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  • Jennifer M Mueller-Phillips
    Section 404 Compliance and Financial Reporting Quality
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 12.0 Accountants’ Reports and Reporting 
    Title:
    Section 404 Compliance and Financial Reporting Quality
    Practical Implications:

    As is asserted in its summary, “this study provides evidence that the S404 compliance effort reduces the likelihood of issuing materially misstated financial statements, and suggests that S404 regulation is meeting its objective of improving the quality of financial reports.”

    For more information on this study, please contact Albert L. Nagy

    Citation:

    Albert L. Nagy (2010) Section 404 Compliance and Financial Reporting Quality. Accounting Horizons: September 2010, Vol. 24, No. 3, pp. 441-454.

    Purpose of the Study:

    As asserted in its introduction, this study examines whether the Sarbanes-Oxley Act Section 404 (S404) compliance efforts lead to higher quality financial reports. This study examines whether the regulators have achieved their objective by examining whether the S404 compliance efforts reduce the likelihood of issuing materially misstated financial statements. 

    Design/Method/ Approach:

    A logistic regression model is estimated using a sample of company data (from years 2005 and 2006) surrounding the S404 compliance threshold to measure the S404 compliance effect on the likelihood of issuing materially misstated financial statements.

    Findings:

    Study results, “show a significant and negative relation between S404 compliance and issuance of materially misstated financial statements."

    Category:
    Standard Setting
    Sub-category:
    Impact of 404
  • Jennifer M Mueller-Phillips
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.04 Impact of 404, 01.05 Impact of SOX, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    Practical Implications:

    The findings support the regulators’ contention that the new top-down, risk-based approach under AS5 makes the audit process timelier and efficient by decreasing audit report lags and facilitating firms’ efforts to meet the reporting deadline set by the SEC, especially when the firms have an effective internal control system. However, the firms with material internal control problems that persist either at the company level or at the accounts/transaction level continue to experience larger reporting lags in the post-AS5 years compared with the clean SOX 404 firms. The results are generally consistent with auditors focusing more on critical risk areas associated with ineffective internal controls and applying principle-oriented top-down, risk-based audit procedures to minimize risk, which requires increased audit efforts and longer audit time to accomplish their work properly.

    Citation:

    Mitra, S., H. Song, and J. S. Yang. 2015. The Effect of Auditing Standard No. 5 on Audit Report Lags. Accounting Horizons 29 (3): 507-527.

    Keywords:
    AS5, audit report lags, PCAOB, SOX 404
    Purpose of the Study:

    This study investigates whether the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 5 (AS5), which was introduced in June 2007, makes the audit process timelier in an extended post-AS5 period from 2007 to 2011 relative to a pre-AS5 period of 20062007. For this, the authors focus on evaluating the AS5 effect on audit report lags (ARL) both for the firms with material internal control weaknesses (ICW) and the firms with a clean SOX 404 opinion (non-ICW). ARL, a proxy for audit effort, has long been an important topic of academic research because ARL is considered critical in influencing timely judgment and decision making by financial statement users.

    First, the authors investigate the impact of the change from AS2 to AS5 on audit report lags over an extended period from 2006 to 2011. Second, they compare the effect of AS5 on report lags separately for the large accelerated filers and accelerated filers given significant differences in the 10-K filing deadlines for these two types of filers. Third, they examine the impact of AS5 on audit report lags for firms with internal control weaknesses (ICW) with separate analyses for firms with company-level control weaknesses and for firms with account-specific control weaknesses.

    Design/Method/ Approach:

    The analyses are conducted for the period from 2006 to 2011, which covers the AS2 period of 20062007 and the AS5 period of 20072011. The sample comprises 2,062 AS2 observations (divided between 1,877 non-ICW and 185 ICW observations) and 9,200 AS5 observations (divided between 8,870 non-ICW and 330 ICW observations). The authors use Compustat Annual and Business Segment files to gather information.

    Findings:
    • Audit report lags in the AS5 years were significantly lower than those in the AS2 years; the report lags decline, on an average, by 1.85 days.
    • ICW firms, in general, have larger report lags than the clean SOX 404 firms, but AS5 does not have an incremental effect on the report lags for the ICW firms, indicating the report lags decline only for the firms with a clean SOX 404 opinion.
    • Separate analyses for the ICW firms with company-level and account-specific material weaknesses show that audit report lags for those firms do not significantly change between the AS2 and AS5 periods and continue to be higher compared with those for the clean SOX 404 firms.
    • Additional tests using a constant sample of firms demonstrate a learning curve effect of AS5 in reducing report lags in the post-AS5 period both for the full sample and for the firms with a clean SOX 404 opinion.
    • The report lags significantly decline in both the early and late AS5 periods for both the large accelerated filers and accelerated filers and for the full constant sample.
    • Overall, the results show that the new top-down, risk-based approach under AS5 makes the audit process more efficient and timelier by decreasing audit report lags.
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Audit Standards, Consequences of Adverse 404 Opinions, Impact of 404, Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Impact of Internal Audit Function Quality and...
    research summary posted July 24, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 11.0 Audit Quality and Quality Control 
    Title:
    The Impact of Internal Audit Function Quality and Contribution on Audit Delay.
    Practical Implications:

    This research should be of interest to regulators who are concerned with the timeliness of financial reports, practitioners who are responsible for preparing and auditing financial statements, and standard setters who provide auditing guidance. In particular, the findings indicate that firms’ decisions regarding the structure of the IAF and their role in the financial statement audit can significantly affect audit completion times. Reducing audit delay from current levels back to pre- SOX 404 levels could potentially reverse the decline in the reliability of earnings announcements. The results are useful to external auditors in determining whether and how IAF work can be incorporated into the financial statement audit. This study also provides support for recent PCAOB guidance contending that external auditors can improve audit efficiency by making more extensive use of work performed by others.

