee sample and, hence, results based on
these samples are unlikely to generalize to those companies in the audit fee sample not in
the other samples.

‘We state a maximum size for each sample because in later analysis we examine partitions of these samples,
for example, the audit fees of companies audited by a Big N auditor, and before and after SOX passage in
2002.
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3.2 Governance proxies

Our first proxy, G, is the fitted value of an ordinary least squares (OLS) regression of the
Gompers et al. (2003) G-index on 33 individual governance variables in the Governance
database (included in Model 1 as x ) and an estimate of internal control spending (included in
Model 1 as a ) ,based on Carcello et al. (2005).'We use a subset of the governance variables
in the Governance database by including only those with a significant coefficient (t value
significant at less than five percent). Unreported analysis shows that most coefficients have
an estimated value of close to plus or minus one, and the regression attains an adjusted R2
of over 90 percent. Log of internal audit budget (our estimate of internal control spending)
is also highly significant in explaining the G-index.
Our review of the finance and accounting literature on corporate governance indicates
widespread use of the G-index as an overall measure of corporate governance. However,
as explained in Gompers et al. (2003), the G-index (and hence G) is primarily a function
of the number of anti-takeover and other (e.g., charter) provisions relating to the rights
and powers of managers relative to shareholders such that the more provisions that favor
management over shareholders the higher the index. At first glance, therefore, we are
tempted to interpret lower (higher) levels of the index as suggesting stronger (weaker)
corporate governance and, indeed, those studies that examine the relation between the
G-index and company performance apparently premise their analysis on this view.
However, a higher level of the index is also symptomatic of higher agency costs, more
entrenchment, and greater management inefficiency (Masulis et al., 2007) and, thus, from
the standpoint of an auditor or board, this is a reason to apply increased resources to
governance mechanisms such as auditing, q , and internal control, a. In other words, for
those companies with high agency costs as reflected by a high index, a way to mitigate
such restrictions is to increase auditing, thereby improving governance. Such increased
auditing should result in a reduction in control risk for those with high agency costs (as
reflected by a high index). That is, more auditing through its effect on governance lowers
audit risk and, therefore, moderates the higher fees driven by a higher index.
A higher index also increases the likelihood that shareholders and boards may introduce
additional mechanisms to attain better governance, such as appointing a more independent
board and/or a stronger audit committee, which we include in Model 1 as part of x .
Interpreted in this way, we expect a positive relation between audit fees and (or the c
G-index). We also expect positive relations among (or the G-index) and our other proxies

* Since we cannot observe internal control spending, we derive a proxy for a based on a model of the log of
internal control spending in Carcello et al. (2005). That study reports the regression coefficients for 20 key fac-
tors, which explain about 45 percent of companies' actual internal audit budgets for 2002 (both the in-house and
outsourced portions) (Carcello et al., 2005, Table 3 ) . We then multiply the regression coefficients reported in
Table 3 of Carcello et al. (2005) by the equivalent regression variables for the companies in our sample (except
for Stock issue, Debt issue, Budget AC, and Outsource, which were not available for our sample) to obtain a
proxy of internal control spending for the companies in our sample. This measure, which is in log form, should
he better than others used in prior research, for example, based on the number of internal audit employees
(Goodwin-Stewart and Kent, 2006), as it is based on actual budgeted amounts.
28 Paul A . Gr$fin, David H . Lonr and Yuun Sun
Journal of Conternporury Accounting & Economics vOl4, N o I (June 2008) 18-49

for governance since, at a minimum, they should reflect common dimensions?

Our second proxy equates governance to the fraction of non-management (outside)
directors on the board. We derive the director type from the Directors' database and denote
the proxy as IDIR in the empirical analysis. Consistent with prior research (eg., Larcker
and Richardson, 2004), we premise this variable on the assumption that non-management
directors should be more independent, which should lead to better governance. Beasley
(1996) and Dechow et al. (1996) show a negative relation between outside directors and
financial fraud. Carcello et al. (2002) and Abbott et al. (2003) use this variable to document
a positive relation between board independence and audit fees. Tsui et al. (2001) show a
negative relation between independent boards and audit fees.
Our third proxy considers the composition of the audit committee. We define this as
equal to one if the chair of the audit committee is not the CEO or CFO of the company, and
zero otherwise, and denote it as IAUD in the empirical analysis. We justify this proxy on
the grounds that a non-CEO or non-CFO audit chair should be more independent, which
leads to better governance.'" Abbott et al. (2003) and Mitra et al. (2007) show a positive
relation between a similarly defined variable and audit fees. Also, Anderson et al. (2004)
find that independent (and active) audit committees lower the cost of debt, and Agrawal
and Chadha (2005) report that companies with more independent audit committees (and
boards) restate earnings less often.
Our fourth proxy represents the percentage of common shares outstanding held by
management (from IRRC and Cornpusrat)." This proxy has also been used in auditing
research by Francis and Wilson (1988), who find that managerial ownership does not
affect the demand for audit quality, and by Mitra et al. (2007), who document a negative
association between managerial ownership and audit fees. This proxy, however, may reflect
offsetting effects. For instance, the higher the percentage of shares owned, the more likely
managers' interests will be aligned with shareholders in general, which should lead to better
governance. Yet higher management shareholding could also vest more control in such
persons and, thus, lead to a greater potential for conflicts of interest between management
and shareholder decisions (e.g., compensation), which can weaken governance (Harris and
Raviv, 2006). We denote this variable INSD in the empirical analysis.
We also construct a second version of instrument G, as the fitted value of the G-index
from a regression of the G-index on the 33 governance variables in x, internal auditing, a ,
plus the other governance proxies IDIR, INSD, and IAUD. Where necessary, we denote
this as G, to distinguish it from the first version, or GI, which does not include IDIR, INSD,
and IAUD in the regression.

In unreported analysis, we tind that the mean G-index for high G-index companies on average tends to fall
over time, as we would expect, assuming auditors. shareholders, and boards. possibly prompted by outside
regulations, address governance issues to reduce agency costs and solve related problems. We also find that the
mean G-index for low G-index companies on average tends to rise over time. The same result holds for compa-
nies with high and low measures of the governance instrument c.
"'While the SEC has always encouraged audit committees to comprise independent directors. Section 301
of SOX (effective in early 2004) tightened the requirements considerably, among other rules, by barring any fee
payments to audit committee directors for services other than audit committee services.
" Our empirical analysis, in fact, uses the log of the percentage of shares held by management to approximate
a normal distribution. Section 5.3 also examines the percentage of common shares held by the median director
as an alternative share ownership measure of governance.
 Paul A. GrifJin,David H . Lont and Yuan Sun 29
Journal of Contemporary Accounting & Economics Vol4,No 1 (June 2008) 18-49

