Original Article

Post-SarbanesOxley changes in the composition of boards: Have they impacted spending for audit services?
Received (in revised form): 9th May 2011

Timothy G. Coville
is an assistant professor (CPA, MBA, PhD) in the Accounting and Taxation Department of the Peter J. Tobin College of Business at St. Johns University. He came to academia after a successful 20-year career as a controller and risk manager for international derivatives trading rms. His banking career entailed a number of extended assignments and travel in Europe, Asia and South America, as well as the USA. His research examines issues concerned with corporate governance, derivative products and sustainability.

Gary Kleinman
is an associate professor of Accounting, Law and Taxation. His principles areas of research are auditor independence, individual and group decision making in auditing, international accounting research, and standard setting in accounting. He previously taught at the Touro Graduate School of Business and at the Rutgers School of Business. He holds a PhD in Management, MBA in Finance and BA in Economics from Rutgers University. He is also a CPA in Colorado.

ABSTRACT The issue of the importance of the independent auditors audit to the integrity of corporate nancial statements has been a staple of the corporate governance and nancial market functioning literature since the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts required auditor attestation of corporate nancial statements. Subsequent to the passage of the auditor attestation requirement, occasional nancial reporting scandals erupted. None of these had the impact of the Enron/Worldcom scandals of 2001 and 2002. These scandals illustrated the ability of corporate management to game the corporations nancial statements, despite or perhaps with the tacit concurrence of the boards of directors of affected rms. Accordingly, much of the 2002 legal response to corporate nancial reporting scandals came in the form of new corporate governance requirements on all publicly held rms. The impact of these requirements, however, differed between rms. Some rms had introduced use of independent directors and fully independent committees before their being made compulsory in 2002. One instrument of control over corporate management that the board of directors possesses, in actuality or potentially, is control of the extent of the work of the independent auditors. The auditors work can result in the board learning of accounting-related corporate mis-and malfeasance. Accordingly, the extent of the auditors work is important and the obvious surrogate for this effort is the audit fee. This investigation examines the effect on spending by listed rms for audit services attributable to the SarbanesOxley Act of 2002 and related stock exchange regulations. It uses the difference-in-differences methodology to overcome endogeneity concerns. The results reveal that rms that were compelled by law to change their boards increased their spending on nancial statement-related audit services more than did rms that had pre-adopted the SarbanesOxley corporate board composition requirements.

International Journal of Disclosure and Governance (2012) 9, 3651. doi:10.1057/jdg.2011.12; published online 23 June 2011
Keywords: SarbanesOxley; governance; independent director; audit fees; boards; natural experiment
Correspondence: Timothy G. Coville St Johns University, Queens, NY 11439, USA

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Post-SOX Changes in the Composition of Boards

INTRODUCTION
The aim of this study is to identify empirical evidence as to whether or not the Sarbanes Oxley Act of 2002 (SOX) and the related New York, NASDAQ, and American Stock Exchanges listing requirement for changes to board composition contributed to changes in the listed rms spending for nancial statement audit services. This is a question of discovery. As such, this study seeks to examine the impact of the historic scandals and subsequent reactive laws and regulations on audit spending through use of the difference-in-differences (DID) methodology. The central question is whether the recent regulatory emphasis on greater use of independent directors on publicly listed corporate boards and board committees, has been an effective means of increasing the quality of nancial statement audits. Higher quality audits are relevant to shareholders given the steep cost of earnings restatements and the positive value ascribed to unbiased, and materially accurate nancial statements. According to a report of the General Accounting Ofce (GAO, 2002) on nancial statement restatements, the average negative stock price response to restatement announcements was nearly 10 per cent over a 3-day period surrounding the announcement, with cumulative losses in market capitalization of nearly US$100 billion dollars in the surrounding period (from January 1997 to June 2002). The GAO report provides a retrospective look at prior, poor, nancial statement quality and the subsequent improvement owing to nancial statement restatements. Generally, nancial statement audit quality cannot be observed directly. Audit failures are one indication, but it is empirically unknown just what percentage of audits fail, since only some failed audits will result in litigation against the auditor. Further, even if litigation is undertaken against the auditor, it is unclear whether that litigation is warranted and whether any settlement agreed to was due to fear of reputation or litigation loss if the suit continued. This study uses spending for auditing services

to proxy for the quality of nancial statement audits. All publicly listed rms must report that spending, so the trend of that spending can be observed over time. Further, given that audits are frequently described as legally required commodities undertaken in a very competitive audit market, the trend in audit fees across providers is a strong indicator of audit effort exerted. Audit effort, of course, must be purchased, with the auditors effort serving both the internal agency needs of management and the external agency needs of the rms stakeholders, its shareholders and creditors (for example, Jensen and Meckling, 1976). In modern corporate governance, the boards of directors are supposed to serve the shareholders interests. As Fama and Jensen (1983) state, An important function of the board of directors is to minimize costs that arise from the separation of ownership and decision control in the modern-day corporation. Yet, Jensen (2000) notes that these mechanisms may be inadequate. He recommends that the only inside board member should be the CEO (p. 39). In the historic background section, it is obvious that the scal monitoring and decisionmaking entrusted to boards has often failed. This study contributes evidence to the highly active debate about the importance of using independent directors. Directors are intended to monitor and advise executives to help assure that the executives act in a manner consistent with shareholders interest. How well they do so is a matter of dispute. Mitra et al (2007), for example, cite research that holds that independent corporate boards do a better job of overseeing the rms nancial reporting process, in part through leading rms to acquire better audit services. Others, however, argue that the relationship between the members of the board and management are too cozy, and have mutually benecial aspects (for example, Stein (2008). In addition, Jonathan Macey (2009), then Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School, has also