    Citation:

     Pizzini, M., Lin, S., & Ziegenfuss, D. E. 2015. The Impact of Internal Audit Function Quality and Contribution on Audit Delay. Auditing: A Journal Of Practice & Theory 34 (1): 25-58.

    Keywords:
    audit delay, audit report timeliness, internal audit contribution, internal audit quality
    Purpose of the Study:

    This study investigates the internal audit function’s (IAF’s) role in the financial statement audit by examining whether measures of IAF quality and the IAF’s contribution to the financial statement audit affect audit delay. Audit delay, measured as the number of days between a firm’s fiscal year-end and the audit report date, generally captures the time required to complete fieldwork. Current interest in audit delay stems from recent accelerations in reporting deadlines and the implementation of Section 404 of the Sarbanes-Oxley Act (SOX), which together require preparers and external auditors to do more work in less time. Given the increased attestation requirements created by SOX, it is important to investigate ways in which the IAF can influence audit delay. In this study, the authors argue that the IAF can significantly affect audit completion times by helping management establish and maintain a strong system of internal control over financial reporting (ICFR) and by assisting the external auditor in the financial statement audit. The authors investigate whether IAF quality and the IAF’s contribution to financial statement audits affect audit delay in a sample of 292 firm-year observations drawn from the pre-SOX 404 period. 

    Design/Method/ Approach:

    The authors use firm-level data collected by the IIA through their 2003 and 2004 GAIN surveys. They then collect firm financial data from Compustat and audit fee and restatement data from Audit Analytics. The resulting sample contains 293 firm-year observations from 216 firms with fiscal years ending on or after December 31, 2000 and prior to November 15, 2004.

    Findings:
    • A one standard deviation increase in the comprehensive quality measure corresponds to audit delay reductions of 3.1 to 3.9 days, which are primarily driven by the competence of the internal audit staff and the quality of their fieldwork.
    • Objectivity and investment in the IAF are also associated with reductions in audit delay, but significance levels vary with time period and model specification.
    • Audit delay is significantly shorter (4.1 to 6.6 days) when the IAF contributes to the financial statement audit by independently performing relevant work, but not when the IAF works under the direction of the external auditor.
    • The mean delay is 41.9 days, and earnings are announced an average of 9.8 days prior to the audit report date.
    • High-quality IAFs are more likely to assist the external auditor by independently performing relevant work, while low-quality IAFs are more likely to be used as direct assistants.
    • The authors expect the impact of IAF quality and contribution would be even larger in the current period. The more rigorous attestation requirements of SOX 404 expanded the IAF’s potential to contribute to the financial reporting process and, therefore, should increase the impact of IAF quality and contribution on audit delay.
       
    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent, Standard Setting
    Sub-category:
    Impact of 404, Reliance on Internal Auditors
  • Jennifer M Mueller-Phillips
    The Influence of Auditor and Client Section 404 Processes on...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.04 Assessing Remediation of Weaknesses 
    Title:
    The Influence of Auditor and Client Section 404 Processes on Remediation of Internal Control Deficiencies at All Levels of Severity
    Practical Implications:

    Overall, this study suggests that remediation of detected ICFR problems prior to the balance sheet date is one benefit of Section 404 activity to stakeholders. This study’s finding of lower remediation of auditor-discovered ICDs implies that client personnel missed the control flaw in their own Section 404(a) process, so may lack the expertise to remediate the problem. This calls into question the current policy of relying on Section 404(a) alone for non-accelerated filer (most public companies). Further, this study’s results on client processes imply that the most important factors affecting remediation are not who directly manages the process, but rather the client’s organization of the process in making an early start and coordinating the effort with IT personnel.

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

    Citation:

    Graham, L., and J.C. Bedard. 2013. The Influence of Auditor and Client Section 404 Processes on Remediation of Internal Control Deficiencies at All Levels of Severity. Auditing: A Journal of Practice & Theory 32(4): 45-69

    Keywords:
    Remediation; Sarbanes-Oxley Section 404; internal control deficiencies.
    Purpose of the Study:

    This paper investigates remediation of a comprehensive census of deficiencies in internal control over financial reporting (ICFR) detected in a sample of companies under Section 404 of the Sarbanes-Oxley Act. Internal control weaknesses have often been implicated in fraud and business failure. Section 404 was designed to improve corporate controls by requiring company management and external auditors to document, test and report ICFR. Research on the costs and benefits of Section 404 remains important, due to continued pressure to reduce financial regulation. Several prior studies examine remediation of publicly disclosed material weaknesses (MWs). However, auditors and company personnel detect many internal control deficiencies (ICDs), of which relatively few are MWs. Because publicly available data do not reveal non-MW ICDs, research has not yet considered the nature and extent of remediation activity that takes place behind the scenes. We study remediation of all ICDs, whether publicly reported or not, among companies with effective, as well as ineffective controls. We further address the issue of the benefits of Section 404(b) by measuring the impact of auditor activity in the remediation process. In addition, we directly examine the impact of whether, at the time of the auditor’s assessment, the flawed control had already failed to prevent a misstatement in the accounts.

