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  • Jennifer M Mueller-Phillips
    Auditor Attestation under SOX Section 404 and Earnings...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Auditor Attestation under SOX Section 404 and Earnings Informativeness
    Practical Implications:

    Section 404 is one of the most controversial provisions of the Sarbanes-Oxley Act. Many studies have examined the negative consequences of adverse reports on internal control issued by the auditor. Other studies have looked at the cost of compliance of Section 404 and find that it is burdensome, disproportionately so for small companies. This study focuses on the benefits of internal control audits. Regulators have argued that the benefits of Section 404 are hard to measure because of the difficulty in quantifying the benefits. This study contributes to the debate on the benefits of Section 404 by documenting evidence that although compliance with Section 404’s requirements has been reported to be associated with high costs, the first-time internal control reports seem to have increased earnings informativeness. 

    Citation:

    Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).

    Keywords:
    earnings informativeness; internal control; Sarbanes-Oxley; Section 302; Section 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act (SOX) requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). This policy is intended to enhance the credibility of firms’ financial statements. Prior research suggests that audit characteristics that enhance the credibility of financial reporting are associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. This study examines the SEC’s and PCAOB’s expectation about the increased quality and reliability of financial reporting resulting from Section 404. By using a difference-in-differences approach, the authors compare the change in earnings informativeness for the test sample used with that for a control sample of non-accelerated filers. 

    Design/Method/ Approach:

    The authors used previous research and policy makers’ expectations to develop the following hypothesis for testing:

     

    H1: Earnings accompanied by the first-time clean SOX404 ICFR reports are more informative that the previous annual earnings that were not accompanied by ICFR.

     

    This hypothesis was tested by comparing earnings informativeness for the annual filings containing the first-time ICFR reports and the annual filings of the previous year. The sample consisted of two types of firms (1) accelerated filers with clean Section 404 reports for the current year and clean Section 302 management reports for the seven preceding quarters, and (2) non-accelerated filers with clean Section 302 management reports throughout the sample period. The sample period included firm year-ends between November 15, 2003 and November 15, 2005. The final sample consisted of 381 firms. 

    Findings:
    • Firms with first-time clean ICFR reports have higher earnings informativeness in SOX years than in the pre-SOX years when they received only financial statement audit reports.
    • The firms that benefited the most are those with higher likelihood of material weaknesses.
    • Firms with both low and high costs of compliance experience an increase in earnings informativeness. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
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  • Jennifer M Mueller-Phillips
    Auditor Realignments Accompanying Implementation of SOX 404...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements
    Practical Implications:

    The results of this study are important for showing the impact of SOX requirements on the audit environment.  The evidence suggests that ICFR opinions provide clients with information to assess the effectiveness of auditors.  After adverse internal control opinions, clients dismiss auditors in order to obtain higher quality audits, measured by switches to Big 4 and industry specialist auditors.  However, only industry specialist auditors are associated with remediation of adverse reports. 

    Citation:

    Ettredge, M., J. Heintz, C. Li, and S. Scholz. 2011. Auditor realignments accompanying implementation of SOX 404 ICFR reporting requirements. Accounting Horizons 25 (1): 17-39.

    Keywords:
    auditor realignments; dismissals; internal control; SOX Section 404; remediation
    Purpose of the Study:

    This study was motivated by the increased frequency of client dismissals of auditors since the implementation of SOX in 2002.  The added requirement that auditors opine on the client’s internal control over financial reporting (ICFR) brought concern among financial statement users that clients would seek more compliant auditors decreasing the quality of the audit.  This paper studies the impact of adverse auditors’ opinions on clients’ internal controls to determine whether:

    • Clients dismiss auditors after receiving an adverse SOX 404 ICFR opinion.
    • Clients dismiss auditors to improve financial reporting by obtaining a higher-quality auditor.
    • Dismissals and hiring a new auditor are associated with subsequent improved ICFR opinions.
    Design/Method/ Approach:

    The authors study accelerated filers from November 2004 through December 2007 and obtain data on ICFR opinions, auditor dismissals, and auditor switches.  Higher audit quality is measured as changes to Big 4 and industry specialist auditors. 