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argued that even so-called independent directors can become captured by the rm, raising questions about whether board independence is of much use. The importance of corporate governance structures in controlling managerial behavior remains strong, especially given the alleged governance lapses that led to the overleveraging and subsequent collapse of such key US nancial institutions as Lehman Brothers, Bear Sterns and Merrill Lynch. The role of the Enron Board of Directors in overseeing, or overlooking, the behaviors that led to the collapse of that institution has become the stuff of legend. This research article proceeds with the following sections: Historical background related to greater use of independent directors. A description of the recent legislative and regulatory initiatives and the opportunity they provide to implement a DID or natural experiment investigation. A review of the academic literature relevant to use of independent directors (a.k.a. board composition) in relationship to audit fees and the substantive hypothesis developed from this literature. A modeled relationship and data employed, with a discussion of the results obtained. Discussion of results and future research envisioned.

HISTORIC BACKGROUND
As Coville (2008) notes, board of directors inuence on their rms has been a topic of considerable debate and academic investigation for several decades now. Much of the concern is with the excess inuence of rm management over their boards and the lack of independent diligence by the board members. A common theme echoed by many corporate governance commentators is the desirability of increased board of director independence from management, most specically from the CEO. The push for greater use of independent directors

has been slow, and has often received additional impetus in reaction to scandals. In response to the Penn Central and Lockheed scandals of the 1970s, and additional scandals and ensuing blue-ribbon reports (for example, the 1987 National Commission on Fraudulent Financial Reporting and the 1999 Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees) the listing requirements of both the NYSE and the NASDAQ were changed to require independent audit committees for listed rms, using precise denitions of what constitutes an independent director. Nonetheless, even with these requirements, in less than 3 years time, 20002002, the market again witnessed several high prole nancial reporting failures, all attributed to deliberate deceptions by executive management. This latest round of scandals forced the required use of independent directors beyond just the boards audit committees. The situation was broadly considered serious, given that the Dow Jones Industrials and the NASDAQ index lost over 30 and 60 per cent of their respective values. Some of this loss may be attributed to the recession of the early part of the 20002010 decade, as well as geopolitical factors. There is no doubt, however, that some of this decline was because of the impact of accounting scandals on investor condence. Also, beyond the signicant steps of requiring the use of independent directors, SOX, the Securities and Exchange Commission (SEC) and the Exchanges regulated by the SEC now required greater clarity over who may be considered independent and what that label entails. The topic of SOXs new board composition requirements, and their efcacy, is important given both (a) the failure of market forces to eliminate it as an issue despite decades of concern, and (b) the oft raised concerns with how or whether SOX should be amended. The regulatory changes enacted in 2002 give rise to a relatively unique opportunity

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to examine the impact of the regulations on corporateauditor relationships, as proxied for by the nancial statement audit fees charged by the audit rms.

NATURAL EXPERIMENT OPPORTUNITY

The focus of this study is on the 2002 requirements for greater use of independent directors on publicly listed rms boards of directors by SOX, the NASDAQ, AMEX and NYSE (hereinafter, the exchanges). The historical background above shows that rms could have known of the suggested use of a majority of independent directors and the establishment of fully independent Audit, Compensation and Nominating Committees as best practice, at least in the eyes of some. Nonetheless, by 2001, only 254 or less than 17 per cent of the top 1500 US Firms tracked by the Investor Responsibility Research Center (hereinafter, IRRC) had taken all these steps and nearly 6 per cent or 89 rms had failed to comply with any of these recommendations. Now under the force of law, SOX and the exchanges requirements, all listed rms were given until their 2004 annual stockholder meetings to become fully compliant. There were other new legal and regulatory responses, initiatives and requirements arising from the scandals which would affect all rms (for example, CFO and CEO nancial statement and internal controls certications and the banning of some non-audit services, long considered a threat to the independence of the auditor.) Understanding whether independent board members indeed exerted greater control over corporate management is difcult to tease out, as the notion of director capture mentioned above indicates. There is, however, a clear record of spending by corporations on fees paid to the auditors for the nancial statement audits alone. Accordingly, the research question pursued here is: Do rms that were forced to change their board compositions to achieve compliance with changed legal and exchange requirements experience

greater increases in audit fees linked to these board composition changes, than did rms that pre-adopted the ultimately required board composition changes? This investigation captures, on a timely basis, the effects, if any, of these 2002 enacted changes in regulation, affecting board composition, on spending for nancial statement audits. The design and methodology will offer greater certainty that any effect on nancial statement audit spending detected is related to a change in Board of Director composition, a change which is exogenous and occurs in a rm-level setting.

