The Failure to Remediate Previously-Disclosed Material Weaknesses in Internal Controls

This study analyzes the severity of Internal Control over Financial Reporting deficiencies (Deficiencies, Significant Deficiencies and Material Weaknesses) in a sample of Italian listed companies, in the period 2007- 2012. Using proprietary data the severity of the deficiencies is tested for account-specific, entity level and information technology controls and for industries (manufacturing and services vs finance industries). The results on ICD severity is compared with one of the most frequent ICD (Acc_Period End/Accounting Policies): for account-specific, ICD in revenues, purchase, fixed assets and intangible, loans and insurance are more severe while ICD in Inventory are less severe. Differences in ICD severity have been found in the characteristic account: ICD in loan and insurance for finance industry and ICD in revenue, purchase for manufacturing and service industry are more severe. Finally, we found that ICD in entity level and information technology controls are less severe than account specific ICD in all industries. However, the results on entity level and information technology deficiencies could also mean that the importance of these types of control are under-evaluated by the manufacturing and service companies.

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Real Earnings Management before and after Reporting SOX 404 Material Weaknesses

Accounting Horizons ◽

10.2308/acch-51310 ◽

2015 ◽

Vol 30 (1) ◽

pp. 119-141 ◽

Cited By ~ 21

Author(s):

Tuukka Järvinen ◽

Emma-Riikka Myllymäki

Keyword(s):

Earnings Management ◽

Internal Control ◽

Internal Controls ◽

Real Earnings Management ◽

Public Disclosure ◽

High Quality ◽

The Public ◽

Material Weaknesses ◽

Internal Control System ◽

Before And After

SYNOPSIS The purpose of this study is to investigate whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The empirical findings indicate that, compared to companies with effective internal controls, companies with existing material weaknesses in their internal controls engage in more manipulation of real activities (particularly inventory overproduction). This implies that the weak commitment by management to provide effective internal control system and high-quality financial information relates to a tendency to use real earnings management methods. Moreover, we find evidence suggesting that companies employ real earnings management (overproduction and reduction of discretionary expenses) after disclosing previous year's material weaknesses. We conjecture that the public disclosure of material weaknesses induces management to strive to mitigate the expected negative reactions of stakeholders to the disclosure by engaging in real earnings management, which is not easily detected or constrained by outsiders. Overall, this study suggests that material weaknesses in internal controls signal an environment where management is more inclined to employ real earnings management.

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The Effect of Change in the Reporting Threshold and Type of Control Deficiency on Equity Analysts' Evaluation of the Reliability of Future Financial Statements

Auditing A Journal of Practice & Theory ◽

10.2308/ajpt-10237 ◽

2012 ◽

Vol 31 (2) ◽

pp. 1-17 ◽

Cited By ~ 8

Author(s):

Stephen K. Asare ◽

Arnold M. Wright

Keyword(s):

Financial Statements ◽

Internal Controls ◽

Material Weakness ◽

Equity Analysts ◽

Material Weaknesses ◽

Lower Likelihood ◽

The Future ◽

Reasonable Possibility ◽

Level Versus ◽

Specific Material

SUMMARY We examine the joint effects of reporting threshold (more than remote versus reasonably possible) and type of control deficiency (entity level versus account specific) as described in the adverse report on internal controls on equity analysts' evaluation of the reliability of a company's future financial statements. We hypothesize that equity analysts interpret a “more than remote” threshold to mean a significantly lower likelihood than a “reasonable possibility” threshold. We also hypothesize that when the reporting threshold is more than remote, equity analysts who evaluate an entity level material weakness will indicate a higher likelihood of future material misstatements than those who evaluate an account specific material weakness. However, when the reporting threshold is reasonably possible, equity analysts will assess the same likelihood of future misstatements for both types of material weakness. The results from an experiment that employed 65 equity analysts support our hypotheses. Taken together, the findings suggest that the change to the “reasonably possible” regime has made the account specific material weakness more consequential in evaluating the reliability of the future financial statements but had no effect on the evaluation of entity level material weaknesses.

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Material Weaknesses in Tax-Related Internal Controls and Last Chance Earnings Management

Journal of the American Taxation Association ◽

10.2308/atax-51511 ◽

2017 ◽

Vol 39 (1) ◽

pp. 25-44 ◽

Cited By ~ 14

Author(s):

Cristi A. Gleason ◽

Morton Pincus ◽

Sonja Olhoft Rego

Keyword(s):

Earnings Management ◽

Financial Reporting ◽

Internal Control ◽

Internal Controls ◽

Early Years ◽

Control Material ◽

Material Weaknesses ◽

Implementation Period ◽

Tax Expense

ABSTRACT We investigate the consequences of tax-related internal control material weaknesses (ICMWs) for financial reporting. We hypothesize that the presence of ineffective controls over the tax function makes earnings management through the income tax accrual (both income increasing and income decreasing) easier to implement relative to firms with effective controls. We also predict that the remediation of tax-related ICMWs has the effect of constraining earnings management through the tax accrual. The results provide support for our predictions. We also find that last chance earnings management via tax-related ICMWs is concentrated in the early years of our sample, during the initial SOX implementation period. Our results suggest that tax-related ICMWs were initially associated with greater tax-expense management but that SOX internal control assessments subsequently improved the quality of financial reporting by reducing opportunities for tax-expense management.

