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

2017 ◽  
Vol 37 (4) ◽  
pp. 49-74 ◽  
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.

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

2017 ◽  
Vol 39 (1) ◽  
pp. 25-44 ◽  
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.

The Severity of Internal Controls over Financial Reporting Deficiencies: Differences among Types and Industries

2014 ◽  
pp. 55-77
Author(s):  
Tatiana Mazza ◽  
Stefano Azzali
Keyword(s):  
Information Technology ◽  
Financial Reporting ◽  
Internal Control ◽  
Service Industry ◽  
Listed Companies ◽  
Internal Controls ◽  
Service Companies ◽  
Finance Industry ◽  
Material Weaknesses ◽  
Fixed Assets

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.

scholarly journals Integration of Internal Control and Financial Statement Audits: Are Two Audits Better than One?

2018 ◽  
Vol 94 (2) ◽  
pp. 53-81 ◽  
Author(s):  
Lori Shefchik Bhaskar ◽  
Joseph H. Schroeder ◽  
Marcy L. Shepardson
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Quality ◽  
Internal Controls ◽  
Data Availability ◽  
Financial Statement ◽  
Auditor Judgment ◽  
Public Company ◽  
Better Than

ABSTRACT The quality of financial statement (FS) audits integrated with audits of internal controls over financial reporting (ICFR) depends upon the quality of ICFR information used in, and its integration into, FS audits. Recent research and PCAOB inspections find auditors underreport existing ICFR weaknesses and perform insufficient testing to address identified risks, suggesting integrated audits—in which substantial ICFR testing is required—may result in lower FS audit quality than FS-only audits. We compare a 2007–2013 sample of small U.S. public company firm-years receiving integrated audits (accelerated filers) to firm-years receiving FS-only audits (non-accelerated filers) and find integrated audits are associated with higher likelihood of material misstatements and discretionary accruals, consistent with lower FS audit quality. We also find evidence of (1) auditor judgment-based integration issues, and (2) low-quality ICFR audits harming FS audit quality. Overall, results suggest an important potential consequence of integrated audits is lower FS audit quality. Data Availability: Data are publicly available from the sources identified in the text.

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.

Perceptions of Tone at the Top from the Inside: Insights into Audit Pricing

2021 ◽  
Author(s):  
Jace Garrett ◽  
Rani Hoitash ◽  
Douglas F. Prawitt
Keyword(s):  
Risk Assessment ◽  
Financial Reporting ◽  
Internal Control ◽  
Employee Perceptions ◽  
Audit Pricing ◽  
Management Communication ◽  
Tone At The Top ◽  
Material Weaknesses ◽  
Assessment Decisions

Tone at the top plays an important role in entities’ internal control over financial reporting (ICFR) and in auditors’ planning and risk assessment decisions. Using a novel measure based on employee perceptions, we find that strong tone at the top is associated with reduced audit pricing and that this relation holds even for firms that report effective ICFR. This relation is stronger when employees’ tone perceptions are more consistent throughout the organization, when accounting is more complex, and when earnings manipulation risk is higher. We also find that strong tone is negatively associated with the incidence of reported material weaknesses and positively associated with positive abnormal accruals, and that the management integrity component of tone is more strongly associated with audit pricing than is the quality of management communication. Finally, we find evidence that auditors become familiar with employees' tone perceptions in the normal course of an audit.

Determinants of the Persistence of Internal Control Weaknesses

2012 ◽  
Vol 26 (2) ◽  
pp. 307-333 ◽  
Author(s):  
Bonnie K. Klamm ◽  
Kevin W. Kobelsky ◽  
Marcia Weidenmier Watson
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Management Training ◽  
Internal Controls ◽  
Senior Management ◽  
Data Availability ◽  
The Public ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
Specific Control

SYNOPSIS This paper analyzes the degree to which material weaknesses (MWs) in internal control reported under the Sarbanes-Oxley Act of 2002 (SOX) affect the future reporting of MWs. Particularly, we examine information technology (IT) and non-IT MWs and their breakdown into specific IT-related entity-level, non-IT-related entity-level, and account-level deficiencies. Analysis reveals that most account-level and entity-level deficiencies occur at a significantly higher rate in SOX 404 reports with at least one IT MW than in MW reports with only non-IT MWs. Further, the presence and count of both types of MWs and all three types of deficiencies are associated with increased future MWs, as are lower profitability, non-Big 6 auditor, and firm complexity. Specific control deficiencies related to senior management, training, and IT control environment have the strongest impact on future MWs. These results indicate that effective corporate governance of both the IT and non-IT domains is pivotal in establishing and maintaining strong internal controls over financial reporting. Data Availability:  Data are available from the public sources identified in the paper.

