The Disclosure of Material Weaknesses in Internal Control after the Sarbanes-Oxley Act

2005 ◽  
Vol 19 (3) ◽  
pp. 137-158 ◽  
Author(s):  
Weili Ge ◽  
Sarah McVay
Keyword(s):  
Internal Control ◽  
Foreign Currency ◽  
Revenue Recognition ◽  
Return On Assets ◽  
Material Weakness ◽  
Negatively Associated ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
Specific Material ◽  
Business Complexity

This paper focuses on a sample of 261 companies that disclosed at least one material weakness in internal control in their SEC filings after the effective date of the Sarbanes-Oxley Act of 2002. Based on the descriptive material weakness disclosures provided by management, we find that poor internal control is usually related to an insufficient commitment of resources for accounting controls. Material weaknesses in internal control tend to be related to deficient revenue-recognition policies, lack of segregation of duties, deficiencies in the period-end reporting process and accounting policies, and inappropriate account reconciliation. The most common account-specific material weaknesses occur in the current accrual accounts, such as the accounts receivable and inventory accounts. Material weakness disclosures by management also frequently describe internal control problems in complex accounts, such as the derivative and income tax accounts. In our statistical analysis, we find that disclosing a material weakness is positively associated with business complexity (e.g., multiple segments and foreign currency), negatively associated with firm size (e.g., market capitalization), and negatively associated with firm profitability (e.g., return on assets).

scholarly journals Predicting Material Weaknesses In Internal Control Systems After The Sarbanes-Oxley Act Using Multiple Criteria Linear Programming And Other Data Mining Approaches

2011 ◽  
Vol 25 (6) ◽  
Author(s):  
Wikil Kwak ◽  
Susan Eldridge ◽  
Yong Shi ◽  
Gang Kou
Keyword(s):  
Data Mining ◽  
Linear Programming ◽  
Internal Control ◽  
Foreign Currency ◽  
Predictive Ability ◽  
Cash Flows ◽  
Multiple Criteria ◽  
Font Size ◽  
Sarbanes Oxley ◽  
Material Weaknesses

<h1 style="TEXT-JUSTIFY: inter-ideograph; TEXT-ALIGN: justify; MARGIN: 0in 0.5in 0pt"><span style="font-family: Times New Roman;"><span style="COLOR: black; FONT-SIZE: 10pt">Our study proposes a multiple criteria linear programming (MCLP) </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other data mining </span><span style="COLOR: black; FONT-SIZE: 10pt">method</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">s</span><span style="COLOR: black; FONT-SIZE: 10pt"> to predict </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">material weaknesses in a firm&rsquo;s internal control system after the Sarbanes-Oxley Act</span><span style="COLOR: black; FONT-SIZE: 10pt"> (SOX) using </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">2003-2004</span><span style="COLOR: black; FONT-SIZE: 10pt"> </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">U.S. </span><span style="COLOR: black; FONT-SIZE: 10pt">data.<span style="mso-spacerun: yes">&nbsp; </span>The results of the MCLP </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other data mining </span><span style="COLOR: black; FONT-SIZE: 10pt">approaches in </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">our</span><span style="COLOR: black; FONT-SIZE: 10pt"> </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">prediction </span><span style="COLOR: black; FONT-SIZE: 10pt">study show that the </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">MCLP</span><span style="COLOR: black; FONT-SIZE: 10pt"> method performs</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO"> </span><span style="COLOR: black; FONT-SIZE: 10pt">better overall than the </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">other data mining approaches </span><span style="COLOR: black; FONT-SIZE: 10pt">using financial </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other </span><span style="COLOR: black; FONT-SIZE: 10pt">data from the Form 10-K report.</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO"><span style="mso-spacerun: yes">&nbsp; </span>Consistent with prior research, firms that disclosed material weaknesses in their SOX Section 302 disclosures were more complex (based on the existence of foreign currency translations), more often used Big 4 auditors, and had lower operating cash flows-to-total assets ratios than the non-material weakness control firms.<span style="mso-spacerun: yes">&nbsp; </span>Because of mixed results on several profitability measures and marginal predictive ability for the MCLP and other methods used, more research is needed to identify firm characteristics that help investors, auditors, and others predict material weaknesses.</span></span></h1>

The Impact of SOX Section 404 Internal Control Quality Assessment on Audit Delay in the SOX Era