3.3 Sample characteristics

We first compare the three samples by their three-digit NAICS industry code. An
unreported comparison reveals two main differences in the governance and directors’
samples relative to the audit fee sample: the former have a larger representation of utilities
(code 221), and a smaller representation of professional service companies (code 541).
Computers and electronic products (code 334) reflect the largest proportion of observations
(from 12.34 to 14.03 percent) of the samples. We exclude banks and other depository
institutions from the samples, consistent with prior research that suggests that such
companies’ audit fees are determined differently (Fields et al., 2004).12Overall, the mix of
industries in the governance and directors’ samples does not differ too substantially from
the audit fee sample (of non-bank companies with Audit Analytics fee data and Compustat
and ZBES financial information).
We also examine how key financial characteristics of the samples differ on a univariate
basis. Table 1 presents the means and medians of log of audit fees and the audit effort and
audit risk determinants, e and r , used to estimate Model 3, transformed where appropriate
to approximate a symmetric distribution. Table 1 also reports a t test of whether the sample
means differ from one another.
Table 1 suggests the following. First, Panel A shows that the means for log of total assets
(SIZE), log of audit fees (LAFE), and log of non-audit fees (LNAF) increase monotonically
as the sample size decreases - from the audit fee sample (smallest means) to the directors’
sample (largest means). Second, Panel B shows that the governance and directors’ samples
report fewer losses (LOSS) and their auditor resigns (RSGN13)less often, but are more
likely to be a utility (UTIL), a manufacturer (MANU), audited by PricewaterhouseCoopers
(PWCP), receive an auditor qualification (QUAL), and be subject to an internal control audit
(ICAO).These differences are statistically significant,which indicate that the samples differ
cross-sectionally on the basis of these variables. Results for the governance or directors’
samples, therefore, are unlikely to generalize to those companies in the audit fee sample
not also in the other samples.
We also compare audit fees and the audit risk and effort variables temporally from 2000
to 2006. Panel C reports the means for the governance sample only, although the other
sample means show similar trends. First, log of audit fees (LAFE) generally increases
from 2000 to 2006, whereas log of non-audit fees (LNAF) and the use of debt (DEBT)
tend to decrease over those same years. The sum of log of audit fees and non-audit fees,
therefore, remains relatively constant. Second, losses (LOSS) peak in 2002 and drop in
the subsequent years, and the one minus the chance of bankruptcy (ZSCR) is higher in the
later years, also consistent with increased financial well being. Third, resignations (RSGN)
appear to be more concentrated in the later years (note 13 defines the variable RSGN).
Fourth, the percentage of companies with prior litigation and late filings (LITG) remains
fairly steady over 2000 through 2006, although it drops somewhat in 2004 through 2006
because the mix of companies in the sample changes slightly in those later years. Fifth,

I2Banks, also, are not covered in the IRRC databases.

l3We define RSGN as one for the first full year following the year of resignation, zero otherwise, to ensure
that we reflect fully 12 months of the successor auditor’s fees following a resignation, and not partial year
fees.
30 Paul A . Griffin, David H . Lont and Yuan Sun
Journal of Contemporary Accounting & Economics Vol4, N o 1 (June 2008) 18-49

Table 1
~ ~

Summary Statistics for Audit Fees and Control Variables: By Sample and Year

Audit fee Governance Directors Audit fee G o v m Directors Significance of

Mean Median t-test of difference in means
(1) (2) (3) (4) (5) (6) ( 1 vs.2) (1 vs.3) (2vs.3)

Punel A: Continuous vcrrruh1e.s

LAFE 12.897 14.000 14.093 12.810 1 3.960 1 4.057 *** *** ***
LNAF 11.802 13.081 13.168 11.806 13.100 13.191 *** *** *
SIZE 19.338 21.335 2 I ,497 19.468 21.210 21.377 *** *** ***
SALE 19.219 21.193 21.371 19.452 21.110 2 I ,274 *** *** *
SEGM 2.362 3.030 3.034 1.000 3 .000 3.000 *** *** *
QUIK 2.707 1.843 1.748 1.292 1.226 I ,211 *** *** -k
DEBT 0.203 0.213 0.210 0.130 0.197 0. I98 ns ns ns
CVRG 4.949 6.419 6.433 4.000 5.000 5.000 *** *** ns
ZSCR 3.094 4.128 4.384 2.860 3.280 3.445 *** *** **
Punel B: Noniinul variables

FISC 0.666 0.663 0.655 ns ns ns

MANU 0.487 0.522 0.524 *** *** ns
UTIL 0.043 0.069 0.07 I *** *** ns
PWCP 0.205 0.286 0.293 *** *** ns
LOSS 0.35 I 0.212 0.177 *** *** ***
LITG 0.093 0.140 0.136 *** *** ns
QUAL 0.395 0.477 0.486 *** *** ns
IPUB 0.048 0.012 0.01 1 *** *** ns
RSGN 0.009 0.004 0.003 *** *** ns
ICAO 0.250 0.420 0.442 *** *** ns
No. obs. 18,923 6,448 5.277 18,923 6,448 5,277

Pntiel C: Meun by year (Covernutice sumple onl.~)

2000 200 1 2002 2003 2004 2005 2006 Total

LAFE 1 3.402 1 3.407 13.551 13.741 14.280 14.564 14.708

LNAF 13.767 13.727 13.152 13.110 12.923 12.678 12.684
SIZE 2 1.362 21.318 21.144 21.198 21.314 21.41 1 21.693
SALE 21.186 2 I ,240 20.945 2 I ,020 21.147 21.285 21.638
SEGM 3.150 3.093 2.959 2.994 2.967 3.027 3.131
QUIK 1.666 1.593 2.062 1.93I 1.973 1.831 1.629
DEBT 0.249 0.235 0.225 0.216 0.204 0.193 0.189
CVRG 7.734 6.589 7.067 7.176 5.979 5.802 5.42 1
ZSCR 3.814 4.056 3.675 3.977 4.419 4.35 I 4.45 1
FISC 0.998 0.647 0.655 0.651 0.667 0.655 0.543
MANU 0.544 0.527 0.521 0.517 0.510 0.521 0.533
 Paul A. GrifJln,David H . Lont and Yuan Sun 31
Journal of Contemporary Accounting & Economics Vol4, No 1 (June 2008) 18-49

Table 1 (Cont.)

Summary Statistics for Audit Fees and Control Variables: By Sample and Year

2000 200 I 2002 2003 2004 2005 2006 Total

UTIL 0.083 0.074 0.069 0.068 0.066 0.064 0.068

PWCP 0.299 0.265 0.281 0.297 0.295 0.280 0.290
LOSS 0.165 0.256 0.328 0.252 0.177 0.166 0.094
LITG 0.155 0.136 0.148 0.147 0.135 0.134 0.131
QUAL 0.160 0.253 0.615 0.691 0.440 0.297 0.702
IPUB 0.001 0.006 0.005 0.016 0.056
RSGN 0 .oo1 0.001 0.002 0.004 0.008 0.007
ICAO 0.680 1.020 1.010
No. obs. 412 860 1,06I 1,017 1,132 1,084 822 6,448

Dsfinitions of the variables

Variable Definition Data Sourcea

LAFE Natural log of total audit fees for fiscal year. AA

LNAF Natural log of non-audit fees. AA
SIZE Natural log of total assets as of end of fiscal year. Comp
SALE Natural log of sales revenue for year. Comp
SEGM Number of segments! Comp
QUIK Ratio of current assets less inventories to current liabilities. Comp
DEBT Ratio of total debt to total assets at end of fiscal year. Comp
CVRG No. of analysts covering stock, end of fiscal year! IBES
ZSCR Altman Z-score Comp
FISC Fiscal year end = December 3 1, otherwise 0. Comp
MANU Manufacturing industry = I , otherwise 0. NAICS
UTIL Utility industry = 1, otherwise 0. NAICS
PWCP PricewaterhouseCoopers = I , otherwise 0. AA
LOSS Negative income before extraordinary items = 1, otherwise 0. Comp
LITG Prior securities class action, restatement, or NT filing = 1, otherwise 0. ISS, AA, SEC
QUAL Going concern qualification = I , otherwise 0. AA
IPUB Initial public offering within prior two fiscal years = I , otherwise 0. Comp
RSGN Resignation = 1 if resignation in prior fiscal year, otherwise 0. AA
IC'AO Internal control audit opinion: effective = I , adverse = 2, disclaimer = 3. otherwise 0. Comp

**,*,+,++ indicate the significance level at the0.0001,0.001,0.01,0.05,0.10respectivelyand

*;I:*, ns indicates
not significant.
P ,tes to Table 1.
AA = Audit Analytics, Comp = Coinpustat, NAICS = North American Industry Classification System, ISS =
Institutional Shareholder Services, Inc., SEC = SEC Edgar, IBES = Institutional Brokers' Estimate System.
The regressions in Section 4 specify SEGM as the square root of the number of segments, ie., SGMT =
SEGM"O.5, and restate CVRG as a risk factor by taking the reciprocal of the number of analysts covering
the stock, i.e., RCVR = IICVRG.
32 Paul A. Grifin, David H. Lont and Yuan Sun
Journal of Contemporary Accounting & Economics Vol4, No 1 (June 2008) 18-49

the mean number of analysts covering the companies (CVRG) declines after 2003. Later
analysis uses coverage as a risk factor by taking the reciprocal of the number of analysts
covering the stock, i.e., RCVR=l/CVRG.
While these time trends represent economy-wide changes in general, some may also be
linked to the SOX legislation passed in July 2002. For example, the reduction in non-audit
fees relative to audit fees could relate to the restrictions and disclosures required by SOX
regarding such services under Sections 201 and 202; and the increase in audit fees and,
possibly, the timing of auditors’ qualifications and resignations may be linked to increased
scrutiny by auditors in conjunction with the implementation of Section 302 on certification
and Section 404 on internal control. For example, the variable for an internal control audit
opinion (ICAO) begins in 2004. In later analysis, we examine the sensitivity of our tests
of Model 3 to the pre- and post-SOX time periods. We also include time-related indicator
variables in certain of the regression analyses to account for possible temporal variation
in audit fees unrelated to the audit fee determinants in Model 3.