    Findings:
    • Companies receiving adverse ICFR opinions are more likely to dismiss their auditor in the subsequent year.
    • Companies that dismiss their auditor after an adverse ICFR opinion are more likely to hire Big 4 and industry specialist auditors.
    • Remediation of adverse reports is only associated with clients that switch to an industry specialist auditor.
    Category:
    Standard Setting, Internal Control
    Sub-category:
    Impact of 404, Impact of SOX, Impact of 404 on Fees and Financial Reporting Quality
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  • Jennifer M Mueller-Phillips
    Auditors’ Internal Controls over Financial Reporting D...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.01 Scope of Testing 
    Title:
    Auditors’ Internal Controls over Financial Reporting Decisions: Analysis, Synthesis, and Research Directions
    Practical Implications:

    In the planning phase, the PCAOB and key stakeholders should consider developing an ICOFR audit risk model to serve as a conceptual planning and evaluative model. Audit firms should pay attention to aligning auditors’ skill sets to their task assignments and employ other mechanisms that encourage consultations.

    Scoping decisions remain underexplored. Nevertheless, anecdotal evidence suggests that auditors may be cognitively wired to scope some types of ELCs but not others. Firms may consider the interactions between auditors and client personnel that explain the tendency for auditors to evaluate only the ELCs scoped by the client.

    Audit firms should pay special attention to how audit teams design testing plans to test ELCs that are not easily tested by attribute sampling methods (e.g., management philosophy and operating style). This is necessary to address concerns by PCAOB inspections that some auditors identified ELCs that appeared to be designed to operate with a high degree of precision, but failed to obtain sufficient audit evidence of their operating effectiveness.

    In the evaluation phase, firms should consider mechanisms that can help auditors “imagine what could go wrong where nothing wrong has happened.” Examples of such mechanisms include restructuring the task (e.g., documentation, decomposition of the task, or requirements to list what could go wrong). In the reporting phase, firms should consider having a requirement to specifically require auditors to consider the needs of a prudent official. This requirement may be a countervailing check on their detection and disclosure incentives.

    For more information on this study, please contact Stephen K. Asare.

    Citation:

    Asare, S. A., B. C. Fitzgerald, L. E. Graham, J. R. Joe, E. M. Negangard, and C. J. Wolfe. 2013. Auditors’ Internal Controls over Financial Reporting Decisions: Analysis, Synthesis, and Research Directions. Auditing: A Journal of Practice and Theory 32 (sp1): 131-166.

    Keywords:
    Auditor judgment and decision-making; internal controls; Sarbanes-Oxley Act; literature synthesis; standard setting
    Purpose of the Study:

    This paper synthesizes the literature on auditors’ evaluation of and reporting on companies’ internal control over financial reporting (ICOFR) as required by the Sarbanes-Oxley Act (SOX). The purpose of the synthesis is (1) to provide stakeholders with information on how, and how well, auditors perform the ICOFR task; (2) to highlight implementation issues related to auditors’ application of the ICOFR standard and empirical findings related to regulatory concerns; (3) to identify gaps in the existing accounting literature and fruitful areas of future research; and (4) to stimulate additional research focusing on important regulatory areas as well as understanding and improving auditors’ ICOFR decisions.

    Design/Method/ Approach:

    The authors develop a framework to organize the literature on post-SOX ICOFR research. The framework suggests that there are five phases of the ICOFR audit: (1) planning; (2) scoping; (3) testing; (4) evaluation; and (5) reporting. It also suggests that auditors’ performance on the tasks within each phase are affected by (a) the auditor’s attributes, (b) the client’s attributes, (c) the interaction between the auditor and the client, (d) task attributes, and (e) environmental attributes. Following the framework, the authors describe and evaluate auditors’ performance on the specific tasks within each phase of the ICOFR audit. They end their analysis of each phase with a brief summary of the findings, discussion of the under-studied performance determinants, and suggestions for future research.