DIFFERENCE-IN-DIFFERENCES
Triest (1998) wrote that The differencein-differences (DID) estimation technique has been used extensively in work examining the ways in which government policies affect behavior. DID estimation consists of identifying a specic intervention (often the passage of a law), which may be considered analogous to an experimental treatment (Meyer, 1994). The differences in outcomes before and after the intervention are then compared between entities/rms affected by the treatment, the treatment group, on the one hand and differences for those entities/rms relatively unaffected by the intervention, the control group, on the other. In this study, the intervention is SOX and the related stock exchange listing requirement changes. The unaffected/ control group consists of those rms which had previously adopted the new board of director and committee composition requirements, similar to those mandated by SOX. The affected/treatment group consists of those rms which had not adopted SOX mandated requirements until SOX and the stock exchanges compelled this compliance subsequent to 2002.

PRIMARY INDEPENDENT VARIABLE

The level of the pre-SOX compliance index served as the primary independent variable. The DID method requires that a suitable variable is available with which to classify observations

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between the treatment and control groups. This study will use an index which is the sum of four indicator variables for whether a rm had in the year 2001, before SOX: (1) an independent nominating committee; (2) an independent compensation committee; (3) an independent audit committee; and (4) a majority of independent directors. This measure is similar to one used by Chhaochharia and Grinstein (2006), although they used the year 2000 proxies instead of the 2001 proxy information used in this investigation. The sum, of all four indicator variables, is used because the combination of all is most likely to help assure the adequacy of the auditing process. The use of independent nominating committees helps reassure directors, present and potential, that their role on the board of directors is less likely to be jeopardized by management, should the directors take a stand on an issue contrary to managements wishes, than the director may feel if the nominating committee was not independent of management. The use of an independent compensation committee also helps assure that the process of evaluating managements performance is being done by those who have no relationship to the rm that may lead to an inappropriately positive evaluation of managements performance. The independent compensation committee will appreciate the importance of the nancial statement-based performance metrics used in their compensation decisions. Similarly, having a majority of members of the board of directors, who are independent of management helps assure the completeness of the audit process since that majority provides a protection to the auditor with respect to his/her ndings and his/her continued tenure with the client entity. Obviously, as well, the independent audit committee provides an immediate buffer between the auditor and client management, enabling the auditor to present his/her case to these independent directors before having to address managements perhaps self-interested concerns. Taken together, we believe that separating the sample between rms that, in 2001, had

none of these independent board features and those that had all of them provides a strong test of the impact on auditor fees of the SOX and the exchange-compelled changes in board composition. The advent of SOX, then, provides a transparent exogenous source of variation in this index variable that determines the treatment assignment. This as Meyer (1994, p. 1) suggests: may allow a researcher to obtain exogenous variation in main explanatory variables. This occurrence is especially useful in situations where estimates are ordinarily biased because of endogenous variation due to omitted variables or selection. As Hermalin and Weisbach (2003) noted such endogeneity concerns have been a consistent concern across many earlier board composition studies. One drawback of this index, as noted by Chhaochharia and Grinstein, is that it simply assigns equal weight to each of the four indicator variables. The concern with the equal weights is that to the extent that certain provisions of the rules are more important than others in affecting board oversight, the index will not capture the true level of oversight. This concern is overcome, in their and, in this investigation by comparing only zero score rms versus four score rms. Two groups of rms were created based on board of director and committee composition compliance at the time their boards were formed at their 2001 annual shareholders meetings the last meetings before 2002s regulatory changes. The rst group BOD0 consists of rms with a zero compliance score, the second group BOD4 consists of rms with a perfect score of four. This study used 2001 as the pre-intervention compliance period, because that was the last full year in which no rm would have been aware that director independence would be compelled by law. Firms in the analysis remain in their assigned groups and are only those rms that remained independent and publicly listed through all ve observation years, 20012005.

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REVIEW OF ACADEMIC LITERATURE

Board composition and auditor fees
Much of the literature on board composition and auditor fees (for example, Lorsch and MacIver, 1989) advocated for increased use of independent directors and committees composed solely of independent directors. Such committees would include the audit, compensation and nominating committees. Accordingly, regulators concluded that independent directors should be used to oversee the reliability of nancial reports and other stockholder fairness concerns. Owing to the long history of concern with boards of directors, the academic literature investigating the impact of boards and such aspects of boards as their membership/composition runs quite deep. Academic researchers have not yet, however, had ample opportunity to explore the impact of SarbanesOxley itself in great depth (for example, Anandarajan et al, 2008) owing to SOXs relatively recent enactment. Next, we present a review of board of director composition literature focused on auditor fees. We also develop our hypothesis concerning this important dependent construct. A meta-analysis of the last 25 years of audit fee determination models by Hay et al (2006) calls for further investigation into: How a rms governance and the regulatory environment that the rm operates in affect the market for audit services and the fees that the external auditor charges; and audit quality and the circumstances in which increased quality is demanded and paid for by stakeholders. (p. 182) Audit fees are known to vary considerably with the size, complexity, riskiness, and other characteristics of the audited entity (Simunic and Stein (1996, p. 121). A rational auditor will seek to minimize total cost by balancing their costs of performing more audit work and their expected future losses from legal liability (Carcello et al, 2002, p. 369). More