3.4 Governance characteristics of the samples

Table 2 summarizes the governance characteristics of the governance and directors’

samples. Panel A provides summary statistics for the governance index (G-index), log of the
percentage of insider shareholdersto total shareholders (INSD), the fraction of independent
directors to total directors (IDIR), and a unit variable equal to one if the chair of the audit
committee is not the company’s CEO or CFO, zero otherwise (IAUD).I4
Based on a two-sided t test of the difference in the means, we observe that the directors’
sample generally has higher mean governance scores. The exception is INSD, which
is lower for the directors’ sample. However, as others have commented (e.g., Morck
et al., 1988; Harris and Raviv, 2006), this measure can be ambiguous in that not only
might insider shareholders better align their decisions with shareholders generally, thus
strengthening governance but, also, insider shareholders might align themselves more
with management, which could induce additional agency costs and weaken governance.
Overall, these governance measures are broadly consistent with our economic framework
and the financial characteristics of the samples.
Panel B of Table 2 shows the time trend of the G-index for the governance sample and
for partitions of the governance sample expected to change over the study period. Because
we report temporal data, we restrict this analysis to those companies in the governance
sample with consecutive observations. We arbitrarily use 2001 to 2005 as the period for
the consecutive observations. The interval from 2000 to 2006 would be too restrictive
because of the smaller number of observations in 2000 and 2006.
We observe the following. First, Panel B shows that the overall mean G-index jumps
from 9.293 in 2001 to 9.667 in 2002 and remains reasonably stable thereafter. Second, Panel
C shows that the mean G-index is higher when audit risk is higher (LOSS=l, LITG=l ,and
QUAL=l) and lower when audit risk is lower (LOSS=O, LITG=O, and QUAL=O). Third,

c,
’‘Summary statistics for the instrumental variables and c2are qualitatively identicaI to those in Table 2
c, c2
for the G-index. As noted in Section 3.2, and are the fitted values of the G-index from a regression analy-
sis.
 Paul A . Griffin, David H . Lont and Yuan Sun 33
Journal of Contemporary Accounting C? Economics Vo14, No 1 (June 2008) 18-49

Table 2

Summary Statisticsfor G-index and Other Governance Variables: By Sample and Year

Governance Directors Governance Directors

t test prob.
Mean Mean Median Median Diff. Signif. of DiH.

Panel A: Governance variables (all observations)”

G-index 9.194 9.297 9.000 9.000 0.035 4-

INSD 0.562 0.477 0.389 0.3 13 0.005 *

IDIR 0.682 0.687 0.679 0.679 0.074 ++
IAUD 0.798 0.785 0.021 +
No. of obs. 6,448 5,277

Panel B: Governance sample partitions by year, mean (common observations for 2001-2005)

2000 2001 2002 2003 2004 2005 2006

G-index 9.389 9.293 9.666 9.667 9.614 9.673 9.801
No. of obs. 298 644 644 644 644 644 493
~ ~ ____ ~______~______

Panel C: Governance sample partitions by year, mean (common observations with available data for 2001-2005)

200 1 2002 2003 2004 2005

G-index x LOSS=O 8.744 8.241 8.340 8.505 8.928
G-index x LOSS=I 9.008 9.303 9.028 9.121 9.284
G-index x LITG=O 8.946 8.241 8.24I 8.477 8.567
G-index x LITG=I 9.341 9.458 9.465 9.408 9.408
G-index x QUAL=O 9.382 8 SO0 8.619 9.030 9.095
G-index x QUAL= 1 9.828 9.781 9.819 9.765 9.912

***,**,*,+,++indicate the significance level at the 0.0001,0.001,0.01,0.05,0.10 respectively and ns indicates

not significant.
Note to Table 2.
a
The governance variables are defined as follows: G-index = G-index from the IRRC Governance database;
INSD = Log of percentage of common shares held by management to total shares outstanding; IDIR = Fraction
of non-management directors on the board; and IAUD = 1 if the chair of the audit committee is not the CEO
or CFO of the company, otherwise 0. The remaining variables are defined in Table 1.

Panel C shows that from 2001 to 2002 the G-index generally increases when audit risk is
higher and declines when audit risk is lower. For example, for LOSS=O (i.e., profitable)
companies, the mean decreases from 8.744 in 2001 to 8.241 in 2002, whereas for LOSS=l
(unprofitable) companies, the mean increases from 9.008 in 2001 to 9.303 in 2002. The
results for the same partitions of the directors’ sample are similar.
We note, also, that the differences in the partition means each year (e.g., mean LOSS=l
minus mean LOSS=O) are greatest in 2002 and 2003 and decline in 2004 and 2005. This
effect, in conjunction with our observations in the previous paragraph, could be due to
34 Paul A . Griffin, David H. Lont and Yuan Sun
Journal of Contemporary Accounting & Economics Vol4,N o I (June 2008) 18-49

governance changes imposed by SOX, although we do not conduct controlled tests in this
regard. We observe, however, a similar, but not SOX-related, finding in Farber (2005),
who reports with respect to SEC fraud investigations that the governance indicators in that
study (e.g., percentage of outside directors on the board) improved within a few years of
the SEC investigation.l5

4. Regression Results

Table 3 summarizes the results of six regressions applied to the governance sample.’h
All regressions include the same audit effort, e, and audit risk, r , control variables in
Model 3. Because so few companies in the governance sample have non-Big N auditors
(376 observations with available regression data), we restrict the regressions in Table 3
to Big N firms only ” This also provides for greater homogeneity of the accounting firm
characteristics in the sample. We attempt to be parsimonious regarding the final set of
control variables in Model 3, although we realize that researchers have a wide berth in the
choice and definition of an audit fee model.
For audit effort, e, we choose as our proxies the log of total assets (SIZE) (Simunic,
1980; Francis, 1984; Palmrose, 1986), log of sales revenue (SALE) (Hay et al., 2006),
the square root of the number of business segments (SGMT) (Simunic, 1984; Francis and
Simon, 1987), quick assets ratio (QUIK) (Whisenant et al., 2003), busy period (FISC)
(Palmrose, 1986; Craswell and Francis, 1999), and we distinguish between those general
industry categories where audit effort should be higher, such as manufacturers (MANU),
and lower, such as utilities (UTIL). We expect the regression coefficients to be positive
for these variables, with the exceptions of QUIK and UTIL, which should be negative,
and DEBT, which could be either, as greater debt may reflect both positive (greater risk)
and negative (better auditor-company matching) effects.
We also include log of non-audit fees (LNAF) to control for other services provided
by the accounting firm to the client (Simunic, 1984; Palmrose, 1986; Turpen, 1990;
Davis et al., 1993; Parkash and Venable, 1993; O’Keefe et al., 1994), distinguish between
PricewaterhouseCoopers and the other firms (PWCP) to control for perceived differences
in audit quality among Big N firms, and include a unit variable to control for economy-
wide changes in audit fees since the passage of SOX (YR03) for reasons other than those
for which we include control variables, and check whether audit fees are higher within
two years of an initial public offering (IPUB).
The remaining variables proxy for audit risk, r . We expect a positive coefficient for each
of the audit risk variables, since prior studies show and auditing theory suggests that audit
risk and audit fees should be higher for a company that reports negative earnings (LOSS)

c,
Is Unreported analysis shows an almost identical time trend for and G2.We report G-index data in Table
3. as these data have been included in the prior research whereas G has not, because the prior research, for the
most part, has used single-equation regression methods.
“The results (available on request) are qualitatively similar when we apply the Model 3 regressions to the
directors’ sample.
” Our final sample for regression analysis, therefore, comprises 4,901 observations (5,277 in the merged
sample with governance and directors’ data less the 376 non-Big N observations).
 Paul A . Crifin, David H . Lont and Yuan Sun 35
Journal of Contemporary Accounting & Economics Vol4,No I (June 2008) 18-49