    Findings:

    Key takeaways from the synthesis paper include the following:

    • In the planning phase, there is an absence of a generally agreed upon ICOFR audit risk model akin to the audit risk model used in the audit of the financial statements. Auditors are not fully aware of the risks in complex enterprise resource planning systems, may be overconfident in their ability to assess risks in this setting, and are reluctant to seek consultation from computer assurance specialists.
    • The evidence from the studies on scoping suggests that the more prescription-oriented Auditing Standard No. 2 induced inefficiencies, some of which have been eliminated by the risk-based scoping prescribed by Auditing Standard No. 5. Further, there is evidence that management trustworthiness and investment in monitoring controls affect scoping decisions.
    • Auditors’ experience, knowledge, and training enhance testing strategies. However, providing auditors with client-prepared documentation before they make an independent assessment can hinder their ability to evaluate internal controls.
    • In the evaluation phase, auditors’ severity assessments are unduly influenced by the absence of a misstatement.
    • In the reporting phase, detection and disclosure incentives play a role in whether existing material weaknesses are reported.
    • The article includes a summary of the authors’ findings related to the Public Company Accounting Oversight Board (PCAOB) staff’s stated interest in the auditor’s testing of entity-level controls (ELCs), multi-location scoping, and the effect of compensating controls on the evaluation of identified control deficiencies.
    • Proposed areas of research related to the audit of ICOFR likely to influence future regulation are presented.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404, Scope of Testing
  • Jennifer M Mueller-Phillips
    Balancing the Costs and Benefits of Auditing and Financial...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.03 Impact of New Accounting Pronouncements, 01.04 Impact of 404 
    Title:
    Balancing the Costs and Benefits of Auditing and Financial Reporting Regulation Post-SOX, Part I: Perspectives from the Nexus at the SEC
    Practical Implications:

    The results of this study are important because they illuminate the impact of new accounting rules on standard setters and companies abiding by these rules (in this case, the specific context was the implementation process related to SOX Section 404). The study suggests that a number of steps are required in order to perfect the guidance. It is important to understand the meaning and intentions behind authoritative literature in order to follow it. The observations suggest that the process for implementing new guidance has room for change, yet has evolved over time to increase effectiveness. The findings are specific to the implementation for assessment and auditing of internal controls for public companies.

    For more information on this study, please contact Zoe-Vonna Palmrose (zv.palmrose@marshall.usc.edu).

    Citation:

    Palmrose, Z.-V. 2010. Balancing the Costs and Benefits of Auditing and Financial Reporting Regulation Post-SOX, Part I: Perspectives from the Nexus at the SEC. Accounting Horizons 24 (2):313-326.

    Purpose of the Study:

    Sarbanes-Oxley (SOX) Section 404 adds requirements for disclosures discussing management’s assessment of internal controls. Zoe-Vonna Palmrose served as the Deputy Chief Accountant for Professional Practice in the Office of the Chief Accountant. From August 2006 to July 2008, Palmrose observed the effects of SOX Section 404 on practice. The paper describes her observations related to:

    • The purpose of SOX Section 404.
    • Initial implementation efforts related to SOX Section 404.
    • Improvements for the implementation of SOX Section 404. These improvements primarily focus on the cost-benefit for smaller companies that had to report under SOX Section 404.
    • Overall cost-benefit effect on SOX Section 404 filers.
    Design/Method/ Approach:

    The author collected data through personal experiences from August 2006 through July 2008. She observed and recorded information related to SOX Section 404 during her time as the Deputy Chief Accountant in the Professional Practice Group.

    Findings:
    • The author finds that SOX Section 404 does not require a company to implement adequate internal controls because previous standards released in 1977 already accomplished that objective. Instead, SOX Section 404 requires disclosure of management’s assessment of the adequacy of its internal controls. The assessment is based on whether the internal controls can provide reasonable assurance about the reliability of the financial statements. SOX Section 404 does not allow management to disclose that its internal controls are effective if it determines material misstatements exist in the financial statements. The guidance also requires that a registered PCAOB auditor opines on management’s assessment of internal controls.
    • The author finds that the problems associated with the initial implementation of SOX Section 404 arose because it was issued from the top down. Few companies were reporting on internal controls before SOX required public companies to do so. The author observes that AS No. 2 was initially poorly suited for reporting on internal controls because it was difficult to determine the respective responsibilities of the auditor and management. In June 2006, the PCAOB clarified the standard in response to this confusion.
    • The author finds that the PPG aided the amendment to AS No. 2, accomplished in AS No. 5. Furthermore, an open meeting between the SEC and the PCAOB was primarily held to discuss how to make management and the auditor’s responsibilities more effective with respect to the responsibilities of each party.
    • The author finds that deferring implementation of SOX Section 404 for smaller public companies allowed the implementation flaws to be discovered before smaller companies were harmed.
    • The author finds that audit fees rose in order to compensate for the added work for the auditors. Cost-benefit relationships were analyzed in order to determine the effectiveness of the work to be completed.
    Category:
    Standard Setting
    Sub-category:
    Changes in Audit Standards, Impact of 404, Impact of New Accounting Pronouncements
  • Jennifer M Mueller-Phillips
    Board Independence and Internal Control Weakness: Evidence...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 01.04 Impact of 404, 07.03 Reporting Material Weaknesses, 13.01 Board/Audit Committee Composition 
    Title:
    Board Independence and Internal Control Weakness: Evidence from SOX 404 Disclosures
    Practical Implications:

    This study examines the effects on internal control weaknesses associated with an independent board of directors. A benefit of having an independent board is the timely remediation of ICWs. This is of high importance because the quicker a material weakness is resolved, the sooner a company can return to normal operations. Another contribution of this study is the discovery of implications regarding Auditing Standard No. 5. The standard changed internal control evaluation to become more holistic and less detailed. This provides the board of directors less tangible information on the status of internal controls.

    Citation:

    Chen, Yangyang, Robert. W. Kechel., V. B. Marisetty, C. Truong, and M. Veeraraghavan.2017. Board Independence and Internal Control Weakness: Evidence from SOX 404 Disclosures. Auditing, A Journal of Practice and Theory 36(21): 45-62.

    Keywords:
    internal control weakness; board independence; unitary versus dual leadership; SOX 404
    Purpose of the Study:

    An important role of corporate governance is its duty to manage various aspects of risk. One way to accomplish this goal is through oversight of management’s system of internal controls. This study examines how corporate governance structure affects management’s disclosure of material weaknesses in internal control over financial reporting. Specifically, the authors investigate how the board’s characteristics of independence and leadership style (a unitary leader versus separate CEO and chairman) influence the frequency of internal control weaknesses (ICWs) reported, the types of ICWs reported, and timeliness of ICW remediation. 

    Design/Method/ Approach:

    Reported ICWs were gathered from Audit Analytics, based on forms 10-K, 10-K/A, 20-F, and 40-F. Board demographics, including independence variables, were gathered from RiskMetrics. The final sample consisted of 2,048 firms and 11,226 observations, from 2004 – 2012.

    Findings:

    The authors find the following related to board independence:

    • Board independence is negatively associated with the disclosure of ICWs. The evidence suggests that higher board independence causes a lower probability of ICWs occurring.
    • There was lower number of both account-specific and company-level ICWs in boards with more independent directors.
    • Board independence is associated with timely remediation of ICWs.

     

    The authors also find:

    • The negative relation between board independence and ICWs is strongest in a company that has unitary leadership. This demonstrates that an effective board is based more on board independence rather than board leadership style.
    • The implementation of Auditing Standard No. 5 in 2007 somewhat weakened the effect of board independence on the disclosure of ICW’s.
    Category:
    Governance, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Impact of 404, Reporting Material Weaknesses
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  • Jennifer M Mueller-Phillips
    Detection and Severity Classifications of Sarbanes-Oxley...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.04 Assessing Remediation of Weaknesses 
    Title:
    Detection and Severity Classifications of Sarbanes-Oxley Section 404 Internal Control Deficiencies
    Practical Implications:

    The results of this study support the value of auditor involvement at two stages of the ICFR assessment process (detection and classification), and contribute to understanding of factors associated with client and auditor performance in both stages. The study also provides direct evidence on the “yield” of detection methods used by auditors. This issue is at the heart of the debate on the value of auditor involvement in assessing and testing internal controls. Lastly, the findings of this study imply that the recent exemption of Section 404(b) for smaller U.S. public companies could result in failure to fully realize potential improvements in financial reporting quality in that sector of the market.

    For more information on this study, please contact Jean Bedard.
     

    Citation:

    Bedard, J. C. and L. Graham. 2011. Detection and Severity Classifications of Sarbanes-Oxley Section 404 Internal Control Deficiencies.  The Accounting Review 86 (3):  825-855. 