    Design/Method/ Approach:

    This study is based on a sample of almost 4,000 ICDs detected by audit firm or client personnel in 76 engagements on 44 different companies in 2004–2005 (the first two years of compliance with SOX 404(b)), obtained from engagement teams at several large auditing firms. Sample companies have a mix of effective and ineffective control reports that is similar to the population as whole during that period. 

    Findings:
    • Prior research using publicly available finds substantial remediation of MWs from one reporting year to the next. In contrast, the authors of this paper find relatively low remediation within the year, between time of identification and the balance sheet date. Thus, a number of control flaws of varying severity remain to affect financial reporting quality in the following year.
    • The authors find higher remediation rates when there is an earlier start to control testing and better integration of the client’s IT personnel into the Section 404 process.
    • The authors also find lower remediation rates among auditor-discovered ICDs, detection through substantive tests (often performed late in the year or after year-end), and by the presence of a previously unknown misstatement that has already resulted from a control failure. The combination of auditor detection and an associated misstatement is particularly problematic, as this implies that not only did the client miss the problem in its own testing, but also the auditor has already linked it to an account misstatement, elevating its importance. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Assessing Remediation of Weaknesses, Impact of 404
  • Jennifer M Mueller-Phillips
    The Interactive Effects of Internal Control Audits and...
    research summary posted July 28, 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:
    The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices.
    Practical Implications:

    The results demonstrate a demand for IC audits such that, even in the presence of increased manager liability, the IC audit incrementally motivates managers to spend on improving IC and to provide more consistent and accurate ICFR disclosures. Unlike managers, investors react as though manager liability and IC audits are substitutes. This finding has implications for policymakers as it demonstrates the need to consider the possible differing effects of regulation on managers and investors. Moreover, with respect to regulatory actions to simultaneously implement both manager liability and an IC audit, the results suggest that both mechanisms may not be necessary to improve investors’ confidence and in turn market prices.

    Citation:

    Wu, Y., & Tuttle, B. 2014. The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices. Contemporary Accounting Research 31 (2): 444-468.

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

    This study investigates the effects of the audit of internal controls (IC audit) and manager liability for the company’s internal controls on investor confidence and market prices. This research is motivated by the substantial debate regarding the incremental effectiveness of IC audits and manager liability on investor confidence in financial disclosures. This debate came to the forefront with the Sarbanes-Oxley Act of 2002 (SOX) when the U.S. Congress simultaneously implemented both regulatory mechanisms. Section 302 requires that CEOs and CFOs personally attest, under penalty of perjury, that effective internal controls over financial reporting (ICFR) have been established, maintained, and evaluated on a timely basis. Section 404 requires that the auditors of publicly-traded companies provide assurance on the effectiveness of ICFR. However, direct empirical evidence remains limited regarding the individual versus joint effectiveness of these two regulatory mechanisms in (1) motivating managers to spend on improving ICFR and to provide more accurate ICFR disclosures and (2) improving investor confidence and market prices.

    Design/Method/ Approach:

    Seventy-six MBA students from a major public university participated in this study. The 76 participants resulted in a total of 19 sessions with four participants assigned to each. The experiment is programmed and conducted using ZTree software. Each session takes approximately 90 minutes and includes three practice rounds followed by 21 experimental rounds. The number of rounds is not known by participants. The evidence was collected prior to the summer of 2014.

    Findings:
    • Results suggest that the effects of manager liability and an IC audit are additive with respect to IC spending, with the IC audit having a stronger effect than manager liability.
    • Even after controlling for managers’ IC spending, results also demonstrate that IC audits improve the accuracy of managers’ ICFR disclosures.
    • Similar improvement is not associated with increased manager liability. In the presence of the IC audit, managers’ IC spending strategies are more constant over time and enable managers to provide accurate information more consistently regarding the effectiveness of ICFR.
    • Managers will spend more to improve ICFR when either liability or IC audits are present and that even in the presence of manager liability the IC audit incrementally increases managers IC spending.
    • The results demonstrate that investor confidence and stock price are no greater when both regulatory mechanisms are present than when only one is present.
    • Supplemental analyses suggest that manager reputation for accurate ICFR disclosures explains, at least in part, why investors perceive manager liability and IC audit to be substitutes.
    • The results suggest that when managers accrue a reputation for accurate ICFR disclosures, both regulatory mechanisms may not be necessary to improve investor confidence in managers’ earnings reports.
    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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