Table 3

Regression Results of Log of Audit Fees on Control and Governance Variables

Two-stage least squares Singleequation Singleequation

Regressiona (1) (2) (3) (4) (5) (6)
Pred .
Sign Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig.

Panel A: Control variableb

Intercept 1.483 *** 1.650 *** 1.514 *** I ,701 *** 1.475 *** 1.881 ***
LNAF + 0.169 *** 0.171 *** 0.167 *** 0.169 *** 0.169 *** 0.171 ***
SIZE + 0.283 *** 0.286 *** 0.283 *** 0.286 *** 0.284 *** 0.286 ***
SALE + 0.128 *** 0.131 *** 0.128 *** 0.131 *** 0.127 *** 0.129 ***
SGMT + 0.222 *** 0.217 *** 0.222 *** 0.217 *** 0.221 *** 0.220 ***
QUlK - -0.009 ++ -0.008 ns -0.010 ++ -0.008 ns -0.010 ++ -0.008 ns
DEBT ? -0.223 *** -0.235 *** -0.217 *** -0.229 *** -0.222 *** -0.222 ***
ZSCR - -0.019 *** -0.020 *** -0.019 *** -0.020 *** -0.019 *** -0.020 ***
FISC + 0.130 *** 0.138 *** 0.125 *** 0.132 *** 0.131 *** 0.132 ***
MANU + 0.207 *** 0.220 *** 0.207 *** 0.220 *** 0.207 *** 0.219 ***
LJTlL - -0.266 *** -0.223 *** -0.269 *** -0.226 *** -0.264 *** -0.223 ***
PWCP + 0.084 *** 0.086 *** 0.086 *** 0.088 *** 0.083 *** 0.090 ***
Y R03 + 0.798 *** 0.666 *** 0.802 *** 0.645 *** 0.789 *** 0.547 ***
LOSS + 0.212 *** 0.221 *** 0.209 *** 0.216 *** 0.21 1 *** 0.146 ***
LITG + 0.183 *** 0.195 *** 0.167 *** 0.174 *** 0.183 *** 0.171 ***
QUAL + 0.177 *** 0.184 *** 0.138 *** 0.136 *** 0.178 *** 0.177 ***
RCVR + 0.301 * 0.340 * 0.301 * 0.337 * 0.336 * 0.039 ns
IPUB ? 0.062 ns 0.065 ns 0.074 ns 0.080 ns 0.062 ns 0.075 ns
RSGN + 2.735 * 2.663 * 2.795 * 2.728 * 2.563 * 0.967 ***
ICAO + 0.445 *** 0.443 *** 0.456 *** 0.458 *** 0.445 *** 0.450 ***
~

Panel B: Governance variable'

-
GI + 0.019 * 0.024 *** 0.013 + 0.017 * 0.019 **
INSD + 0.059 * 0.055 * 0.047 *
IDIR + 0.489 *** 0.493 *** 0.491 ***
IAUD + 0.059 ++ 0.077 + 0.059 ++

(Simunic, 1980; Francis, 1984; Craswell and Francis, 1999; Whisenant et al., 2003); faces
litigation risk (Lys and Watts, 1994; Simunic and Stein, 1996; Gul and Tsui, 1997) such as
prior securities litigation or filing of its annual report after the SEC due date (LITG); receives
an audit report qualification (QUAL) (Simunic, 1980; Palmrose, 1986; Francis and Simon,
1987; Simon and Francis, 1988; Simunic and Stein, 1996); has a smaller number of analysts
that cover its stock, premised on the idea that analysts and their institutional clients prefer
to cover companies with higher quality financial statements (Ayres and Freeman, 2001;
Bushman et al., 2005) (defined as RCVR = the reciprocal of analyst coverage); reports
36 Priul A . Grifln, David H. Lont and Yuun Sun
Journal of Contemporury Accounting & Economics Vol4, No I (June 2008) 18-49

Table 3 (Cont.)

Regression Results of Log of Audit Fees on Control and Governance Variables

Two-stage least squares Singleequation Singleequation

Regression" (1) (2) (3) (4) (5) (6)
Pred.
Sign Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig.

Panel C: Inteructioii <&c/

Audit risk
Intercept 1.483 *** 1.650 *** 1.514 *** 1.701 *** 1.475 *** 1.881 ***
GxLOSS - -0.016 ** -0.018 ** -0.009 ++ -0.009 ++ -0.016 **
G xLITG - -0.007 ++ -0.008 ++ -0.001 ns 0.000 ns -0.007 ++
G xQUAL - -0.006 ++ -0.006 + 0.005 ++ 0.006 + -0.006 +
GxRCVR - -0.028 + -0.033 * -0.027 + -0.032 * -0.031 *
GxRSGN - -0.177 + -0.168 + -0.184 + -0.175 + -0.157 +
Other
G x Y R 0 3 - -0.009 ns -0.016 + -0.004 ns -0.010 ns -0.008 ns
G x l N S D - -0.008 *** -0.008 ** -0.007 **
lDIRxYR03 - -0.299 + -0.308 + -0.301 +
L4UDxYR03- 0.001 ns -0.014 ns 0.003 ns
F 525.0 *** 633.4 *** 521.9 *** 629.2 524.6 *** 856.4 ***
R' 77.4% 77.0% 77.3% 76.9% 77.4% 76.8%
No. of obs. 4,901 4.90 1 4.90 I 4,901 4,901 4,901

***,**,*,+,++indicate the significance level at the0.0001,0.001 ,0.01,0.05,0.10respectivelyand ns indicates

not significant.
Notes to Table 3 .
'I
Regressions 1,2,5,and 6 define the LOSS, LITG,QUAL.and RSGN components of the governance interaction
variables as a one for the presence of the condition of a loss, prior 1itigation.qualification for fiscal years 2000
through 2002 only, otherwise zero; Regressions 2 and 4 define LOSS, LITG, QUAL, and RSGN as a one for
the presence of the condition o f a loss, prior litigation, qualification for all fiscal years, otherwise zero; YR03
= 1 for fiscal years 2003 and later, otherwise zero. The remaining variables are defined in Tables 1 and 2.
Regressions 1 and 3 use G, as the governance proxy, which is the fitted value from an OLS regression of
the G-index on LNAF and 33 individual determinants from the Governance database. Regressions 2 and 4
use G2as the governance proxy, which is the fitted value from an OLS first-stage regression of the G-index
on the 33 individuat determinants from the Governance database, and INSD, IDIR, and IAUD. Regressions
5 and 6 set G equal to the G-index.
Regressions 1 through 6 use Big N audit fee observations only.
Control variables are defined in Table I .
Governance variables are defined in Table 2.

