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Voluntary certification and disclosure of internal controls over Australian financial reporting, audit fees and value relevance

posted on 06.03.2017, 05:57 by Garg, Mukesh
This thesis draws on agency theory to primarily investigate whether CEOs’ and CFOs’ voluntary certification of internal controls over financial reporting (hereafter, ICFR) is associated with audit fees and value relevance of Australian financial reports. The thesis also examines whether corporate governance and audit quality are associated with the likelihood that firms provide the CEOs’ and CFOs’ voluntary ICFR certification. While agency theory predicts that firms with high agency costs are less likely to implement sound internal control procedures, however, sound corporate governance and higher audit effort provides avenues to mitigate such high agency costs. This theoretical framework is used to examine three Research Questions. CEOs’ and CFOs’ voluntary ICFR certification is a recommendation within the Australian Securities Exchange Corporate Governance Council Best Practice Recommendations. The ICFR certification states that the integrity of financial reports is formed on the soundness, efficiency and effectiveness of firms’ risk management systems and internal compliance and controls (hereafter, CERTDISC). While disclosure of ICFR certification is not mandated, if there is a non-compliance of the recommendation, that information has to be disclosed in the annual report with an “if not why not” approach. Studies in a mandatory disclosure setting in the US find internal control deficiency is related to several firm level outcomes. For example, it is found to be negatively associated with earnings quality (Doyle, Ge and McVay, 2007b; Ashbaugh-Skaife, Collins, Kinney and LaFond, 2008; Chan, Farrell and Lee, 2008), positively associated with audit fees (Raghunandan and Rama, 2006; Hoitash, Hoitash and Bedard, 2008; Lu, Richardson and Salterio, 2011) and positively associated with cost of equity (Beneish, Billings and Hodder, 2008; Ashbaugh-Skaife, Collins, Kinney and Lafond, 2009). The inferences drawn from studies in a mandatory setting may not be applicable in a voluntary environment where disclosures of good news as opposed to bad news, are affirmative and not assured by an external auditor. Three specific related Research Questions are examined in this thesis: (1) Are corporate governance and audit quality associated with ICFR certification and disclosure? (2) Is ICFR certification and disclosure associated with audit fees? (3) Is ICFR certification and disclosure value relevant? This thesis aims at establishing a view on the effect of CERTDISC on audit fees and the value relevance of CERTDISC by investigating whether firms with strong corporate governance and audit quality implement CERTDISC and whether auditors and investors are affected by CERTDISC. Prior studies show that the effectiveness of the board and audit committee positively affects voluntary disclosures and the quality of ICFR (Klein, 2002; Leuz, Nanda and Wysocki, 2003; Beekes, Pope and Young, 2004; Agrawal and Chadha, 2005; Farber, 2005; Ashbaugh-Skaife, Collins and LaFond, 2006; Doyle, Ge and McVay, 2007a). Sound, effective and efficient ICFR reduces the auditors’ control risk which, in turn, according to the audit risk model, increases detection risk. Firms with high detection risk (the risk that the auditor’s testing procedures will not be effective in detecting a material misstatement) require less audit effort and therefore lower audit fees, ceteris paribus. The thesis is conducted using a sample of 498 Australian listed firms in 2004, the year post the introduction of CERTDISC provisions. In testing first Research Question it is found that firms audited by big-4 audit firms are associated with CERTDISC. Moreover, it is found that the positive association between corporate governance and CERTDISC is stronger for firms audited by big-4 auditors consistent with agency theory. In the audit fee tests to address Research Question 2, it is found that while CERTIDISC has no significant main effect on audit fees, corporate governance has a significant positive main effect. This suggests firms with strong corporate governance are likely to demand higher audit effort also consistent with agency theory and a study by Carcello, Hermanson, Neal and Riley Jr (2002). However, when CERTDISC and corporate governance variables are tested for interaction effect, it is found that there is a significant positive interaction effect between CERTDISC and corporate governance on audit fees. Further analysis of the interaction effect suggests that the effect of CERTDISC on audit fees is conditional on corporate governance. In point of detail, it is found that at low levels of corporate governance, there is a negative association between CERTDISC and audit fees but at progressively higher levels of corporate governance, the effects of CERTIDISC become weaker. In other words, CERTDISC has a negative effect on audit fees only for firms with low corporate governance. The results from the examination of the value relevance of CERTDISC for addressing Research Question 3 suggest that CERTDISC is positively associated with share price. More specifically, it is found that the value relevance is more prominent for firms with higher information asymmetry proxied by three measures namely audit by big-4 versus non-big-4 audit firms (non-big-4 client firms are assumed to be associated with higher information asymmetry), bid-ask spread and stock liquidity. These results suggest that investors find CERTDISC most useful for firms with high information asymmetry. Findings suggest that costly ICFR audit environment similar to that in the US under Section 404 of Sarbanes Oxley Act, 2002 may not be required as the market is able to recognize the information conveyed by the existence of ICFR. Finally, from the theoretical point of view, this thesis provides evidence consistent with theoretical predictions in agency theory. More specifically, agency theory predicts that stronger internal controls and a commitment by top management (tone at the top) to implement ICFR procedures reduces potential agency conflicts between managers and shareholders thus resulting in higher firm valuation, ceteris paribus. This thesis contributes to the extant literature on ICFR by investigating a unique unaudited and voluntary ICFR certification and disclosure regime. The findings have implications for investors when making an investment decision as it informs them of the reliance they can place on CERTDISC. The thesis also provides some information to the corporate regulators on whether an alternative to the regulation (Section 404 of Sarbanes Oxley Act, 2002) adopted by the US should be considered in Australia. Finally, the thesis adds to the audit fee literature by showing that both corporate governance and ICFR certification affect audit fees. It also adds to the “value relevant” literature by showing that ICFR certification information is value relevant to investors for a sample of Australian listed firms, and that the extent of value relevance depends on the information environment; ICFR is less relevant for firms with big-4 auditors and for firms with low information asymmetry.


Campus location


Principal supervisor

Ferdinand Gul

Year of Award


Department, School or Centre



Doctor of Philosophy

Degree Type



Faculty of Business and Economics