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An Analysis of “Little r” Restatements

Accounting Horizons ◽

10.2308/acch-51104 ◽

2015 ◽

Vol 29 (3) ◽

pp. 667-693 ◽

Cited By ~ 18

Author(s):

Christine E. L. Tan ◽

Susan M. Young

Keyword(s):

Corporate Governance ◽

Audit Quality ◽

Cash Flows ◽

Internal Controls ◽

Data Availability ◽

Policy Implications ◽

Multivariate Tests ◽

Material Weaknesses ◽

Free Cash Flows ◽

Jel Classifications

SYNOPSIS “Little r” restatements occur when a firm's immaterial errors accumulate to a material error in a given year. Unlike “Big R” restatements that must be reported through an SEC 8-K material event filing, little r restatements do not require an 8-K form or a withdrawal of the auditor opinion. This paper documents this previously unexamined form of restatement and analyzes the characteristics of the firms that have used this method of correcting accounting errors over the period 2009 through 2012. Contrary to concerns voiced by regulators and research agencies we find, in multivariate tests, that little r firms are generally more profitable, less complex, and show some evidence of stronger corporate governance and higher audit quality than Big R firms. Compared to non-revising or restating firms, little r firms have lower free cash flows, higher board expertise, higher CFO tenure, are less likely to use a specialist auditor, and less likely to have material weaknesses in their internal controls. We also find that the majority of little r firms do not include any discussion of why these little r's occurred. We discuss policy implications related to disclosure of little r revisions. JEL Classifications: M41; M48; G38. Data Availability: All data used in this study are publicly available from the sources indicated.

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Are Material Weaknesses in Internal Controls Associated with Poor M&A Decisions? Evidence from Goodwill Impairment

Auditing A Journal of Practice & Theory ◽

10.2308/ajpt-51740 ◽

2017 ◽

Vol 37 (4) ◽

pp. 49-74 ◽

Cited By ~ 6

Author(s):

Dennis H. Caplan ◽

Saurav K. Dutta ◽

Alfred Zhu Liu

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Internal Controls ◽

Managerial Performance ◽

Goodwill Impairment ◽

Material Weaknesses

SUMMARY This paper examines the effect of the quality of a firm's internal control over financial reporting (ICFR) on the quality of corporate M&A decisions. We use material weaknesses in internal control (ICMWs) from SOX 404 audits as a proxy for the quality of a firm's ICFR and use future goodwill impairment to proxy for the quality of managers' M&A decisions. We find that goodwill recognized from acquisitions in years concurrent with ICMWs has a greater rate of impairment in subsequent years than goodwill recognized from acquisitions in years without ICMWs, thereby establishing a link between ICMW and goodwill impairment. We further show that disclosure and remediation of ICMWs appear to improve valuations of subsequent acquisitions. Our study contributes to the literature on internal controls by documenting unanticipated benefits of SOX 404 audits on managerial performance, and to the goodwill literature by identifying ICMWs as a determinant of goodwill impairment.

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Social Capital and Internal Control Material Weaknesses

Accounting Horizons ◽

10.2308/horizons-16-153 ◽

2021 ◽

Author(s):

Jayanthi Krishnan ◽

Sang Mook Lee ◽

Myungsoo Son ◽

Hakjoon Song

Keyword(s):

Social Capital ◽

Financial Reporting ◽

Internal Control ◽

Reporting Quality ◽

Internal Controls ◽

Financial Reporting Quality ◽

External Monitoring ◽

Regional Center ◽

Material Weaknesses ◽

Specific Material

Using a measure of social capital provided by the Northeast Regional Center for Rural Development, we document that, after controlling for auditor effort, firms headquartered in US counties with higher social capital are less likely to have ineffective internal control over financial reporting than those located in regions with lower social capital. This negative association between local social capital and ineffective internal controls holds when other forms of external monitoring are weak. We also find that the association is driven by ineffective internal control arising from entity-level, but not from account-specific, material weaknesses. Overall, we contribute to the literature that links firms' social environment with financial reporting quality.