an internal control audit opinion under Section 404 of SOX (ICAO) (Hogan and Wilkins,
2008); experiences an auditor resignation (RSGN) (Sankaraguruswamy and Whisenant,
2004); or has a higher probability of bankruptcy as proxied by a lower Altman Z score
(ZSCR) (Whisenant et al., 2003),which means that the coefficient should be negative.I8 The

"We thank the reviewer for suggesting "internal control audit" (ICAO) as an additional control variable in
Model 3 .
 Paul A. Griffin, David H . Lont and Yuan Sun 31
Journal of Contemporary Accounting & Economics Vol4,No I (June 2008) 18-49

regressions in Table 3 differ, therefore, primarily on the basis of the governance variables.
Regression 1 uses GI as the governance instrument, where GI is the fitted value from an
OLS first-stage regression of the G-index on the log of internal audit budget (defined
in note 8) and certain indicators of governance ( x ) as identified by IRRC. Regression 2
uses G2 as the governance instrument, which is the fitted value from an OLS first-stage
regression of the G-index on the IRRC governance indicators plus log of internal audit
budget, INSD, IDIR, and IAUD.
As explained in Section 4.3, Regressions 1 and 2 define the LOSS, LITG, QUAL, and
RSGN components of the governance-auditrisk interaction variables as one for the presence
of a loss, prior litigation, a qualification,or resignation for fiscal years 2000 to 2002 only,
otherwise zero. Regressions 3 and 4 then replicate Regressions 1 and 2, respectively,
except that LOSS, LITG, QUAL, and RSGN are now defined as one for the presence of
a loss, prior litigation, qualification, or resignation for all sample years, otherwise zero.
Regressions 2 and 4 exclude INSD, IDIR, and IAUD as governance variables, as they are
already reflected in GL
Regression 5 sets G equal to the G-index as the governance variable. This provides a
check on using a two-stage regression approach (Regressions 1 to 4) to address the potential
concern that a single-stage approach may not adequately reflect the co-determination of
audit fees and governance. Finally, we summarize the results of Regression 6, which
excludes the governance variables, to contrast the coefficients of the control variables in
that regression with the equivalent coefficients in Regressions 1 to 5 , which include the
governance variables.

4 .I Control variables

Panel A of Table 3 reports the coefficients for the control variables. Almost all of the
coefficients are highly significant with signs as expected and consistent with prior research.
The signs of the audit effort variables are positive, with the exceptions of QUIK and UTIL,
which are predictably and reliably negative.We observe a significantly negative coefficient
for DEBT. This suggests that possible risk factors associated with higher debt could be
offset by other factors such as better auditorklient alignment and external monitoring of
company activities through the debt contract and, possibly, by further omitted factors.
Importantly,as expected, all audit risk proxies -LOSS, LITG, QUAL, RCVR, ICAO,
and RSGN - are positive and statistically significant. Higher scores for these risk proxies
clearly translate into higher audit fees. We also observe, as predicted, a significantly
negative coefficient for companies closer to bankruptcy (ZSCR). In addition, the signs
and significance of the control variables change little when we estimate Model 3 without
the governance variables (Regression 6).

4.2 Governance variables

The second stage of our analysis documents a positive relation between proxies for
corporate governance and audit fees. This relation supports our contention in Model 1,
that if auditing is a mechanism company boards use to strengthen governance, then we
should observe positive coefficients for those variables associated with governance (and,
thus, reject null hypothesis HI).
38 Pnirl A . Grifin, Dnvid H . Lont iind Yuan Sun
Journal of Contemporury Acrounting & Economics M 4 . No I (June 2008) 18-49

Regressions 1 and 3 show that the coefficient for GI is reliably positive, as are the
coefficients for the other governance measures not in c,
namely, the log of the percentage
of insider shareholders (INSD), the fraction of independent directors (IDIR), and a proxy
for the independence of the audit committee chair (IAUD). Regressions 2 and 4 also show
positive coefficients for G2, which are higher than in Regressions 1 and 3 because Gz
incorporates INSD, IDIR, and IAUD in the instrumental variable. Also, a comparison of
Regressions 1 vs. 3 and 2 vs. 4 shows that the definitions of the indicator variables LOSS,
LITG, QUAL, and RSGN make little difference to the coefficients of the proxies for c.
Finally, Regression 5 shows positive coefficients for G, defined as the actuaI value of the
G-index and INSD, IDIR, and IAUD. Collectively,the coefficients in Table 3 are consistent
with the view that each of the four proxies for corporate governance adds significant
explanatory power to the regression incremental to the other proxies.
The positive coefficient for INSD, however, could reflect two factors with potentially
offsetting signs in an audit fee regression such as Model 3. For example, if managers align
themselves sufficiently with shareholders’ interests in companies with high INSD, this
should strengthen governance. But with better governance from aligned interests, there
would be less need for auditing as a mechanism to improve governance. On the other hand,
a high INSD company could also be dominated by entrenched managers who may increase
agency costs by opportunistic actions rather than actions aligned to shareholders’interests.
This should induce a positive coefficient if boards use auditing as one means to reduce
or minimize such agency costs. This is what we observe in Panel B of Table 3 . In short,
c,
the results in Panel B of Table 3 for INSD, IDIR, and IAUD all indicate the rejection
of H , (in the null form) and, thus, support our theoretical contention of a positive relation
between corporate governance and audit fees.

4.3 Interaction variables

The third stage of analysis tests for a reduction in audit fees induced by an offset in
the price of audit risk from better governance (HJ. We implement this test by predicting
that the positive relation between audit risk and audit fees, which we document in Panel
A of Table 3 , varies negatively on the basis of the strength of corporate governance. In
other words, after controlling for other audit fee determinants, including governance and
audit risk, companies with higher audit risk and stronger governance should have lower
audit fees than companies with higher audit risk and weaker governance. Ideally, we
should observe this relation across alternative audit risk proxies and alternative measures
of governance.
We first interact each of five audit risk proxies as defined thus far, i.e., LOSS, LITG,
QUAL, RCVR, and RSGN, with our instrument for the corporate governance measure,G,
or the actual value of the G-index.” However, this analysis generates coefficients that are
not uniformly significantly negative. One possible reason is that the audit risk variables as
defined for the interactions ignore a fundamental aspect of the relation between audit risk
and governance, namely, that certain of the audit risk factors, in our case LOSS, LITG,

“We are unable to interact ICAO with in Model 3 because lCAO is only available for fiscal years 2004
to 2006.
 P d A . GrifJin,David H. Lont arid Yuun Siin 39
Journul of Conteniporur-yAccounting & Economics V d 4 ,N o I (June 2008) 18-49

QUAL and RSGN, are event-based indicators, and these can signal broader problems at
the company which, in turn, can elicit a change in governance. Such event-related risk
factors may also trigger an immediate change in governance. For instance, a board of
directors following a litigation settlement or auditor resignation may require the company
to implement certain governance changes as a condition of the terms of the settlement or
new audit. For either reason, a company with higher observed audit risk as indicated by a
litigation or similar risk-related event should, eventually, be a company that signals lower
audit risk because of strengthened governance and better controls, spurred in part by the
earlier risk-related events.
We, therefore, define the governance-audit risk interaction variables in two ways. First,
given the preceding, we partition the event-based audit risk proxies, i.e., LOSS, LITG,
QUAL, and RSGN into those events that occur earlier (before 2003) versus later (2003
and after) in the study period, and include only those earlier audit risk events in the risk
component of the governance-auditrisk interaction variables. For example, for Regressions
1 and 2 in Panel C, we define LOSS as a one if a firm reports a loss in years 2000 through
2002, and zero otherwise. We define LITG, QUAL, and RSGN equivalently. We do not
partition RCVR this way, however, as it is not an event-driven audit risk factor (although
the Table 3 regression results are unchanged when we do). Second, for completeness, we
estimate Model 3 where LOSS, LITG, QUAL, and RSGN are defined as a one for the
presence of a condition in all years and report the results in Regressions 3 and 4 in Panel
C.
Panel C of Table 3 summarizes the results for the interactions between audit risk and
c.
the governance instrument This panel shows reliably significant results for Regressions
1 , 2 , and 5 for all audit risk proxies, as defined and discussed above; that is, the coefficients
c c
for x LOSS, x LITG, x QUAL, G x RCVR, and x RSGN are all uniformly and c
significantly negative. The exceptions are G x LITG and G x QUAL in Regressions 3
and 4, whose coefficients are, respectively, insignificant or positive."' Note, also, that
Regressions 3 and 4 show mostly less negative coefficients for the governance-audit risk
coefficients than Regressions I and 2. This possibly reflects the definition of certain of
the governance-audit risk interactions based on all years rather than earlier years only, as
per our earlier discussion.
Overall, these results provide support for our framework, and the rejection of hypothesis
H, (in the null form) that audit fees do not vary negatively with the interaction of audit risk
and governance. In other words, the negative coefficients we observe are fully consistent
with our contention that better corporate governance induces an offset to the price of audit
risk.
We also use the coefficients for the audit risk proxies and the coefficients for the
governance-audit risk interactions to approximate an upper bound on the amount of audit
fee reduction as a result of better governance and to check on the consistency of the results.
We calculate an average coefficient reduction of 6.2 percent of the natural log of audit
fees. For example, the coefficient for LOSS in Regression 1 (0.212) decreases by 0.016
in the presence of better governance or by 7.7 (0.016 i 0.212) percent. The other audit