contemporary evidence is documented in Asthana et als review of the literature on auditor reaction to being hired by former Andersen audit clients (2009). The longer these clients had been audited by Andersen, the greater the fee the successor auditor charged (Kealey et al, 2007: cited by Asthana et al, 2009). In addition, Asthana et al (2009, p. 5) found that bigger and riskier audit clients had larger increases than did less risky audit clients. Boards that desire added assurance beyond an auditors cost-minimizing choice would have to pay for the added audit work required. These costs are born by shareholders, while the benets of reduced liability accrue strictly to the directors. This leads to higher audit fees as the costs are absorbed by the client. The National Association of Corporate Directors stated its expectation that board members demonstrate independence, diligence, and expertise (cited in Carcello et al, 2002, p. 370). Chen and Zhou (2007: cited in Asthana et al, 2009) found that sample rms with more independent audit committees, audit committees with greater nancial expertise, and larger and more independent boards dismissed Andersen earlier and were more likely to choose a Big 4 successor rm than were other rms. Chen and Zhous (2007) ndings are consistent with our expectation that the requirement for more independence of board members will result in greater audit efforts. This nding suggests that even pre-SOX, audit fees may have increased from 2001 levels because of higher levels of demanded audit work in 2002.1 SOX mandated additional responsibilities for board audit committees, further strengthening the link between the board and the quality of audit services performed. It also codied the audit committees responsibility for selecting and agreeing the fees of the external auditor, though auditor selection is still formally subject to shareholder ratication. Auditors are now required to report directly to the audit committee causing auditors to see more clearly that boards are their clients, with management now demoted to an interested third party.

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A number of studies document positive associations between board independence and actions that are in the best interests of shareholders (for example, Cotter et al, 1997). Others have noted that because of agency issues between shareholders and management, there are incentives for managers to bias nancial results for personal benet ( Jensen and Meckling, 1976; Watts and Zimmerman, 1983). Outside/Independent directors have incentives to prevent such biased reporting (Fama and Jensen, 1983). Carcello et al (2002) highlights three such director incentives: their reputations; their legal liability; and lastly a sense of responsibility to shareholders who may suffer large losses when nancial reporting issues become public. Beasley (1996) found an inverse relation between the percentage of outside directors on the board and the incidence of fraudulent nancial reporting. Dechow et al (1996) also found an inverse relation between the percentage of outside directors on the board and the incidence of SEC enforcement actions related to earnings overstatements. It would be consistent then for directors seeking to protect their own and shareholder interests to seek higher quality audit services, with resulting higher fees. A known means of reducing the likelihood of fraudulent reporting, and biased reporting behavior, generally is to pay for higher quality audit services. Mitra et al (2009), for example, found that pre-SOX, both higher expected audit fees and unexpected audit fees resulted in lower levels of discretionary accounting accruals as a whole (that is, in absolute terms), and separately for positive accruals and negative accruals. They found that, post-SOX, there was less of a relationship between greater levels of expected and unexpected audit fees and the levels of accruals studied. Although the authors attributed this latter effect to the auditors concern about reputational effects, it may also have been a result of the required CEO and CFO certications that SOX required. The Mitra et als study (2009) demonstrates the impact of SOX on nancial reporting practices of the client entities. It does not,

however, clearly indicate the impact of corporate governance changes required by SOX on accounting practice. One may view independent directors as more concerned with audit quality than are management directors, who face greater conicts of interest. Mitra et al (2007), using a sample of NYSE rms drawn from the year 2000, found that both (a) the percentage of non-management outside directors on the board; and (b) having an audit committee consisting solely of independent directors were positively related to audit fees. Having at least one audit committee member with nancial or accounting expertise, however, was not related to audit fees. The Mitra et als study (2007) dealt with 1 year, pre-SOX, and as such could not address both endogeneity questions and the change in the business environment that led to SOXs enactment Ghosh and Pawlewicz (2008) also found an increase in audit fees with the adoption of SOX but did not explore the change in governance requirements triggered by SOX. They concluded that the relative importance of audit risk in inuencing audit pricing increased signicantly following SOX (p. 194). They also found that (a) Big 4 auditors charged higher fees after the adoption of SOX; and (b) that higher legal liability was not an explanation for the increased audit fees. Our study hypothesizes that, given the expectation of heightened board independence, boards that undergo the greatest change to comply with these new rules will generate the greatest increase in their rms audit fees. To test this hypothesis, we will use an index of pre-compliance with these new regulations before they were known in order to test the following substantive hypothesis: Hypothesis 1: The change in average Audit Fees for rms in group BOD0, from preSOX periods (20012002) to post-SOX periods (20042005) will be signicantly different than the change in average Audit Fees between the same periods for rms in group BOD4.

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It is possible, of course, that the greater attention to the adequacy of corporate governance mechanisms may have led both auditors and corporate management to be less concerned with potential audit failures, accordingly, audit fees may have declined in the postSOX period. As Jensen and Meckling (1976) may have argued, with greater, independent, in-house monitoring capability resident on the board, an argument could be made that audit fees would decline with the enactment and subsequent governance changes introduced by SarbanesOxley. With the greater independent monitoring ability, auditors may have felt more assured that the clients management may have been less likely to engage in suspect activities than otherwise, and accordingly the auditors may have felt comfortable with reducing the level of their audit efforts. Ultimately, whether the changes wrought by SOX resulted in an increase or a decrease in audit fees is an empirical question with the expectation guided by theoretical concerns. In this section, we laid out our theoretical arguments and expectations for increased spending for audit services based on higher demand from increased use of independent directors. The arguments just mentioned, for reduced audit fees based on the audit rms perceptions of improved governance, will make any empirically identied increases all the more telling about the added demand for audit work related to increased use of independent directors. In the next section, we present our methodology for addressing the empirical issues involved.

