Market Response to Audited Internal Control Weakness Disclosures

2020 ◽  
Vol 5 (1) ◽  
pp. 2-20
Author(s):  
Subash Adhikari ◽  
Binod Guragai ◽  
Ananth Seetharaman
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Market Reaction ◽  
Financial Statements ◽  
Data Availability ◽  
Market Response ◽  
Market Participants ◽  
Sarbanes Oxley ◽  
Time Periods ◽  
First Time

ABSTRACT To help guard against weaknesses in internal control over financial reporting (ICFR), the Sarbanes-Oxley Act of 2002 requires certain filers to have their ICFR assertions audited. Beneish et al. (2008) show that market participants fail to react negatively to adverse ICFR audit opinions. This is puzzling because weak ICFR heightens the risk of fraud or materially misstated financial statements. Our study reexamines this issue for the time periods covered by Auditing Standard No. 2 (AS2) and Auditing Standard No. 5 (AS5). We too find no significant negative market reaction to the disclosure of adverse ICFR audits in the AS2 era. However, we show that markets react negatively for first-time disclosures of adverse ICFR audits after the adoption of AS5. Furthermore, in the AS5 regime, markets seem to differentiate between entity-wide versus account-specific ICFR weaknesses. We also show that correcting previous ineffective ICFR results in a positive market reaction. Data Availability: Data are available from sources cited in the text.

scholarly journals Does Attestation of the effectiveness of Internal Control over Financial Reporting Discourage Earnings Management? Evidence from China

2018 ◽  
Vol 7 (4) ◽  
pp. 1
Author(s):  
Li Dang ◽  
Qiaoling Fang
Keyword(s):  
Earnings Management ◽  
Financial Reporting ◽  
Internal Control ◽  
Reporting Quality ◽  
Financial Statements ◽  
Financial Reporting Quality ◽  
Chinese Government ◽  
Chinese Firms ◽  
Public Firms ◽  
Sarbanes Oxley

To improve financial reporting quality, the Chinese government issued the Basic Standard for Enterprise Internal Control in 2008 and other related guidelines/regulations in the following years (hereafter China SOX). The scope of China SOX is broader but similar to Section 404 of the Sarbanes-Oxley Act (SOX) in the U.S. Formal adoptions of China SOX requires management and external auditor’s report on the effectiveness of internal control over financial reporting (ICFR). A company’s ICFR, if effective, should provide reasonable assurance that the company’s financial statements are reliable and prepared in accordance with the applicable accounting standards. The purpose of this study is to investigate whether China external auditor attestation of ICFR discourage earnings management, an indicator of financial reporting quality. By analyzing a sample of Chinese public firms during 2011 to 2013, we find that: (1) Chinese firms that disclose audited ICFR reports exhibit lower earnings management than firms that do not; (2) Chinese firms that are mandated to disclose audited ICFR reports exhibit lower earnings management than firms that voluntarily disclose audited ICFR reports. Our empirical results seem to suggest that attestation of the effectiveness of ICFR discourages earnings management and therefore improve financial reporting quality. 

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.

Section 404 Compliance and Financial Reporting Quality

2010 ◽  
Vol 24 (3) ◽  
pp. 441-454 ◽  
Author(s):  
Albert L. Nagy
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Reporting Quality ◽  
Financial Statements ◽  
Securities And Exchange Commission ◽  
Small Companies ◽  
Section 404 ◽  
Financial Reports ◽  
Sarbanes Oxley

SYNOPSIS: This study examines whether the Sarbanes-Oxley Act Section 404 (S404) compliance efforts lead to higher quality financial reports. An objective of S404 is to encourage companies to devote adequate resources and attention to their internal control systems, which should lead to more reliable financial statements. A natural laboratory of S404 compliance and noncompliance companies exists because the Securities and Exchange Commission has deferred the S404 compliance date for small companies (nonaccelerated filers). A logistic regression model is estimated using a sample of companies surrounding the S404 compliance threshold to measure the S404 compliance effect on the likelihood of issuing materially misstated financial statements. The results show a significant and negative relation between S404 compliance and issuance of materially misstated financial statements, and suggest that the S404 regulation is meeting its objective of improving the quality of financial reports.