    Keywords:
    internal controls; Sarbanes-Oxley Section 404; risk assessment; materiality
    Purpose of the Study:

    In the aftermath of large company failures (Enron and WorldCom), Congress enacted the Sarbanes-Oxley Act (SOX) and, more specifically, Section 404 to improve the reliability of information provided by public companies to the financial markets by requiring company management and auditors to test internal control over financial reporting (ICFR) and to disclose severe control flaws that are not remediated as of the balance sheet date. Prior research uses publicly available annual report data to distinguish characteristics of companies disclosing ineffective controls (i.e., at least one MW) under Section 404, or quarterly management reports under Section 302  but does not address the full extent of detected control flaws, how those problems are detected, or how auditors determine which problems are disclosed. This study extends prior research and investigates detection and severity classification of internal control deficiencies (ICD) under Section 404 to determine (1) the relative contribution of clients and auditors to ICD detection and (2) the factors are associated with the auditor’s severity classifications of detected ICD.

    Design/Method/ Approach:

    The authors obtained proprietary data from several large audit firms, under confidentiality agreements that limit the ability of the authors to results separate results by firm or firm size. The authors asked that each firm randomly select from 2004–2005 engagements of smaller accelerated filers (with revenues of about $1 billion or less) in non-regulated industries allowing them to increase generalizability to the large number of U.S. public companies. Contact personnel from participating firms helped the authors develop a spreadsheet to be completed by engagement teams, containing both company-level and control-level information. The authors first examine the overall percentage of ICD detected by clients/auditors and also model the factors associated with likelihood of client detection. In addition, because auditors are sometimes aware of the client’s preliminary classification of ICD, the authors test whether auditors override those classifications by judging ICD to be more severe. Lastly, the authors test expectations regarding factors associated with severity classification of ICD.

    Findings:
    • The authors find that clients detect fewer ICD than auditors, and are less likely to detect severe and pervasive ICD and therefore infer that many of the control flaws most likely to affect financial reporting would not be found in a client-driven process such as Section 302.
    • Furthermore, the analysis shows that the use of a large accounting firm consultant for Section 404(a) work is associated with improved client detection
    • The authors find that control tests provide initial evidence on a large proportion of ICD, including most MW and entity-level problems viewed as more serious by financial report users which affirms auditors’ Section 404 control testing as an important source of detecting control deficiencies.
    • The authors find that clients tend to classify ICD as less severe, but auditors frequently override those classifications.
    • Lastly, the authors find higher severity associated with:
    1. greater knowledge and independence in the client’s Section 404(a) process;
    2. more objective evidence (e.g., an existing misstatement);
    3. control flaws other than documentation problems (e.g., inappropriate design);
    4. certain types of entity-level ICD (e.g.,  Control Environment);
    5. certain types of account-specific ICD (revenue and tax), consistent with the regulatory climate of the period.
       
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Assessing Material Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Impact of 404
  • Jennifer M Mueller-Phillips
    Do Small Firms Benefit from Auditor Attestation of Internal...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 12.0 Accountants’ Reports and Reporting, 12.07 Attestation Services 
    Title:
    Do Small Firms Benefit from Auditor Attestation of Internal Control Effectiveness?
    Practical Implications:

    This study can inform regulators, investors, and others of the potential consequences of exempting non-accelerated filers from Section 404(b) of SOX. The results of this study support the notion that an auditor’s opinion on the effectiveness of internal control over financial reporting adds value beyond certifications provided by management. Additionally, the results of the study support the notion that investors in small public firms regard auditors’ assessment of the effectiveness of internal controls as adding value via higher revenue quality relative to firms that are not required to submit themselves to additional scrutiny by their auditors. Thus, firms contemplating exiting accelerated status may want to consider that such a move may have an adverse effect on firm valuation.

    Citation:

    Krishnan, G. V., and W. Yu. 2012. Do Small Firms Benefit from Auditor Attestation of Internal Control Effectiveness? Auditing: A Journal of Practice and Theory 31(4): 115-137.

    Keywords:
    Dodd-Frank Act; SOX 404; revenue quality; non-accelerated filers; valuation
    Purpose of the Study:

    Several sections of the Sarbanes-Oxley Act of 2002 (SOX) mandate disclosure of information on the effectiveness of internal control over financial reporting (ICFR):

    • Section 302 requires the CEO and CFO to certify 10-K and 10-Q reports, and establish and maintain internal controls.
    • Section 404(a) requires each company’s annual report to include an internal control report containing management’s assessment of the effectiveness of ICFR (management report).
    • Section 404(b) requires companies to have the auditor evaluate the effectiveness of the internal controls.