c
?"The switch in the sign of the coefficient for x QUAL from Regressions I and 2 to Regressions 3 and 4
in Table 3 suggests that audit qualifications in the later years induce higher fees, possibly because the additional
audit effort from qualification exceeds the audit risk reduction from better governance.
40 Paul A . Grifin, David H . Lont and Yuan Sun
Journal of Contemporary Accounting & Economics Vol4, No I (June 2008) 18-49

risk variables in Regression 1 decrease by 4.0 percent (LITG), 3.4 percent (QUAL), 9.2
percent (RCVR), and 6.5 percent (RSGN).
To the extent that our governance measures (G or G-index) reasonably reflect a quantity
of governance rather than the dollar value of governance, and assuming that the quantity
of audit risk is unchanged by the governance changes, we can interpret such negative
governance-audit risk interaction coefficients as initial proxies for the decline in the price
of audit risk from superior governance. As such, subject to the aforementioned caveats, we
estimate that companies with better governance practices of the kind in the study period
should receive a mean reduction in the price of the risk component of their audit fee of
approximately six percent (6.2 percent).

4.4 Economic impact

Our regressions also allow a calculation of the dollar impact on fees of the offsets to
the price of audit risk. If we denote log(y) = log of audit fees and r = audit risk, then the
first partial derivative of audit fees, y , with respect to audit risk, r , assuming the other
variables are unchanged, is dyldr = y.(fi, + fi,. G) for audit-risk governance coefficient,
fi, # 0, and dyldr = y . fi, for audit-risk governance interaction, fi, = 0. We then substitute
for y the governance regression sample mean audit fees of $2,717,465,for G the regression
sample mean of 9.311, and for fi, and fi, the coefficient estimates in Table 3 for a given
risk factor. For the average company in the sample, the minimum dollar impact on audit
fees of the audit risk offsets is $179,143:’

4.5 Other analyses

Table 3 reports four other interaction effects.Three variables interact with the governance
proxies with fiscal years before and after December 3 1,2003 (YR03) to control for the
generally higher levels of governance later in the study period and, possibly, in response to
SOX. Two of YR03 interactions - x YR03 and IDIR x YR03 - show negative coefficients.
This suggests that the increases in audit fees from superior governance as represented in

For example, for LOSS, from Table 3, the estimated coefficient for risk factor (3, = 0.212 (rounded) and
the risk offset p, = -0.016 (rounded). Thus, based on Table 3 and the formula for aylar in the text above, ayldr
= $158,672 for p4= -0.016, and dylar = $395,799 for p4= 0. The difference is -$237,127. This is the difference
in the first partial derivative of audit fees with respect to audit risk r , defined as LOSS, when there is an audit
risk offset versus no offset. When (3,= 0, we re-estimate the (3, risk factors in a regression (Model 3) without the
c x audit risk interaction variables to estimate the unconditional effect of an audit risk factor on audit fees, that
is, one that is not conditional on the interaction of c a n d a risk factor. We calculate similar dollar offsets for risk
factors LITG and QUAL and take the average of the three factors, which is -$179,143 (we drop CVRG and
RSGN from this calculation as their inclusion produces extremdoutlier results). This represents an initial mini-
mum estimate of the dollar impact on audit fees of the audit risk offsets from better governance. We also partition
the governance sample into large and small companies (with average market capitalizations of $1.648 billion
and $936 million, respectively) and re-estimate the regression coefficients. The average estimated audit fee
offsets for large and small companies under this approach are -$5 16,151 ( I 1.9 percent of average audit fees) and
464,572 (5.8 percent of average audit fees), respectively. Implicit in these estimates is the assumption that each
audit risk factor in the model proxies for the same underlying factor. The dollar offset for the average company
in the sample would be greater if we relaxed this assumption.
 Puul A . Grzfin, David H . Lont and Yuan Sun 41
Journal of Contemporary Accounting & Economics Vol4, No I (June 2008) 18-49

the Panel B coefficients are moderated negatively when the superior governance occurs
later versus earlier in the study period. These time-related interaction effects for and c
IDIR, in addition, are less than the coefficients for the same variables in Panel B, which
provides a reasonableness check on the analysis. We are less certain about the IAUD x
YR03 interaction, since the IAUD x YR03 coefficients in Panel C are insignificant. We
also estimate the effect of the interaction between and INSD to assess whether superior
governance moderates negatively the positive coefficient for INSD in Panel B. The negative
c
coefficients for the interaction variable x INSD support this view.
Finally, Table 3 shows that a two-stage regression approach (Regressions 1 to 4)
generates coefficients that are qualitatively identical to those using a single-equation
approach (Regressions 5 and 6). This occurs most likely because we derive thecinstrument
in Regressions 1 to 4 from a regression of the G-index on the individual governance factors
and internal control spending, and this has an R2of over 90 percent. This similarity of results
of the regression estimation approaches suggests that the potential problems associated with
the so-called “simultaneous equations bias” are unlikely to lead to misleading inferences
in research designs of the kind that we use in this study, despite the fact that our results
are consistent with an endogenous link between governance and auditing.
While we cannot be sure that these results would occur with other governance
instruments, we examine the sensitivity of our results to the use of alternative governance
indexes and alternative governance-audit risk interactions in Section 5. In unreported
analysis, we also find that the results in Table 3 are qualitatively identical when we exclude
utilities and professional service companies and/or new audits (up to two years following a
dismissal) from the analysis, and when we replace the log of internal audit budget with log
of audit-related fees or non-audit fees in the construction of the instrumental variable, G.

5. Robustness Analysis

5.1 Pre- and post-SOX analysis

This analysis considers further whether the passage of SOX and its perceived or actual
effects on corporate governance might mostly explain the results thus far. While the passage
of SOX provides a “natural” experiment to test how imposed additional governance might
affect audit risk and audit fees, our theory of the relation between governance and auditing
should extend to periods with “shocks” in anticipation of or following such legislation?*We,
therefore, partition the sample into audit fee observations before and after SOX’s passage
on July 25,2002. Because we partition by date, we omit the time-dependent variables in
Model 3 from the regressions. We also split the pre- and post-SOX partitions by company
size based on market capitalization to check the possibility that the impact of SOX might
be costlier for small companies.