Internal Control Deficiencies in Tax Reporting: A Detailed View

2015 ◽  
Vol 29 (4) ◽  
pp. 917-942 ◽  
Author(s):  
Lynford Graham ◽  
Jean C. Bedard
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Public Information ◽  
Data Availability ◽  
Fiscal Year ◽  
Sarbanes Oxley ◽  
Financial Misstatement ◽  
Internal Control Deficiencies ◽  
Using Data ◽  
Tax Reporting

SYNOPSIS Prior research, using data from Sarbanes-Oxley Act Sections 302/404 (SOX, U.S. House of Representatives 2002) disclosures, finds that material weaknesses (MWs) in internal controls over financial reporting of taxes are more frequent and consequential than other account-specific MWs. Understanding internal control deficiencies (ICDs) in tax reporting is important but public information is limited, as MWs comprise only control flaws remaining unremediated at year-end and few details on their nature are available from SEC filings. We supplement prior studies by providing a detailed look at all Section 404 control deficiencies in tax reporting in a proprietary sample of engagements in 2004–2005 from several large auditing firms. We find that tax ICDs are less likely to be remediated between discovery and fiscal year-end, more likely to be severe, and more likely to have caused a financial misstatement. Remediation failure for tax ICDs is greater when management missed detecting the problem, and more prevalent for poorly designed controls, controls over the tax provision, and monitoring control activities. Auditors' severity classifications imply that ICDs relating to the tax provision and deferred taxes, and those that failed in operation, have higher potential for producing misstatements. Overall, our results underscore the importance of auditor involvement in internal control reporting in the tax area. Data Availability: Data used for this study were provided under confidentiality agreements, and cannot be shared.

The Impact of Culture on Internal Control Weaknesses: Evidence from Firms That Cross-List in the U.S.

2017 ◽  
Vol 16 (3) ◽  
pp. 119-145 ◽  
Author(s):  
Maria T. Caban-Garcia ◽  
Carmen B. Ríos Figueroa ◽  
Karin A. Petruska
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Power Distance ◽  
Data Availability ◽  
Country Level ◽  
Sarbanes Oxley ◽  
And Control ◽  
Section 302 ◽  
The Impact

ABSTRACT This study addresses the impact of culture on the likelihood of U.S. foreign issuers reporting material weaknesses in internal control over financial reporting (MWICs). Specifically, we explore whether Hofstede's (1980, 2001) country-level dimensions of power distance, individualism, uncertainty avoidance, masculinity, and long-term orientation explain the likelihood of U.S. foreign issuers reporting internal control deficiencies under Section 302 of the Sarbanes-Oxley Act (SOX). To assess whether home country guidance on internal control reporting influences U.S. foreign issuers detecting and reporting MWICs, we identify and control for the adoption of internal control guidance in foreign jurisdictions. Our results show that firms from countries with a high power distance and long-term orientation are more likely to report MWICs. In addition, we find that firms from countries that implement internal control guidance are less likely to report MWICs, suggesting that the effectiveness of U.S. foreign issuers' internal control over financial reporting is influenced by their home countries' regulation and oversight. These results are generally robust to a number of additional sensitivity tests. JEL Classifications: M14; M16; M48. Data Availability: Data are from publicly available sources.