Modeled relationships
The DID methodology was discussed above along with a description of the primary independent variable of interest here, the level of pre-SOX compliance with board of director and board committee independence requirements. As described there, the index measure used captured low pre-SOX compliance assigned rms to treatment group BOD0 and highly pre-compliant rms to control group BOD4. Throughout the following you will see membership in the BOD0 group included as an indicator variable in the regression model. This regression model will be specied using control variables consistent with extant literature regarding auditor fees. This same model will also include changes between the time periods of interest, pre- and post-SOX, and the indicator variable for membership in BOD0. The null hypotheses tested are stated as a test of whether the BOD0 coefcient is equal to zero in the change in spending for audit services dependent variable regression model. The alternative hypothesis developed earlier, Hypothesis 1: Firms that undergo the greatest changes to board composition to come into compliance also experience the greatest change in average audit fees from pre-SOX periods (20012002) to post-SOX periods (2004 2005), leads to null statistical hypotheses: Hypothesis 2: The regression coefcient B1 for BOD0 will be equal to zero, in the following model:
LNAFEE2004-2005 LNAFEE2001-2002 =B0 +B1 BOD0+B 2 LNTA 2001-2002 + B3 RECINV2001-2002 +B4 SQRTSEGMENT2001-2002 +B5 FORGN 2001-2002 + B6 ( LNTA 2004-2005 LNTA 2001-2002 ) +B7 (RECINV2004-2005 RECINV2001-2002 ) +B8 (SQRTSEGMENT2004-2005 SQRTSEGMENT2001-2002 ) +B9 (FORGN 2004-2005 FORGN 2001-2002 ) +e it

METHODOLOGY
The years 20012002 is used as the pre-SOX period because the SEC rules requiring the disclosure of audit and non-audit fees became effective for proxies led on or after 5 February 2001. Therefore, the year 2000 audit fee data was not available. See the following Modeled Relationships and Data section for the specic statistical model and control variables used to test this substantive hypothesis.

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where BOD0 is indicator variable equal to one for rms that had none of the following governance characteristics: an independent nominating committee, an independent compensation committee, an independent audit committee or a majority of independent directors, in 2001. LNAFEE is natural log of the average audit fees for the periods subscripted. LNTA is natural log of sample rms average total assets for the periods subscripted; to control for client size. RECINV is average proportion of total assets in accounts receivable and inventory for the periods subscripted; to control for inherent audit risk. SQRTSEGMENT is square root of the number of business and geographical segments for the periods subscripted; to control for client complexity. FORGN is variable equal to the number of years, during the period subscripted, that the rm has foreign currency exposure; again to control for client complexity. The above model uses control variables consistent with Carcello et al (2002) with the exception of SQRTSEGMENT, which is being used instead of their use of the square root of the number of consolidated subsidiaries. We also do not use an opinion variable because all of the rms in our sample received unqualied opinions throughout the years of data collected. Accordingly, we dropped the use of an opinion variable and an opinion change variable. In a recent metaanalysis of the audit fee literature (Hay et al, 2006), the authors expected positive signs on all control variables. However, the audit fee models reviewed therein all focused on individual year audit fee levels as opposed to a change in average audit fees between periods. Therefore, in this study positive signs are only anticipated on the change in control variables between periods, not necessarily on the initial periods control variables. If the coefcient of BOD0 is found not equal to zero, then the alternate hypotheses that rms in the group BOD0 have had their audit fee decisions affected by forced changes in board and board committee composition,

will be supported. If inferences in the literature that independent directors are willing to spend more for the assurances of an audit are supported, then this coefcient should be positive and statistically signicant.

Data
The data source for board structure and director information was the IRRC database. Its database includes information about directors in rms that belong to the S&P 1500 index. Director information was available for the years 2000 and 2001 (before SOX), 2002 (the year of SOX) and 2003, 2004 and 2005 (after SOX). To ensure that there were no changes in dependent variables owing to rms entering and leaving the samples, only rms that existed in the databases for the entire period were included. Financial information for each of the rms was sourced from Compustat. The initial sample consists of all 1572 unique rms (7860 rm-years) in the 2006 version of the IRRC database. Accounting and security data is obtained from the CRSP/ Compustat Merged Database. The IRRC data was merged with the CRSP/Compustat Merged Database based on CUSIP, ticker and date using the CRSP/Compustat merged historical header list (crsp.headcst). The intersection of the IRRC and CRSP/Compustat les consists of 1553 unique rms (7765 rm-years). Each rm was required to have complete data for all 5-years. This requirement reduced the number of unique rms in the sample to 781 (3905 rm-years). Another two unique rms were removed for lack of audit fee data and still another 10 were removed due to a lack of receivables and inventory data. These exclusions reduced the sample size to 769 unique rms (3845 rmyears). This nal sample consists of 64 zeroscore, 101 one-score, 153 two-score, 256 three-score and 195 four-score rms based on their year 2001 corporate governance data. Table 1 summarizes the impact of each merge and lter on the number of unique rms in the sample.