’’ Neither period is likely to be immune to exogenous shocks, although they are unlikely to be of the sig-
nificance of the passage of SOX on July 25,2002. For example, the period before SOX experienced several
market upheavals with governance implications, such as the demise of Enron and WorldCom and the market
drop from the “re-pricing’’ of internet stocks. The period after SOX witnessed similar events also, such as the
implementation of the SOX provisions. Many of these had significant implications for governance that may not
have been fully appreciated as’of SOX’S passage in 2002. Model 3, however, does control for SOX-mandated
internal control audits, which commenced in late 2004.
42 Paul A . GrifJin, David H . Lon1 und Yuun Sun
Journal of Contemporary Accounting & Economics Vol4, No I (June 2008) 18-49

Table 4 reports the results. Regressions 1 and 2 summarize Model 3 for the full sample
and include four corporate governance variables (G, INSD, IDIR, and IAUD) and four
corporate governance-audit risk interaction variables (G x LOSS, G x LITG, G x QUAL,
and G x RCVR). We exclude the interaction between governance and resignation (c x
RSGN) as we lack sufficient observations for both the pre- and post-SOX periods. Panel A
reports the coefficients for the non-governance audit fee determinants. These coefficients
are mostly significant and in the expected direction as per the prior literature. They are also
similar in sign for both sub-periods and consistent with the results in Table 3, although
the regressions in Table 3 include additional time dependent variables and are estimated
using larger samples. Panel B of Table 4 offers a further test of H, (in the alternative
form) - that the coefficients for the governance variables should be positive. This panel
documents positive and significant coefficients for and IDIR for both sub-periods, which
c
support the rejection of H, for these variables. For example, the pre-SOX coefficient is
0.034 (Regression 1) whereas the post-SOX G coefficient is 0.022 (Regression 2). INSD
is significantly positive only in the post-SOX period, and IAUD is insignificant for both.
When we split on size, the coefficients for the governance variables show no clear pattern,
c
however. The pre- and post-SOX coefficients are more positive for larger than smaller
companies. Also, the IDIR coefficient increases (decreases) for large (small) companies
from before to after SOX. None of the governance coefficients in any of the regressions,
however, is significantly negative, which would be inconsistent with the rejection of H,.
Panel C offers a further test of H, (in the alternative form) - that the governance-audit
risk interactions should be negative, consistent with an audit risk price reduction. The
audit risk variables in Panel C are defined for the entire study period, and not truncated
as in Panel C of Table 3, since the regressions in Table 4 require both pre- and post-SOX
observations for all audit risk variables. Consistent with our second hypothesis (HJ,
Regressions 1 and 2 show significantly negative coefficients in both sub-periods for cx
c
LITG,c x LOSS, and x QUAL. The coefficient for G x RCVR is significantly negative
for the pre-SOX period only. In addition, as we would expect, the offsets for the impact of
governance on audit risk proxies LITG, LOSS, and QUAL, which are all reliably negative,
are less in magnitude than the risk factors themselves, which are all reliably positive. Also,
none of the interaction coefficients in Panel C is significantly positive, which would be
inconsistent with the rejection of H,. Lastly, Regressions 3 to 6 show that the negative
c
interaction coefficients in both sub-periods for G x LITG, x LOSS, and x QUAL also
occur for both larger and smaller companies. In other words, the governance-audit risk
interactions do not appear to depend on either the passage of SOX or the size of the firm
subject to governance changes during the study period.
On balance, this analysis shows that we can reject H, and H, (in the form of a null
hypothesis) for a majority but not all of the governance proxies and governance-audit risk
interactions for both the pre- and post-SOX sub-periods and for small and large companies.
These sub-sample results, therefore, support the rejection of both hypotheses, but they are
not as uniformly consistent as those based on the entire study period.

5.2 Alternative governance-audit risk interactions

We also estimate the equivalent of Regression 5 in Table 3, except that we substitute

 Paul A . GriJfm,David H . Lont and Yuan Sun 43
Journal of Contemporary Accounting & Economics Vol4, No I (June 2008) 18-49

Table 4

Regression Results of Log of Audit Fees on Pre- and Post-SOX Variables and Market Capitalization

Pre-sox Post-sox Pre-sox Post-sox Pre-sox Post-sox

all all large I'arge small small

Sign Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig.

Panel A: Control voriuhleh

Intercept -0.423 ns 1.036 *** -0.212 ns 1.217 * 0.678 ns 2.506 ***

LNAF + 0.099 *** 0.073 *** 0.103 *** 0.081 *** 0.103 ** 0.059 ***
SIZE + 0.381 *** 0.378 *** 0.329 *** 0.372 *** 0.350 *** 0.311 ***
SALE + 0.172 **:* 0.129 +** 0.215 ** 0.119 *** 0.152 + 0.142 ***
SGMT + 0.229 *** 0.235 *** 0.252 *** 0.277 *** 0.207 * 0.171 ***
QUlK - 0.001 ns -0.011 ns 0.000 ns -0.024 + -0.002 ns -0.005 ns
DEBT ? -0.521 ** -0.427 *** -0.164 ns -0.382 * -0.780 ** -0.366 **
ZSCR - -0.018 + -0.018 *** -0.015 ns -0.017 * -0.029 + -0.022 **
FISC + 0.129 * 0.195 *** 0.118 ++ *** 0.125
0.224 ++ 0.145 ***
MANU + 0.160 ** 0.248 *** 0.146 + *** 0.182
0.284 * 0.209 ***
UTlL - -0.332 * -0.381 *** -0.239 ++ -0.339 *** -0.376 + -0.388 ***
PWCP + 0.062 ns 0.079 * 0.004 ns 0.061 ++ 0.096 ns 0.081 +
LOSS + 0.300 *** 0.196 *** 0.100 ns 0.135 ++ 0.399 *** 0.227 ***
LITG + 0.343 *** 0.292 *** 0.347 *** 0.286 *** 0.351 ** 0.284 ***
QUAL + 0.241 *** 0.213 *** 0.214 * 0.207 *** 0.228 * 0.200 ***
RCVR + 0.852 * 0.525 * 1.514 + 0.088 ns 0.553 ns 0.500 +
IPUB ? 0.221 ns 0.406 *** 0.002 ns 0.372 * 0.211 ns 0.428 *
Punel B: Governance variuhle'

-
G + 0.034 * 0.022 * 0.046 * 0.021 + 0.005 ns 0.011 ns
INSD + 0.054 ns 0.070 * 0.085 ns 0.045 11s -0.039 ns 0.057 ns
IDIR + 0.688 *** 0.596 *** 0.451 + 0.695 *** 0.897 ** 0.485 **
IAUD + 0.051 ns -0.040 ns -0,081 ns -0.108 * 0.176 + 0.054 ns

IDIR, IAUD, or INSD for in the five variables that interact governance with audit risk.
For IDIR, the five alternative interactions are IDIR x LOSS, IDIR x LITG, IDIR x QUAL,
IDIR x RCVR, and IDIR x RSGN. Unreported results show that each of the coefficients
for these interactions is negative, and the coefficients for three of the interactions - IDIR x
LOSS, IDIR x LITG, and IDIR x QUAL - are significantly negative. The coefficients for
the Panel A variables are similar to Regression 5 in Table 3 , as they are the same variables
in the original and re-estimated regressions. Likewise, for IAUD, unreported analysis
finds that three of the interactions - IAUD x LOSS, IAUD x QUAL, and IAUD x LITG
- are negative and the IAUD x LOSS and IAUD x QUAL interactions are significantly
44 Paul A . Grifln, David H . Lont and Yuan Sun
Journal of Contemporary Accounting & Economics Vol4,No I (June 2008) 18-49

Table 4 (Cont.)

Regression Results of Log of Audit Fees on Pre- and Post-SOX Variables and Market Capitalization

pre-sox Po9-SOX pre-sox Post-sox pre-sox Post-sox

all all large large small Small
Regression” (1) (2) (3) (4) (5) (6)
Pred.
Sign Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig. Coeff. Sig.