Accounting Errors in Nonprofit Organizations

2015 ◽  
Vol 29 (2) ◽  
pp. 341-361 ◽  
Author(s):  
Jeffrey J. Burks
Keyword(s):  
Nonprofit Organizations ◽  
Financial Reporting ◽  
Internal Control ◽  
Error Rate ◽  
Positive Association ◽  
Financial Statements ◽  
Data Availability ◽  
Financial Reports ◽  
Public Charities ◽  
Accounting Errors

SYNOPSIS This study examines the accounting errors committed by public charities as revealed by searching for disclosures of their corrections in auditor reports, financial statements, and footnotes. A sample of 5,511 audited financial statements, predominantly from the years 2006 to 2010, was obtained from GuideStar, a data provider for nonprofits. Public charities report errors at a rate that is 60 percent higher than that of publicly traded corporations, and almost twice as high as that of similar-sized corporations. The errors are commonly errors of omission (i.e., failing to recognize items). The error rate has a strong positive association with internal control deficiencies and a strong negative association with Big 4 and second-tier auditors. Regressions are unable to detect a significant association between the error rate and organization size, type, or portion of the budget devoted to administrative activities. The error corrections often have low visibility in the financial reports issued by public charities; although they are reported in the footnotes of the audited financial statements, they often are not mentioned in auditor reports and in IRS Form 990s. The study improves our understanding of the accounting challenges faced by nonprofits, and may enhance nonprofit financial reporting by helping nonprofit managers and auditors understand the common circumstances and types of errors, and thus what activities to monitor more closely. The study also contributes to the academic literature by comparing the errors of nonprofits to those of corporations, by examining the outcomes of audits conducted by large as well as small auditors, and by advancing our understanding of discrepancies between audited and unaudited financial reports. Data Availability: Data are available from sources identified in the paper.

Behind the Numbers: Insights into Large Audit Firm Sampling Policies

2014 ◽  
Vol 29 (1) ◽  
pp. 61-81 ◽  
Author(s):  
Brant E. Christensen ◽  
Randal J. Elder ◽  
Steven M. Glover
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Data Availability ◽  
Future Research ◽  
Accounting Firms ◽  
Sarbanes Oxley ◽  
Big 4 ◽  
National Office ◽  
Current Sampling ◽  
Audit Sampling

SYNOPSIS Changes in the audit industry after the Sarbanes-Oxley Act, including mandatory audits of internal control over financial reporting and PCAOB oversight and inspection of audit work, have potentially changed the nature and extent of audit sampling in the largest accounting firms. However, little academic evidence exists on these firms' current audit sampling policies (Elder, Akresh, Glover, Higgs, and Liljegren 2013). As such, we administer an extensive, open-ended survey to the national office of the Big 4 and two other international accounting firms regarding their firm's audit sampling policies. We find variation among the largest auditing firms' policies in their use of statistical and nonstatistical sampling methods and in inputs used in the sampling applications that could result in different sample sizes. Sampling experts' internal reviews indicate that projecting and resolving identified misstatements is one of the biggest difficulties that audit engagement teams face when using sampling techniques. Finally, we present evidence that some firms have significantly changed their approach to revenue testing due to PCAOB inspections. This evidence provides important insights into current sampling policies and presents opportunities for future research. Data Availability: Please contact the authors.

The Market Reaction to SEC IFRS-Related Announcements: The Case of American Depository Receipt (ADR) Firms in the U.S.

2014 ◽  
Vol 28 (3) ◽  
pp. 579-603 ◽  
Author(s):  
Jenice J. Prather-Kinsey ◽  
Paul N. Tanyi
Keyword(s):  
Financial Reporting ◽  
Market Reaction ◽  
Abnormal Returns ◽  
Financial Statements ◽  
The United States ◽  
Equity Market ◽  
Market Reactions ◽  
Market Participants ◽  
Common Basis ◽  
The U.S