2006 ◽  
Vol 25 (2) ◽  
pp. 1-23 ◽  
Author(s):  
Michael L. Ettredge ◽  
Chan Li ◽  
Lili Sun
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Small Sample ◽  
Impact Factors ◽  
Section 404 ◽  
Material Weakness ◽  
Control Quality ◽  
Sarbanes Oxley ◽  
Specific Material ◽  
The Impact

This study analyzes the impact of internal control quality on audit delay following the implementation of the Sarbanes-Oxley Act (2002) (SOX). Unlike prior studies of audit delay that obtain information about internal control strength via surveys, or use fairly crude proxies for internal control quality, our study employs external auditor assessments of internal control over financial reporting (ICOFR) that are publicly disclosed in SEC 10-K filings under SOX Section 404. Thus, the empirical evidence provided in this study is both timely and reliable (i.e., not subject to small sample bias or weak proxies). Consistent with our expectation, we find that the presence of material weakness in ICOFR is associated with longer delays. The types of material weakness also matter. Compared to specific material weakness, general material weakness is associated with longer delays. Additional analyses indicate that companies with control problems in personnel, process and procedure, segregation of duties, and closing process experience longer delays. After controlling for other impact factors, this study also documents a significant increase in audit delay associated with the fulfillment of the SOX Section 404 ICOFR assessment requirement. This suggests that Section 404 assessments have made it more difficult for firms to comply with the SEC's desire to shorten 10-K filing deadlines. Our finding thus supports and helps explain the SEC's decisions in 2004 and 2005 to defer scheduled reductions in 10-K filing deadlines (from 75 days to 60 days) for large, accelerated filers.

The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality

2013 ◽  
Vol 33 (1) ◽  
pp. 93-116 ◽  
Author(s):  
Emma-Riikka Myllymäki
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Reporting Quality ◽  
Financial Reporting Quality ◽  
Control Problems ◽  
Section 404 ◽  
Material Weakness ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
History Of

SUMMARY This study examines whether Sarbanes-Oxley (SOX) Section 404 material weakness (MW404) disclosures are predictive of future financial reporting quality. I find evidence that for companies with a history of MW404s, the likelihood of misstatements in financial information continues to be significantly higher for two years after the last MW404 report compared to companies without a history of reported MW404s. The magnitude of the effect decreases non-linearly with decreasing speed. The findings further imply that the reason for the misstatement incidences is the unacknowledged pervasiveness of control problems. In particular, it appears that in many cases, the future misstatements are unrelated to the MW types disclosed in the last MW404 report, suggesting that some MW types are unacknowledged and, hence, control problems are even more pervasive than what was identified. Overall, the findings of this study highlight the importance of discovering and disclosing material weaknesses in internal control over financial reporting.

The Association between IT Material Weaknesses and Earnings Management

2017 ◽  
Vol 32 (3) ◽  
pp. 53-64 ◽  
Author(s):  
William G. Heninger ◽  
Eric N. Johnson ◽  
John R. Kuhn
Keyword(s):  
Earnings Management ◽  
Internal Control ◽  
Positive Association ◽  
Future Research ◽  
Significant Positive Association ◽  
Material Weakness ◽  
Public Companies ◽  
Financial Condition ◽  
Sarbanes Oxley ◽  
Material Weaknesses

ABSTRACT In this paper, we examine the relationship between (1) information technology-related internal control material weaknesses (ITMWs) as reported by public companies between 2004 and 2012, and (2) earnings management. Prior research suggests that companies with internal control deficiencies are more likely to manage earnings; however, no study has specifically examined the incremental effect of ITMWs on earnings management tendencies. Based on a sample of 268 firm-years of ITMWs disclosed by U.S. public companies in their annual SEC filings (pursuant to Section 404 of the Sarbanes-Oxley Act of 2002), we find a significant positive association between ITMWs and income-increasing abnormal accruals. In addition, we find a positive relation between poor financial condition and material weaknesses in these companies. These results are robust with respect to two control samples of firms with non-IT-related-only material weaknesses (non-ITMWs) and firms with no material weakness disclosures. Implications of these findings for investors, regulators, and future research are discussed.