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Table 1: Steps in determining sample membership Sample construction steps Firms Zero 2006 IRRC database Intersection of IRRC and CRSP/Compustat Exclude rms without data for all 5-years Exclude rms without audit fee data Exclude rms without receivable/inventory data 1572 1553 781 779 769 64 64 64 2001 corporate governance score One 101 101 101 Two 154 154 153 Three 262 262 256 Four 200 198 195

RESULTS AND DISCUSSION

We rst ran the Change in Average Audit Fee analysis model using the three industry control variables most often reported as signicant in the Hay et al (2006) review of the audit fee literature. We found that these industry control variables (for utilities, manufacturing and nancial services) separately and in combination did not signicantly inuence our results, and therefore the industry control variables were dropped. To avoid excess inuence from extreme values, any observation that had a studentized deleted residual with an absolute value equal to or greater than two was removed from the sample. This eliminated 14 of the 259, zero and four score, observations are shown in the last row of Table 1. Descriptive data on the 245 rms remaining in the sample are presented in Table 2. The resulting reduced sample was run again using the basic model above. Normality of the models residual distributions was veried by use of the Kolmogorov-Smirnov and Shapiro-Wilk diagnostic tests. Collinearity was screened by use of the variance-ination-factor statistics. No collinearity issues were noted for this audit fee model. Table 3, Model 2, shows the coefcient of the BOD0 indicator variable has a positive coefcient of 0.103 with a P-value, based on a two-tailed t-test, signicant at the 0.05 level.2

This result suggests that membership in the BOD0 group of rms is positive and statistically signicant in the model of change in average audit fees from the 2-year period before SOX until the 2-year period after SOX compliance. Among the control variables the most signicant was the average assets from the pre-SOX 2-year period, which had a negative coefcient of 0.072 and a P-value well below 1 per cent. This negative coefcient is reasonable in that the larger the assets the higher the starting audit fees leading to lower percentage increase requirements, given the already high base. The next most signicant covariate was the change in the assets from the pre-SOX 2-year period until the post-SOX 2-year period, with a positive coefcient of 0.424 and again a P-value well below 1 per cent. The positive sign of this coefcient is also intuitively reasonable in that rm growth leads to greater auditing needs. As a robustness check on these results, in a search for any distortions that dropping the 14 observations with |SDR| 2 may have caused, the same independent control variables and BOD0 were employed again. This time, a robust regression technique referred to as iteratively re-weighted least squares (IRLS) was used. The results of this robustness check are shown as Model 3 in Table 3. The results

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Table 2: Descriptive data Average Zero and four score rms Zero score rms Four score rms 2-year avg. 2-year avg. 2-year avg. 2-year avg. 2-year avg. 2-year avg. 20012002 20042005 20012002 20042005 20012002 20042005 Assets($millions) 15 277 (2856) 24.81 (23.42) 6.2 (6.0) 1.3 (2.0) 2174.9 (929.0) 20 461 (4058) 25.20 (24.28) 5.8 (5.5) 1.4 (2.0) 5086.1 (2571.4) 15 205 (1914) 25.87 (24.42) 5.7 (5.5) 1.2 (2.0) 1843.6 (702.1) 19 700 (2233) 25.99 (25.14) 5.3 (5.0) 1.3 (2.0) 4772.6 (2315.5) 15 300 (3649) 24.48 (22.88) 6.4 (6.3) 1.4 (2.0) 2278.2 (1039.8) 20 699 (4475) 24.95 (23.85) 6.0 (6.0) 1.4 (2.0) 5183.9 (2886.5)

RecInv % of assets

No. of segments

Foreign operating years

Audit fees ($000)

Table 3: Model results Variable Expected sign SDR reduced Model 1 Coefcient BOD0=Score 0 Constant LNTA RECINV SQRTSEGMENTS FORGN LNTA_Chg RECINV_Chg SQRTSEGMENTS_Chg FORGN_Chg N R R2 Adjusted R2 + + ? ? ? ? + + + + 0.128 1.464 0.072 0.095 0.015 0.040 0.424 0.245 0.051 0.032 259 49.7% 24.7% 21.9% t-value Model 2 Coefcient t-value IRLS Model 3 Coefcient t-value 2.44** 10.71*** 4.76*** 0.65 0.51 1.35 5.03*** 0.53 0.92 0.73

2.444** 0.103 10.697*** 1.513 4.753*** 0.076 0.645 0.192 0.510 0.006 1.352 0.047 5.031*** 0.353 0.530 0.317 0.913 0.080 0.725 0.032 245 57.6% 33.1% 30.6%

2.396** 0.128 13.763*** 1.464 6.255*** 0.073 1.584 0.096 0.26 0.015 1.936* 0.040 4.928*** 0.424 0.798 0.245 1.763* 0.051 0.917 0.032

259 Model F=9.07***

Notes: Signicance: ***1% level, **5% level, *10% level.

are similar to those for Model 1, and not much different than those reported for Model 2. The only variables that proved signicant, at the

10 per cent level in Model 2 and not even to that level in Model 3, were the FORGN and the SQRTSEGMENTS_Chg variables.

