Evidence on the Impact of Internal Control and Corporate Governance on Audit Fees

TLDR

Prior research has mixed evidence, with some studies suggesting internal control reduces audit fees while others posit that stronger corporate governance increases audit fees. The study examines whether the substitution or complementary controls views apply. The results show that internal auditing, corporate governance, and ownership concentration all raise audit fees, indicating complementary controls that hold only in less‑regulated environments, thereby challenging the substitution hypothesis.

Abstract

Previous studies generally suggest that internal control and external auditing can substitute for each other, so that better internal control will be associated with lower audit fees. However, their empirical results do not support this view. In contrast, previous studies of the interaction between corporate governance and external audit services often assume that they are complementary, and that improved governance is associated with higher audit fees, although the evidence about this issue is also mixed. We examine whether the ‘substitution’ or ‘complementary controls’ views apply. We find that measures of internal auditing, corporate governance, and concentration of ownership are all positively related to audit fees, consistent with the explanation that controls are complementary. The study makes a contribution by assisting regulators in understanding the effects of regulation of corporate governance, and by showing auditors and auditing standard setters that the view that internal controls can substitute for external auditing may not be helpful. We also find that these relationships hold only in a relatively less‐regulated environment.