Observed effectiveness of the COSO 2013 framework

2019 ◽  
Vol 16 (1) ◽  
pp. 31-45
Author(s):  
Ifeoma Udeh
Keyword(s):  
Control Systems ◽  
Internal Control ◽  
Design Methodology ◽  
Control Process ◽  
Regression Analyses ◽  
Section 404 ◽  
Content Type ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
Practical Implications

Purpose This paper aims to examine the effectiveness of the Committee of Sponsoring Organization’s 2013 Framework, by investigating how the number of auditor-reported material weaknesses compares for Early-, Timely- and Late-adopters of the framework, and how the number of auditor-reported material weaknesses changed for Early- and Timely-adopters following their adoption of the framework. Design/methodology/approach The paper uses regression analyses based on a sample of US firms subject to Sarbanes-Oxley Act Section 404(b). Findings Timely-adopters of the 2013 Framework continued to exhibit fewer instances of auditor-reported material weaknesses than Late-adopters, even though they had a marginal increase in the number of auditor-reported material weaknesses, in the post-2013 Framework period. Practical implications The findings suggest that the effectiveness of the 2013 Framework may lie in the iterative nature of the internal control process, and as firms remedy deficiencies they or their auditors identify, they will continuously improve the effectiveness of their internal control systems. Originality/value Unlike existing literature, this paper uses data from the pre-2013 Framework, transition and post-2013 Framework periods to examine changes in the number of auditor-reported material weaknesses, thus differentiating between Early-, Timely- and Late-adopters of the 2013 Framework. It also shows the effect of adopting the 2013 Framework on the number of auditor-reported material weaknesses.

Using Communication Theory to Teach SOX Reporting Requirements

2011 ◽  
Vol 26 (1) ◽  
pp. 241-256 ◽  
Author(s):  
Marsha Weber ◽  
Sheri Erickson ◽  
Mary Stone
Keyword(s):  
Image Restoration ◽  
Internal Control ◽  
Communication Theory ◽  
Corporate Image ◽  
Annual Reports ◽  
Instructional Resource ◽  
Analytical Skills ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
Restoration Strategies

ABSTRACT: This paper presents an instructional resource and provides suggestions for its implementation. The resource demonstrates a method for teaching students how communication in required SOX Section 404 reports can impact stakeholders’ perceptions of that organization. Students read portions of selected 10-K, 10-Q, and corporate annual reports in which management responds to disclosed internal control material weaknesses. Students then analyze these excerpts according to a well-known image restoration strategy. This assignment enhances written communication skills, analytical skills, research skills, and deepens students’ understanding of Sarbanes-Oxley 404 requirements and of corporate image restoration strategies. The instructional resource would be beneficial in auditing, intermediate, or advanced accounting, as well as a graduate-level accounting course.

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

2012 ◽  
Vol 31 (2) ◽  
pp. 1-17 ◽  
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.

SOX Section 404 Material Weakness Disclosures and Audit Fees

2006 ◽  
Vol 25 (1) ◽  
pp. 99-114 ◽  
Author(s):  
K. Raghunandan ◽  
Dasaratha V. Rama
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Fees ◽  
Internal Controls ◽  
Fiscal Year ◽  
Section 404 ◽  
Control Material ◽  
Material Weakness ◽  
Sarbanes Oxley ◽  
The Mean

Section 404 of the Sarbanes-Oxley Act and Auditing Standard No. 2 (PCAOB 2004) require management and the auditor to report on internal controls over financial reporting. Section 404 is arguably the most controversial element of SOX, and much of the debate around the costs of implementing section 404 has focused on auditors' fees (Ernst & Young 2005). In this paper, we examine the association between audit fees and internal control disclosures made pursuant to section 404. Our sample includes 660 manufacturing firms that have a December 31, 2004 fiscal year-end and filed the section 404 report by May 15, 2005. We find that the mean (median) audit fees for the firms in our sample for fiscal 2004 is 86 (128) percent higher than the corresponding fees for fiscal 2003. Audit fees for fiscal 2004 are 43 percent higher for clients with a material weakness disclosure compared to clients without such disclosure; however, audit fees for fiscal 2003 are not associated with an internal control material weakness disclosure (in the 10-K filed following fiscal 2004). We also find that the association between audit fees and the presence of a material weakness disclosure does not vary depending on the type of material weakness (systemic or non-systemic).

Social Capital and Internal Control Material Weaknesses

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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