Panel C:Interaction efect

Audit risk
c x LOSS - -0.050 *** -0.038 *** -0.039 ++ -0.031 * -0.050 * -0,039 ***
x LITG - -0,049 *** -0.035 *** -0.044 * -0.037 *** -0.049 * -0.028 *
c x QUAL - -0.050 *** -0.045 *** -0.055 *** -0.049 *** -0.045 ** -0,037 ***
c x RCVR - -0.064 + -0.028 ns -0.095 ns 0.029 ns -0.038 ns -0.022 ns
Other
x INSD - -0.006 ns -0.009 * -0.008 ns -0.004 ns 0.004 ns -0.008 ++
F 87.07 *** 282.83 *** 37.07 *** 131.42 *** 15.98 *** 47.77 ***
R2 65.5% 65.2% 61.3% 63.4% 40.0% 38.3%
No. obs. 1 I33 3768 570 1880 563 1888

***,**,*,+,++indicate the significance levelat the0.0001,0.001,0.01,0.05,0.10respectively

andns indicates
not significant.
Notes to Table 4.
Largeismall based on market capitalization as of end of fiscal year.
Control variables are defined in Table I .
Governance variables are defined in Table 2.

negative. In sum, we obtain similar results, consistent with the rejection of the audit pricing
hypothesis in the null form (HJ, when we substitute IDIR and IAUD as alternatives for
G in the Table 3 regressions.
On the other hand, our analysis finds that the coefficients are no different from zero
when we substitute INSD for G in the five interaction variables. We have already noted,
though, that INSD possibly reflects factors that both encourage and discourage stronger
governance, which may explain this insignificant result.

5.3 Analysis based on alternative governance indexes

Brown and Caylor (2006) propose Gov-score as an alternative based on a broader

set of internal and external mechanisms than those used in G-index. Bhagat and Bolton
(2008) suggest that median director’s stock ownership percentage (MedDirOwn) is an
appropriate governance measure because the “median director” can be viewed as a swing
vote in governance decisions. Both studies contend and show that their measures associate
 Paul A. Griffin, David H . Lont and Yuan Sun 45
Journal of Contemporary Accounting & Economics Vol4, No 1 (June 2008) 18-49

better with company performance than the G-index?’

We also apply principal components analysis to extract one or more “governance”
dimensions from the Governance database factors and other variables. While previous
efforts in this area extract multiple dimensions and suggest names for each factor (e.g.,
Larcker et al. (2007) extract 14 dimensions based on 40 governance variables from sources
similar to the IRRC data), our hypothesis tests of the interactions of governance and audit
risk make this approach impra~tical.2~ Consequently, we use a reduced-factor approach,
and apply principal components analysis (a varimax orthogonal rotation) to the individual
Governance variables in (?, IDIR, IAUD, and INSD to obtain two orthogonal principal
components. Of these two components, we then choose the one that maximizes the variance
of the variables used. We denote this component as “ G - f a c t ~ r ” . ~ ~
For each alternative governance index, we re-estimate the equivalent of the regressions
in Table 3, except that we now replace G in Model 3 with Gov-score, MedDirOwn, or
G-factor. Unreported analysis shows the following. First, Gov-score (Brown and Caylor,
2006), IDIR, and IAUD are positively and significantly related to the log of audit fees,
consistent with the governance hypothesis (H,), whereas INSD shows a negative relation.
None of the Gov-score-audit risk interaction coefficients is significant. Second, MedDirOwn
(Bhagat and Bolton, 2008) is not significant,and only one governance-audit risk interaction
coefficient is significantly negative, namely, MedDirOwn x LITG. Third, the coefficient
for G-factor is positively and significantly related to the log of audit fees, consistent with
the governance hypothesis, and all of the G-factor-audit risk interaction coefficients are
negative, and two of these are significantly negative, consistent with the audit pricing
hypothesis. Shortcomings aside, these results favor the G-index or G-factor over Gov-score
or MedDirOwn as an overall measure to discern relations between corporate governance
and audit fees.

6. Summary and Conclusions

How corporate governance relates to and interacts with auditing to influence the fees
paid by companies to their auditors raises interesting and significant empirical issues for
accounting research and practice. Knowledge of this interaction may help professionals and
regulators understand better how spending on corporate governance, including auditing,
which ha: increased substantially since the passage of SOX, might also have induced a
decrease in fees through a reduction in the price of audit risk. Our review of the research

23 We obtain Gov-score from Georgia State University. These data are available for 2,538 firms as of Febru-

ary 1,2003; 2,749 firms as of February 1,2004; and 3,258 firms as of February 1,2005. We obtain the directors’
stock ownership data as used in Bhagat and Bolton (2008) from Brian Bolton, University of New Hampshire.
The median director’s ownership data are available only for 2000 to 2002.
24 For example, 14 dimensions of governance would require that we conduct 70 (14 dimensions times 5

audit risk variables) separate tests of H2, and some of these would likely incorrectly reject the null hypothesis
due to sampling error.
25 The factor analysis pattern solution suggests that G-factor represents mostly the anti-takeover and charter

variables in the Governance database, whereas the second factor reflects mostly directors’ provisions and similar
variables. The correlations between G-factor and G, log of internal audit budget, IDIR, IAUD, and IDEP, respec-
tively, are 0.885,0.279,0.444, -0.169, and -0.389.
46 Paul A . Grljfin, Duvitl H . Lont and Yuun Sun
Journal of Contemporary Accounting & Economics Vol4, N o I (June 2008) 18-49

thus far reveals mixed results. Some studies suggest a positive relation between governance
and audit fees, whereas some suggest a negative relation.
We extend the literature by stating and testing a framework that unjfies the two
countervailing relations. From the perspective of directors or shareholders, we predict and
find that companies that reflect a need for stronger governance or have more independent
boards and audit committees pay higher audit fees, presumably to effect better governance
and auditing outcomes. However, we also predict and find that governance needs and board
or audit committee independence interact negatively with audit risk. We are the first, of
which we are aware, to document significant, co-determined positive and negative relations
between governance, audit fees, and audit risk. These results imply that the audit fee
increases following SOX which, thus far, have been explained in terms of increased audit
effort and risk sharing, may have been moderated by audit fee offsets from governance
induced reductions in the price of audit risk.
First, we document a positive relation between audit fees and each of the governance
measures we examine (instrument based on G-index, G-index, independence of the
board, independence of the audit committee, and percentage of stock owned by insider
shareholders). Collectively, these results support our first proposition - the governance
hypothesis. Second, we interact the governance measures with several proxies for audit
risk, such as whether the company experiences a loss, prior litigation, auditor qualification,
auditor resignation, and the reciprocal of analyst following, and find that governance
as proxied by our G-index instrument and board and audit committee independence
interacts negatively with our proxies for audit risk. Our framework interprets this negative
interaction as a reduction in the price of audit risk from superior governance, which induces
a reduction in audit fees. These results support our second proposition - the audit pricing
hypothesis.
From an economic standpoint, we estimate that this negative interaction, based on the
interaction of the G-index instrument and audit risk, moderates the price of audit risk for
the average company by approximately six percent, which we calculate implies a dollar
offset to the average company’s audit fees of approximately $180,000, and more than
$500,000 for the larger companies in our sample.
We also document a positive governance relation and a negative governance-audit risk
interaction for separate intervals before and after the passage of SOX and for small and large
companies, although the results are stronger and more consistent when we use all company-
year observations. This result may reflect the possibility that the entire period experiences
a substantial shift in governance and auditing resources from before to after SOX, whereas
the sub-period shifts i n governance and auditing are relatively more modest.
While these and other additional tests generally support our findings, they also raise
several avenues for further study. For example, governance might not only be influenced
by companies’ purchase of auditing services (as we model in this paper) but, also, by
specific events such as auditor resignations or dismissals that could prompt boards and
audit committees to make specific changes in governance. In this regard, governance
changes might reflect a negotiation process between the new auditor and management or
the board, which could also be a fruitful area for inquiry.
 Paul A . Griffin, David H . Lont and Yuan Sun 41
Journal of Contemporary Accounting & Economics W 4 , No I (June 2008) 18-49

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