SYNOPSIS The objective of our study is to test whether the adoption of International Financial Reporting Standards (IFRS) in the United States (U.S.) is perceived positively by American Depository Receipt (ADR) firms' equity market participants. We conduct our tests by studying market reactions to the Securities and Exchange Commission's (SEC) IFRS-related press releases, between 2007 and 2011, regarding potential adoption of IFRS in the U.S. Using a sample of ADR firms and multivariate regression analyses, we test the 3-day cumulative abnormal returns (CAR) of investors of ADR firms in response to SEC announcements on potential IFRS adoption. We find a significant and positive market reaction to the SEC's announcements related to the potential adoption of IFRS in the U.S. for ADR firms reporting their financial statements using IFRS, especially in the industry where IFRS is the globally predominant accounting standard. Conversely, we find a significantly negative market reaction to SEC-related announcements of potential adoption of IFRS in the U.S. for ADR firms currently reporting their financial statements using U.S. generally accepted accounting principles (GAAP). We conclude that the SEC's adoption of IFRS may benefit global and U.S. equity market participants relative to Local GAAP reporting (reporting using domestic GAAP that is not IFRS or U.S. GAAP) by providing a common basis for investors, issuers, and others to evaluate investment opportunities.

The Audit Committee: Management Watchdog or Personal Friend of the CEO?

2013 ◽  
Vol 89 (1) ◽  
pp. 113-145 ◽  
Author(s):  
Liesbeth Bruynseels ◽  
Eddy Cardinaels
Keyword(s):  
Earnings Management ◽  
Financial Reporting ◽  
Internal Control ◽  
Audit Committee ◽  
Social Ties ◽  
Data Availability ◽  
Audit Committees ◽  
Sarbanes Oxley ◽  
Negative Effect

ABSTRACT To ensure that audit committees provide sufficient oversight over the auditing process and quality of financial reporting, legislators have imposed stricter requirements on the independence of audit committee members. Although many audit committees appear to be “fully” independent, anecdotal evidence suggests that CEOs often appoint directors from their social networks. Based on a 2004 to 2008 sample of U.S.-listed companies after the Sarbanes-Oxley Act, we find that these social ties have a negative effect on variables that proxy for oversight quality. In particular, we find that firms whose audit committees have “friendship” ties to the CEO purchase fewer audit services and engage more in earnings management. Auditors are also less likely to issue going-concern opinions or to report internal control weaknesses when friendship ties are present. On the other hand, social ties formed through “advice networks” do not seem to hamper the quality of audit committee oversight. Data Availability: All data are publicly available from sources identified in the text.

The Effectiveness of SOX Regulation: An Interview Study of Corporate Directors

2012 ◽  
Vol 25 (1) ◽  
pp. 61-87 ◽  
Author(s):  
Jeffrey R. Cohen ◽  
Colleen Hayes ◽  
Ganesh Krishnamoorthy ◽  
Gary S. Monroe ◽  
Arnold M. Wright
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Committee ◽  
Policy Decision ◽  
Substantial Improvement ◽  
Data Availability ◽  
Internal Auditors ◽  
Sarbanes Oxley ◽  
Financial Expertise ◽  
Accounting Judgments

ABSTRACT: This study provides insights on the effectiveness of the Sarbanes-Oxley Act (U.S. House of Representatives 2002) in promoting high-quality financial reporting and good corporate governance, based on interviews conducted with 22 experienced directors from U.S. firms. Our analysis indicates that SOX has positively impacted the monitoring role of the audit committee (board), which directors attributed to the financial expertise and internal control requirements and heightened substantive diligence. However, some considered that an emphasis on financial expertise at the expense of legal expertise and financial markets expertise could compromise the quality of financial disclosures due to a lack of business savvy needed to inform accounting judgments and the standardization of reporting. SOX was also perceived as having led to a formalistic approach to accounting policy decision making by the audit committee and external auditor, as a buffer against litigation. While CEO certification was viewed as having led to heightened ownership and diligence on the part of decision agents throughout the financial reporting decision hierarchy, it was also identified as a source of the costly resource-intensive reaction to SOX. Directors also considered that SOX had led boards to take a narrow focus on financial reporting risk at the expense of strategy. Further, management was identified as being actively involved in the more overt process of initiating and administering the process. The directors' responses also demonstrate some variation in the extent and nature of the role played by the audit committee to resolve accounting disputes, reflecting varying interpretations of law. Participants indicate that SOX has also led to a substantial improvement in the scope, responsibility, and status of internal auditors. Data Availability: Contact the authors.

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