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Earnings Management of Firms Reporting Material Internal Control Weaknesses under Section 404 of the Sarbanes-Oxley Act

Auditing A Journal of Practice & Theory ◽

10.2308/aud.2008.27.2.161 ◽

2008 ◽

Vol 27 (2) ◽

pp. 161-179 ◽

Cited By ~ 97

Author(s):

Kam C. Chan ◽

Barbara Farrell ◽

Picheng Lee

Keyword(s):

Earnings Management ◽

Internal Control ◽

Internal Controls ◽

Corporate Disclosure ◽

Section 404 ◽

Sarbanes Oxley ◽

Material Weaknesses ◽

Potential Benefits ◽

Internal Control Weaknesses ◽

Reported Earnings

SUMMARY: The main objectives of the Sarbanes-Oxley Act of 2002 are to improve the accuracy and reliability of corporate disclosure. Under Section 404 of the Sarbanes-Oxley Act, the external auditor has to report an assessment of the firm’s internal controls and attest to management’s assessment of the firm’s internal controls. Material weaknesses in internal controls must be disclosed in the auditor and management reports. The objective of this study is to examine if firms reporting material internal control weaknesses under Section 404 have more earnings management compared to other firms. The results provide mild evidence that there are more positive and absolute discretionary accruals for firms reporting material internal control weaknesses than for other firms. Since the findings of ineffective internal controls by auditors under Section 404 may cause firms to improve their internal controls, Section 404 has the potential benefits of reducing the opportunity of intentional and unintentional accounting errors and of improving the quality of reported earnings.

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Audit Fees and Auditor Dismissals in the Sarbanes-Oxley Era

Accounting Horizons ◽

10.2308/acch.2007.21.4.371 ◽

2007 ◽

Vol 21 (4) ◽

pp. 371-386 ◽

Cited By ~ 117

Author(s):

Michael L. Ettredge ◽

Susan Scholz ◽

Chan Li

Keyword(s):

Audit Fees ◽

Internal Controls ◽

Public Companies ◽

Early Evidence ◽

Sarbanes Oxley ◽

Big 4 ◽

Accounting Scandals ◽

Material Weaknesses ◽

Going Concern Reports ◽

The Relationship

The accounting scandals and Sarbanes-Oxley Act (SOX) of 2002 resulted in large increases in required audit work, and corresponding increases in audit fees for public companies. This study provides early evidence regarding the relationship between higher audit fees, both levels and changes, and auditor dismissals in the period immediately subsequent to the passage of SOX. We find that clients paying higher fees are more likely to dismiss their auditors. We also find that dismissals are associated with smaller companies, companies with going-concern reports, and companies that later reported material weaknesses in their internal controls. Among dismissing clients, smaller Big 4 clients, paying higher fees, tend to hire non-Big 4 successor auditors. This result holds when auditors are divided into Big 4, national, and local tiers. We also find evidence that dismissing clients, in particular clients hiring new non-Big 4 auditors, experience smaller fee increases than nonswitching clients in the following year. These results are consistent with the notion that in the immediate post-SOX period, some companies dismissed their auditors in expectation of lower fees from the succeeding auditor.

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Material Weakness in Internal Controls and Stock Price Crash Risk

Journal of Accounting Auditing & Finance ◽

10.1177/0148558x17696761 ◽

2017 ◽

Vol 35 (1) ◽

pp. 106-138 ◽

Cited By ~ 9

Author(s):

Gerald Lobo ◽

Chong Wang ◽

Xiaoou Yu ◽

Yuping Zhao

Keyword(s):

Financial Reporting ◽

Stock Price ◽

Positive Association ◽

Internal Controls ◽

Crash Risk ◽

Significant Relation ◽

Material Weakness ◽

Sarbanes Oxley ◽

Material Weaknesses ◽

Section 302

We investigate the association between material weakness in internal controls (MW) disclosed under Section 302 of the Sarbanes–Oxley Act of 2002 (SOX) and future stock price crash risk. We argue that relative to firms with effective internal controls, firms with MW have lower financial reporting precision. The lower reporting precision (a) increases divergence of investor opinion with regard to firm valuation and (b) facilitates managers’ withholding of negative information, which increases the information asymmetry between managers and outside investors. We hypothesize that both these effects increase the probability of a future stock price crash. We find empirical evidence consistent with our prediction. In additional analyses, we document that the positive association between MW and crash risk is primarily driven by company level rather than by account-specific weaknesses, increases with the number of material weaknesses, and intensifies during the financial crisis. In addition, we find that both the existence and the disclosure of MW incrementally affect crash risk, and that MW facilitates managers’ withholding of bad news. Finally, we fail to find consistent evidence of a significant relation between MW disclosed under Section 404 of SOX and crash risk.

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