    Accelerated filers (public companies with a public float of at least $75 million) and non-accelerated filers are both subject to the provisions of Section 302 and 404(a), but the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 permanently exempts non-accelerated filers from the provisions of Section 404(b). Therefore, the purpose of the study was to examine whether the provisions of Section 404(b) add value incremental to those in Sections 302 and 404(a) for small firms. The authors specifically examined whether there was a difference in the revenue quality (which is discretionary or abnormal revenue) between accelerated filers who are subject to auditor attestation of ICFR and non-accelerated filers. They also examines whether there was a difference in the investor valuation of accelerated filers relative to non-accelerated filers.
     

    Design/Method/ Approach:

    The authors used data between the years 2007 and 2009 from publicly-traded companies. The authors identified accelerated and non-accelerated filers that had beginning assets between $25 million and $125 million. The authors fit this data to a model that estimated discretionary revenues for these firms.

    Findings:
    • On average, discretionary (abnormal) revenues were lower by about 1.5 percent of total assets for accelerated filers relative to non-accelerated filers.
    • After excluding observations that had control deficiencies, the authors found that the discretionary revenues were lower by about 1.9 percent for accelerated filers relative to non-accelerated filers.
    • The authors evaluated firms that had changed from being accelerated filers to non-accelerated filers and found that discretionary revenues had increased by about 1 percent of total assets following the change from accelerated filer to non-accelerated filer.
    • The authors matched non-accelerated filers with accelerated filers by the ratio of audit fees over total assets and found that discretionary revenues were smaller for accelerated filers relative to non-accelerated filers.
    • The book value of equity of accelerated filers was valued more by investors relative to the book value of equity of non-accelerated filers.
       
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Attestation Services, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    Early Warnings of Internal Control Problems: Additional...
    research summary posted May 25, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    Early Warnings of Internal Control Problems: Additional Evidence
    Practical Implications:

    The results of this study raise many interesting questions. The fact that accelerated filers’ adverse internal control opinions continue to be a surprise over 50 percent of the time suggest that auditors continue to find internal control problems that management had not previously identified or had not evaluated as MWs. The results related to non-accelerated filers provide some interesting data related to the ongoing debate about the efficacy of Section 404(b) testing by auditors. The authors also note that examining the early warnings of non-accelerated filers tells us only about what management of these companies report; it does not give us insight into what auditors would report. The results also raise other interesting issues for future research.

    Citation:

    Munsif, V., K. Raghunandan, and D. V. Rama. 2013. Early Warnings of Internal Control Problems: Additional Evidence. Auditing 32 (2).

    Keywords:
    302; 404; internal control; SOX
    Purpose of the Study:

    This study extends the research of Hermanson and Ye (2009; hereafter, HY) that found in the first year of Sarbanes-Oxley Act (SOX) Section 404 reporting, there were many companies with “surprise” adverse internal control reports.  The authors of this study examine a more recent time period (using data from fiscal years 2007 and 2008) and include both accelerated and non-accelerated filers. Motivation for these two extensions of HY comes from the fact that internal control disclosures by public companies and their auditors continue to be of significant interest to legislators and regulators. 

    Design/Method/ Approach:

    Data was obtained from the Audit Analytics and Compustat databases, and from company filings available at the SEC website. This data was used to answer the following two research questions:

    RQ1: What is the proportion of accelerated filers with “surprise” disclosures of material weaknesses in internal control in the fourth and fifth years of Section 404 reporting?

    RQ2: Does the likelihood of “surprise” disclosures of material weaknesses in internal control differ for accelerated and non-accelerated filers?

    To address the research question about characteristics of firms with and without early warning disclosures, following HY, a logistic regression model was used. 

    Findings:
    • The proportions of accelerated filer firms with MW disclosures in their Section 404(b) reports, that had disclosed one or more such MWs in Section 302 certifications in prior quarters of the same fiscal year, are only 40 percent and 39 percent in 2007 and 2008 respectively.
    • In the case of non-accelerated filer firms, the proportions of firms with such early warning disclosures are 20 percent and 56 percent in 2007 and 2008, respectively.
    • A regression model indicates that prior warning disclosures are more likely for firms with (1) more ICWs, (2) a new CFO, (3) more audit committee members, and (4) more frequent audit committee meetings.
    • In 2008, non-accelerated filers were more likely than accelerated filers to have early warning disclosures. 
    Category:
    Accountants' Reporting, Internal Control, Standard Setting
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404, Reporting Material Weaknesses
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  • Jennifer M Mueller-Phillips
    Home Country Investor Protection, Ownership Structure and...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Home Country Investor Protection, Ownership Structure and Cross-Listed Firms’ Compliance with SOX-Mandated Internal Control Disclosures.
    Practical Implications:

    The results carry important implications for regulators, investors, and researchers. The findings suggest both firm-level corporate governance and home country investor protection still matter in explaining the disclosure behavior of cross-listed firms. Hence, it may be warranted for U.S. securities regulators to devote more resources to monitoring the financial disclosure quality of CONTROL_WEDGE firms from weak investor protection countries. The results suggest that U.S. investors should pay closer attention to the financial disclosure quality of cross-listed firms, especially CONTROL_WEDGE firms from weak investor protection countries. This is important because the recent accounting frauds involving cross-listed firms suggest that U.S. investors might not have paid sufficient attention to the disclosure quality, and as a result suffered significant economic losses after the revelation of the accounting frauds.

    Citation:

    Gong, G., Ke, B., & Yu, Y. 2013. Home Country Investor Protection, Ownership Structure and Cross-Listed Firms' Compliance with SOX-Mandated Internal Control Deficiency Disclosures. Contemporary Accounting Research 30 (4): 1490-1523. 

    Keywords:
    investor protection, Sarbanes-Oxley, internal controls
    Purpose of the Study:

    The objective of this study is to assess the effects of home country investor protection and ownership structure on the Sarbanes-Oxley Act (SOX)mandated internal control deficiency (ICD) disclosures by foreign firms that are listed on the U.S. stock exchanges (hereafter referred to as cross-listed firms). In this study, the authors focus on SOX-mandated internal control disclosure provisions, because internal control systems play a crucial role in ensuring the reliability of financial reporting. It is widely recognized that material internal control weaknesses give management the flexibility to manipulate financial reporting to conceal their expropriation activities. In addition, the SOX-mandated internal control disclosure provisions are regarded as the most costly and controversial provisions of SOX. Therefore, it is important to analyze cross-listed firms’ compliance with SOX-mandated ICD disclosure requirements.

    The authors focus on the ICD disclosures during the Section 302 reporting regime and examine whether cross-listed firms whose management is the controlling shareholder of the firm and holds greater voting rights than cash flow rights (denoted as CONTROL_WEDGE firms) have a higher likelihood of misreporting ICDs than other cross-listed firms, especially for cross-listed firms domiciled in weak investor protection countries where managers’ ICD misreporting faces fewer constraints.

    Design/Method/ Approach:

    The sample is restricted to cross-listed firms that are listed on the three major U.S. stock exchanges as of the end of 2002. The sample includes both American Depository Receipts (ADRs) and foreign firms directly listed on the U.S. stock. Using COMPUSTAT, SEC filings, CRSP, and Audit Analytics, the authors created a sample of 355 unique cross-listed firms, of which 41 firms disclosed at least one material weakness during the Section 302 reporting regime.

    Findings:

    For cross-listed firms domiciled in weak investor protection countries, the authors find the following results: 

    • CONTROL_WEDGE firms have a higher likelihood of ICD misreporting than other firms during the Section 302 reporting regime. In addition, the likelihood of ICD misreporting is negatively associated with earnings quality during the Section 302 reporting regime.
    • The likelihood of ICD misreporting is positively associated with the likelihood of voluntary deregistration from the SEC prior to the Section 404 effective date.
    • For cross-listed firms that chose not to deregister, the likelihood of ICD misreporting is positively associated with the likelihood of reporting previously undisclosed ICDs during the Section 404 reporting regime.

    The authors do not find similar results for cross-listed firms domiciled in strong investor protection countries. Overall, the results are consistent with the hypothesis that management of CONTROL_WEDGE firms domiciled in weak investor protection countries is reluctant to disclose ICDs in order to protect its private control benefits. In addition, the results suggest that Section 404 is effective in weeding out cross-listed firms whose management has an incentive to hide ICDs or forcing cross-listed firms to truthfully reveal their ICDs.