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The IRLS model remained signicant, as were Models 1 and 2. Most importantly, the BOD0 coefcient value remained stable and signicant in Model 3. The signicance of BOD0 for our study needs to be seen against the rationale for our study. Our study postulated that the increase in board independence, in the wake of SarbanesOxley, would result in greater spending on audit fees. The increased spending has, of course, an economic impact on the rms. To examine the impact of this increased spending associated with membership in the BOD0 group of rms, we calculated the average additional dollars spent by these rms. We did so using the following procedure. In constructing our dependent variable, we took the difference between LNAFEE20042005LNAFEE20012002 to represent the change in audit fees from the pre-SOX period and the post-SOX period. Accordingly, the dependent variables value is the result of taking the natural log of the average audit fees for the years 2004 and 2005, and subtracting the natural log of the average audit fees for the years 2001 and 2002. The resulting difference in these natural logs may be used as the power to which e should be raised to nd the value that, when multiplied by the average audit fees for the years 2001 and 2002, equals the average audit fees for the years 2004 and 2005. Thus, e raised to the power of our independent variable provides the amount of growth, or the multiplier, needed to get from our base period average audit fees to the later periods average audit fees. Given that the coefcient on BOD0 is + 0.103, this value is added to the value of our predicted independent variable values in the case of these totally non-pre-compliant rms in order to arrive at predicted audit spending post passage of SarbanesOxley. e raised to the power of + 0.103 equals 1.1085, indicating that early period audit fees for pre-SOX non-compliant rms increased an additional 10.85 per cent to reach their post-SOX levels. This result apparently was caused by the non-compliant rms need to comply with SOX and the exchanges increased use of independent director

requirements. Given that the initial periods average audit fees for BOD0 rms is $1 843 600, see Table 2, the average additional dollars spent by each BOD0 rm is slightly more than $200 000, clearly a signicant number of extra billable hours. In addition to the above analyses, which relied on a stark dichotomization of rms between those which did not pre-comply with the SOX requirements in 2001 with respect to having a fully independent audit committee, nominating committee, and compensation committee, as well as a majority of the board of directors that were independent, the so-called BOD0 rms, and those that did pre-comply, the so-called BOD4 rms, we also conducted two supplementary analyses. One of these analyses dichotomized the rms into those that had an independent audit committee in 2001 and those that did not. For this supplementary analysis, we reran the regression using all rms that met this new inclusion criteria with a new indicator variable for not having pre-adopted the use of an independent audit committee, resulting in a sample of 768 rms, 220 without and 548 with an independent audit committee. The 220 could have come from any of the earlier mentioned zero, one, two or three score rms, see Table 1, as long as they did not have an independent audit committee. Similarly, the 548 rms with an independent audit committee could have come from the one, two, three or four score rms. In this analysis, the coefcient for the indicator variable for not having pre-adopted the required use of a fully independent audit committee was slightly positive, but not statistically signicant. In the second supplementary analysis, rms were dichotomized into those that had both an independent audit committee and an independent board majority and those that had neither an independent audit committee nor an independent board majority. We reran the regression using the 549 rms that met this new, inclusion, criteria, now incorporating an indicator variable for the 92 rms in this population that had not pre-adopted use of an independent audit committee nor an independent

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board majority, as opposed to the 457 that had. This time the indicator variable for nonpre-compliance was both positive, 0.093, and statistically signicant at the 1 per cent threshold, this is similar in size and signicance to the BOD0 indicator discussed extensively above. In order to best isolate the effect of the variables on the criterion variable, recognizing that the samples used in the testing were not identical, we calculated the partial R2 of the BOD0 variable in the regression reported in Table 3s Model 2, and the partial R2 of the indicator variable reported here. We found that the BOD0 variable accounted for 2.4 per cent of the variance in the regression reported in Table 3s Model 2, and the NoIndepAuditCommNoBoardMaj variable accounted for 1.4 per cent of the variance in the regression reported here.3 Since the difference between the two regression runs lies in the presence or absence of independent nominating and compensation committees, it may be taken as implied that the independence of these committees should be considered in understanding the relationship between board of director composition and audit fee incurrence.

CONCLUSION
This research investigates the impact of the exogenously compelled increased use of independent directors, resulting from passage of SOX and the concurrent changes in the US Stock Exchanges listing requirements, on a signicant area of board inuence: spending for auditor services with respect to the nancial statement audit. Specically, this research segregates rms into those that had fully preadopted the new board composition-related laws/regulatory requirements before their enactment and those that had not pre-adopted any of the now compelled four new board composition characteristics. The four requirements included having: (1) a fully independent compensation committee; (2) a fully independent nominating committee; (3) a fully

independent audit committee; and (4) a board with a majority of its members that are independent. We then employed the DID methodology to ascertain whether the rms that did not pre-adopt experienced greater otherwise unexplained increases in audit fees between the average of two pre-SOX years and the average of two post-SOX years, than did the pre-adopting rms. We found that they had. The imposition of the SOX board of director composition and governance requirements have generated costs beyond the additional audit fees incurred, as reported here. Other costs include the recruitment and compensation of new outside independent directors and forcing the rms from the pre-existing rmlevel equilibrium to a new, rm-level, position. Whether this change is valuable to society or not depends, in large part, on ones view of the audit function. If one takes the view that the audit function serves corporate management, then forcing the corporations to expend more resources on previously undesired audit efforts may seem a deadweight loss. If, however, the audit function is seen in its broader societal role as a tool to reassure corporate owners of the quality of managements stewardship function, as well as to foster achievement of the optimal allocation of investment capital, then, from that broader perspective, the increased expenditure may be worthwhile (see, for example, Mitra et al, 2009). Balancing issues of local cost to the rm against societal benet is an important discussion to have, but one beyond the goal of this article. Spending on audit services, it should be noted, serves both internal and external agency needs. With respect to internal agency needs, such spending increases the ability of corporate management to understand the reliability of numbers that the lower levels of the rm provide to it, thereby enabling management to improve or ne tune its control over the rm in response to the audited numbers. As an external agency issue, the audited nancial statements provide external stakeholders with presumably reliable numbers with which