Internal control and financial reporting quality of small firms

2020 ◽  
Vol 19 (2) ◽  
pp. 221-246
Author(s):  
Jagan Krishnan ◽  
Jayanthi Krishnan ◽  
Sophie Liang
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Small Firms ◽  
Reporting Quality ◽  
Financial Reporting Quality ◽  
Policy Debate ◽  
Content Type ◽  
Material Weaknesses ◽  
The Impact

Purpose The Dodd–Frank Act of 2010 exempts small, non-accelerated filers from compliance with Sarbanes–Oxley Act (SOX) Section 404b internal control audits. However, these firms are required to comply with other internal control regulations, namely, SOX Sections 302 and 404a, starting in 2002 and 2007, respectively. A small number of these firms also voluntarily adopted (and sometimes dropped) Section 404b during 2004-2010. The purpose of this study is to investigate the impact of a series of internal control regulations introduced by SOX on the financial reporting quality of small firms. Design/methodology/approach The research design for this study is empirical. Using unsigned and signed discretionary accruals as measures of financial reporting quality, the authors compare the financial reporting quality for adopters and non-adopters across four regulation regimes over the period 2000-2010: PRESOX, SOX 302, SOX 404a and SOX 404b. Findings The results indicate that most of the adopters and non-adopters benefited from SOX 302 and 404a compared with the PRESOX period. However, only the non-adopters gained incrementally when moving from SOX 302 to SOX 404a. Also, Section 404b benefited firms with material weaknesses, as well as firms without material weaknesses that had the lowest reporting quality, in the PRESOX period. Research limitations/implications This study helps inform the important policy debate on whether to increase the threshold that is used for the SOX 404b exemption. It shows incremental benefits for firms that adopted Section 404b audits, even when they were complying with Section 302 and Section 404a. Consequently, extending the exemption to more companies would result in a loss of the reporting quality benefit of 404b. Originality/value This study contributes to the literature by focusing exclusively on non-accelerated filers and by examining differences across four regulation regimes over a long window compared to prior studies. It provides evidence that the financial reporting benefit of SOX 404b is not transitional, but rather extends for a few years even after some firms discontinued the 404b audits.

The Quality of Internal Control over Financial Reporting in Family Firms

2014 ◽  
Vol 29 (1) ◽  
pp. 41-60 ◽  
Author(s):  
Indranil Bardhan ◽  
Shu Lin ◽  
Shu-Ling Wu
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Family Firms ◽  
Developed Countries ◽  
Firm Characteristics ◽  
Undue Influence ◽  
Material Weaknesses ◽  
Dual Class Shares ◽  
Dual Class

SYNOPSIS Family firms represent a majority of businesses worldwide, and play a crucial role in the socio-economic development of both developed countries and emerging economies. We study the relationship between family firm characteristics and the quality of internal control over financial reporting, relative to non-family firms. Using a relatively large sample of S&P 500 firms, we report that family firms exhibit more material weaknesses in their internal control over financial reporting than non-family firms. Further investigation suggests that the greater likelihood of material weaknesses is driven by family firms with dual-class shares. Our results are consistent with the entrenchment argument that family owners are motivated to maintain weaker internal controls in order to extract private benefits. Our study contributes to the extant literature on family firms by providing further insight into the mechanisms through which family firms can exert undue influence on internal control over financial reporting.

Audit Fees after Remediation of Internal Control Weaknesses

2011 ◽  
Vol 25 (1) ◽  
pp. 87-105 ◽  
Author(s):  
Vishal Munsif ◽  
K. Raghunandan ◽  
Dasaratha V. Rama ◽  
Meghna Singhvi
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Fees ◽  
Internal Controls ◽  
Future Research ◽  
First Year ◽  
Section 404 ◽  
The Third ◽  
Material Weaknesses ◽  
Audit Fee

SYNOPSIS: In this study, we examine audit fees for SEC registrants that remediate previously disclosed material weaknesses in internal control. We find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years. Firms that had an adverse Section 404 report only in the first year, but remediated the problems in year two and had clean Section 404 reports in years three and four, pay an audit fee premium of 32 (21) percent in the third (fourth) year when compared to firms that had clean Section 404 reports in each of the first four years. The results, thus, suggest that audit fees are “sticky” for firms that have material weaknesses in internal controls over financial reporting, and suggest some interesting questions for future research.

Business Strategy, Internal Control over Financial Reporting, and Audit Reporting Quality

2017 ◽  
Vol 36 (4) ◽  
pp. 49-69 ◽  
Author(s):  
Kathleen A. Bentley-Goode ◽  
Nathan J. Newton ◽  
Anne M. Thompson
Keyword(s):  
Quality Improvement ◽  
Financial Reporting ◽  
Internal Control ◽  
Business Strategy ◽  
Audit Quality ◽  
Reporting Quality ◽  
Internal Controls ◽  
Data Availability ◽  
Material Weaknesses ◽  
Jel Classifications

SUMMARY This study examines whether a company's business strategy is an underlying determinant of the strength of its internal control over financial reporting (ICFR) and auditors' internal control reporting quality. Organizational theory suggests that companies following an innovative “prospector” strategy are likely to have weaker internal controls than companies following an efficient “defender” strategy. Consistent with theory, we find that firms with greater prospector-like characteristics are more likely to report and less likely to remediate material weaknesses, incremental to known determinants of material weaknesses. We also find that auditors' internal control reporting quality is lower among clients with greater prospector-like characteristics when measured using the timeliness of reported material weaknesses. Our findings indicate that business strategy is a useful summary indicator for evaluating companies' internal control strength and suggest that internal control reporting is an important area for audit quality improvement among prospector-like clients. JEL Classifications: D21; 21; M41. Data Availability: Data are obtained from public sources as indicated in the text.

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