     

    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    PCAOB Inspection Consequences, Processes, and Inspection...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX 
    Title:
    PCAOB Inspection Consequences, Processes, and Inspection Team Performance: Perspectives of Triennially Inspected Firms
    Practical Implications:

    The results of this study are important to practitioners, regulators, legislators, academicians, and other market participants as many aspects of SOX and PCAOB inspections have been criticized. Oversight bodies have modified SOX in response to concerns of oversight groups (Advisory Committee on Smaller Public Companies). Researchers and practitioners have called for research to study the impact of SOX on audit quality and the public interest. The Government Accountability Office (GAO), required by SOX to study the potential effects of further mandates, chose to wait several years to monitor and evaluate the effectiveness of SOX and the PCAOB on auditor independence and audit quality before proposing any further modifications (GAO 2004). We interpret our findings as suggesting the efficacy of PCAOB inspections may be enhanced by focusing on potential unintended consequences and inspection process modifications rather than on inspectors’ qualifications and actions.

     

    For more information on this study, please contact Brian Daugherty at University of Wisconsin-Milwaukee.

    Citation:

    Daugherty, B., and W. Tervo. 2010. PCAOB Inspection Consequences, Processes, and Inspection Team Performance: Perspectives of Triennially Inspected Firms. Accounting Horizons 24 (2):189-219.

    Keywords:
    PCAOB inspections: registered auditing firms: Sarbanes-Oxley; peer review
    Purpose of the Study:

    We solicit perceptions of the Public Company Accounting Oversight Board’s (PCAOB) inspection process from the leadership of triennial firms (100 or fewer publicly-traded audit clients, inspected triennially) receiving their initial inspection through the use of a survey. Our research is motivated by a growing stream of research related to triennial firms. Practitioners have called for research to determine if the performance of audits in the Sarbanes-Oxley era may fail to attain the stated objective of enhancing investor confidence in the capital markets. 

    Design/Method/ Approach:
    • Through December 2007, over 1,800 firms and affiliates were registered with and approved by the PCAOB to conduct audits of U.S. registrants, and 467 triennial firms had their initial inspection report posted on the PCAOB’s website. Instruments were mailed from 9/2007 to 1/2008.
    • We asked that the research instrument be completed by the person in each firm most closely involved with PCAOB inspections. 
    • A number of statements were designed to have participants evaluate consequences resulting from initial PCAOB inspections (Consequences), evaluate the inspection process (Process), and rate the performance of their PCAOB inspection team (Team). Consequence statements seek perceptions related to the influence of PCAOB inspections on overall audit quality, the ability to accept and retain public audit clients, public confidence in the audit profession, personnel time incurred in anticipation of inspection, incremental fees billed to clients as a result of inspection, recruitment and retention matters, and litigation risk. Process statements cover inspectors’ criticisms, engagement selection, time devoted to inspection, and confidentiality of findings related to firms’ QC systems and also gauge firms’ level of agreement with inspectors’ findings and evaluations of PCAOB inspections relative to the prior peer-review process. Team statements include those related to the technical knowledge and professional conduct of inspectors as well as the appropriateness of their focus on workpaper documentation, substantive procedures, and internal control audits.
    Findings:
    • Smaller respondents reported initial PCAOB inspections resulted in a negative impact on many aspects of their audit practices while medium and larger firms reported more favorable consequences.
    • Firms with reports released earlier in the initial inspection cycle reported negative consequences that appear to diminish as the process matures.
    • Results suggest very small triennial firms may be ceasing the performance of audits of public enterprises as a result of PCAOB inspections.
    • Smaller triennial firms disagree the PCAOB inspection process increases overall audit quality (contrary to the stated intentions of SOX) and both smaller and medium firms do not view PCAOB inspections as positively impacting their audit business.
    • Respondents generally evaluated inspectors’ performance in favorable terms but were much more critical of the inspection process itself.
    • An overriding concern of many inspected firms is the perception that inspectors are, in many cases, substituting their own judgment for the auditor’s professional judgment in determining whether audit engagements comply with applicable professional standards. This possibility is particularly troubling given the auditors’ direct interaction with client personnel and audit committee members in an ex-ante setting while PCAOB inspections are, by definition, conducted in an ex-post setting with minimal or no audit client contact.
    • Firms evaluated their initial inspection team’s performance favorably, but were more critical of the inspection process itself. Levels of satisfaction with nearly all aspects of PCAOB inspections appear to increase with firm size and the passage of time. 
    Category:
    Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX

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