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to evaluate the owners and creditors stake in the company. Even for the internal agency problem needs of the rm itself, there is, to our knowledge, no known measure for what the optimal spending level is and therefore no certainty that the decision to spend more was a move closer to or farther away from a hypothetically optimal level. Even aside from corporate managements oversight capability, of course, are the needs of independent directors. The latter accrue greater personal benet from higher quality audits, in the form of reduced liability, than do individual investors; and therefore may choose to spend more for audits than is in the best interests of the shareholders the directors represent. It may be true that you can never be too rich, but it is not true that you can never be overaudited. On the other hand, the true preferences of the shareholders are unlikely ever to be known. In the aftermath of the scandals that gave rise to SOX, we suspect that they may have preferred the greater audit-related spending that resulted from SOX and the concurrent exchange-related requirements. This suspicion as to the preferences of stockholders is consistent with Asthana et als nding (2009) that greater degrees of institutional ownership was associated with higher audit fees, although, interestingly, Asthana et al failed to nd a relationship between insider ownership and audit fees, positive or negative. Interestingly, too, Asthana et al (2009) did not nd a signicant relationship between the changes in audit fees in the 2000 to 2002 period and changes in institutional ownership and insider ownership. While the overlap between our sample and the Asthana et al sample is impossible to know, and our study covers audit fees from 2001 to 2005, and their data covers audit fees only from 2000 to 2002, the pattern of their results on institutional ownership suggests that it is not changes in institutional ownership that is driving the results reported here. We can speculate as to whether the events that led to SOXs adoption may have led to a greater relationship between changes in institutional ownership and audit fees. It is

clear from the descriptive data, see Table 2, that audit fee spending increased both for the rms that pre-adopted the SOX and the exchanges requirements, and the rms that adopted the SOX and the exchanges requirements only when they had to. This observation suggests that the events surrounding the fall of Enron, Worldcom and Anderson were important in causing all rms to embrace greater spending on nancial statement auditing. This article identies evidence that a portion of the increase in spending on nancial statement audits may be attributed to greater use of independent directors and fully independent committees. This nding may then be viewed as supportive of this particular aspect of SOX and the concurrent stock exchange listing requirement changes. While some increases might have occurred in SOXs absence, we believe that the move to greater board independence furthered the movement toward purchasing greater auditing effort.

Future research
Coville (2008) suggests an analysis for other possible effects, such as SOXs impact, if any, on CEO Compensation, Dividend Payouts, Earnings Management and Risk-Adjusted Returns. The literature has pointed out several things that may possibly be dependent on independent versus insider dominated boards and committees. These include auditor retention, reduced instances of nancial statement frauds, reduced number of shareholder suits, reduced number of nancial reporting restatements, increased instances of CEO dismissals, reduced entrepreneurship and product diversication. They might not all lend themselves readily to a comparison of averages between two 2-year time periods as was done in this investigation. Still, the possibility of learning more from this historically-unique exogenous shock to board compositions justies a fresh look at these other possible director relevant effects.

Limitations
As this investigation excluded rms that failed to survive as independent entities over the full

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course of the periods used in this study, there is a limited ability to generalize the results across all rms. It may be argued that while the investigation has certain implications for the rms that survived and continued to be publicly listed over this period, non-surviving rms may have been impacted differently. Those impacts, of course, are unrepresented in the studys results. Second though many of the elements of a well-designed experiment were satised, that is, BOD0 constitutes a treatment group and BOD4 constitutes a control group, and the new SOX, SEC and Stock Exchange Governance requirements constitute a treatment, an important exception to experimental design criteria is the lack of random assignment of rms into BOD0 and BOD4. This concern was addressed both by tabled review of the descriptive statistics for these segregated sets of rms (see Table 2) to determine a level of comparability and by the use of control variables in the ordinary least squares regression analysis. This was done to ensure that other potentially correlated variables were considered. Third, we did not attempt to control for audit rm status as a Big 4 or non-Big 4 rm, although prior research has suggested that Big 4 rms are capable of charging a premium over non-Big 4 rms for their services. This may have impacted our results, although we do not believe so for two reasons: (a) the pre-complying and post-complying rms in our sample were very similar in size, as can be seen in Table 2; and (b) as Asthana et al (2009) reported in their study, only about 8.1 per cent of their sample of 771 used non-Big 5 auditors (including former Arthur Andersen clients). Asthana et als sample years were drawn from roughly the same period as ours. Lastly this study did not benet from direct observation or discussion with actual board members.

efforts, these requirements are new to both rms that pre-complied with the ultimate SOX requirements and those rms that did not pre-comply with the ultimate SOX requirements. Accordingly, the required CEO and CFO certications cannot be used to differentiate between the two groups. 2 While the Model 1 results were similar for the BOD0 variable, the model R2 and adjusted R2 values were lower. The Model 1 results, however, are awed by inclusion of 14 cases where the |SDR| 2. Accordingly, our analysis rests on the Model 2 results. 3 Note that the second model was signicant at the 0.000 level, with an F-score of 18.861, with an adjusted R2 of 0.227.

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NOTES
1 Although it may be argued that the SOX certications may also result in greater audit

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