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  • Jennifer M Mueller-Phillips
    An Experimental Examination of Factors That Influence...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses, 09.0 Auditor Judgment 
    Title:
    An Experimental Examination of Factors That Influence Auditor Assessments of a Deficiency in Internal Control over Financial Reporting.
    Practical Implications:

    The results should be of interest to auditing standard setters who provide guidance on the evaluation of control deficiencies as part of an integrated audit. Further, regulators inspecting public company audits may want to further review settings where control deficiencies were not evaluated as material weaknesses and assess whether the presence/absence of a financial statement misstatement was appropriately considered. The findings provide a more complete understanding of how the factors that auditors encounter during the audit engagement influence their judgment about whether identified deficiencies in ICFR are such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis (i.e., material weakness).

    Citation:

    Gramling, A. A., E. F. O'Donnell, and S. D. Vandervelde. 2013. An Experimental Examination of Factors That Influence Auditor Assessments of a Deficiency in Internal Control over Financial Reporting. Accounting Horizons 27 (2): 249-269.

    Keywords:
    audit judgments, control deficiency, internal control over financial reporting, material weakness, operating effectiveness
    Purpose of the Study:

    Beginning in 2004, public company auditors who opine on client financial statements also express an opinion about whether the client’s internal control over financial reporting (ICFR) is effective at year-end. In forming the ICFR opinion, auditors evaluate the severity of each identified control deficiency to determine whether the deficiency is a material weakness. When auditors conclude there is a reasonable possibility that ICFR will fail to prevent or detect a material financial misstatement (i.e., a material weakness exists), they issue an adverse opinion on the effectiveness of ICFR. This study examines how different types of audit evidence accumulated during the audit influence auditor judgment of ICFR operating effectiveness and about whether an identified control deficiency is a material weakness in ICFR.

    The study is motivated by a recognition that many stakeholders, including financial statement users, company management, audit committee members, regulators, researchers, and other auditors, would benefit from an enhanced understanding of the factors an auditor considers when evaluating the effectiveness of ICFR and concluding whether identified control deficiencies represent material weaknesses.

    Design/Method/ Approach:

    The authors analyze responses from the submitted case materials of 138 participants, which include 44 partners, 47 senior managers, and 47 managers. On average, the participants had worked on 4.0 integrated audit engagements and had issued 1.1 adverse opinions on ICFR. For the integrated audit engagements on which the participants had worked, they reported an average of 4.1 potential material weaknesses that were ultimately deemed to be significant deficiencies. The evidence was gathered prior to June 2013.

    Findings:

    Based on experimental results from audit managers and partners, the authors provide evidence regarding whether the following factors are significant determinants of assessed operating effectiveness of an identified control deficiency: (1) whether the client has a material weakness unrelated to the deficiency being assessed (i.e., unrelated material weakness), and (2) whether there is a known misstatement associated with the identified control deficiency (i.e., failure of the specific control to prevent a misstatement). Further, they examine whether these two factors influence the likelihood of assessing a control deficiency as a material weakness. The authors find that the presence of either an unrelated material weakness or a known misstatement influences the assessed operating effectiveness of an internal control, in addition to the likelihood of a material weakness assessment. The presence of either an unrelated material weakness or a known misstatement warrants a decreased operating effectiveness assessment and an increased likelihood of a material weakness assessment. The combination of the two factors together does not further influence those assessments.

    Category:
    Auditor Judgment, Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Internal Control Quality: The Role of Auditor-Provided Tax...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Internal Control Quality: The Role of Auditor-Provided Tax Services.
    Practical Implications:

    The results of this study are important to audit regulators as they make decisions regarding policies, and to corporate governance officials as they make decisions regarding the audit firms they engage to provide tax nonaudit services. The evidence indicates that tax nonaudit services accelerate audit firm awareness of material transactions as these services are associated with a lower likelihood of a material weakness in internal controls. In addition, further evidence supports that this finding is not simply due to impaired auditor independence. Overall, this suggests that tax nonaudit services provided by the audit firm improve internal control quality. As regulators and companies evaluate the consequences of tax nonaudit services, the findings in this paper may impact their conclusions.

    Citation:

    De Simone, L., M.S. Ege, and B. Stomberg. 2015. Internal Control Quality: The Role of Auditor-Provided Tax Services. The Accounting Review. 90(4): 1469-1496.

    Keywords:
    auditor fees, nonaudit services, auditor independence, internal controls, tax, financial reporting quality
    Purpose of the Study:

    Audit regulators and companies’ corporate governance officials are charged with understanding and creating policies for auditor provided nonaudit services. To make informed decisions, it is important for these groups to know the benefits and costs of auditor provided nonaudit services. Previous research has reported a positive association between tax nonaudit services and financial reporting quality and audit quality. This paper investigates the relationship between tax nonaudit services and a specific component of financial reporting quality: internal control quality. Specifically, the authors:

    • Examine the relationship between tax nonaudit services and the probability of a material weakness in internal controls (i.e. internal control quality).
    • Examine whether tax nonaudit services are beneficial to companies experiencing a shock to their internal control environment.
    • Examine how the relationship between tax nonaudit services and internal control quality is affected by audit firm tenure.

    The authors also explain the process through which they propose tax nonaudit services affects non-tax financial reporting quality.

    Design/Method/ Approach:

    The authors collected auditor internal control opinions and data necessary to calculate control variables on publicly-traded companies that are subject to SOX Section 404(b). The information collected on these companies was for years 2004-2012.

    Findings:
    • The authors find that companies that purchase tax nonaudit services are significantly less likely to disclose a material weakness. A one standard-deviation increase in tax nonaudit services is associated with approximately a 13% decrease in the rate of material weaknesses relative to the base rate. Further analysis indicates that impaired auditor independence does not account for this result.
    • The authors find that when companies experience a significant shock to their internal control environment, tax nonaudit services incrementally benefit internal control quality relative to other companies.
    • The authors find that the benefits of tax nonaudit services on internal control quality are greater in the early years of audit firm tenure.
    Category:
    Governance, Independence & Ethics, Internal Control
    Sub-category:
    Board/Audit Committee Oversight, Non-audit Services, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Effect of Human Resource Investment in Internal Control...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses 
    Title:
    The Effect of Human Resource Investment in Internal Control on the Disclosure of Internal Control Weaknesses.
    Practical Implications:

    Using unique data on the number of IC personnel, this study provides direct empirical evidence on the link between IC personnel and ICWs, which has been only suggestive in the literature. Also, the findings in this study suggest that the information related to IC personnel could be useful for companies, as well as investors, to evaluate the quality of a firm’s internal controls over financial reporting.

    Citation:

    Choi, J. H., S. Choi, C. E. Hogan, and J. Lee. 2013. The Effect of Human Resource Investment in Internal Control on the Disclosure of Internal Control Weaknesses. Auditing: A Journal of Practice & Theory 32 (4): 169-199.

    Keywords:
    internal control personnel, internal control systems, internal control weakness, Sarbanes-Oxley Act
    Purpose of the Study:

    This study investigates the effect of human resource investment in internal control (IC) over financial reporting on the disclosure of internal control weaknesses (ICWs) at both the firm and the individual department level. The strength of a company’s internal control system depends on having sufficient personnel (hereafter, IC personnel) to carry out internal control functions. Having a sufficient number of personnel who are in charge of the internal control function ensures adequate segregation of duties, timely review, and monitoring of accounting functions, and may increase the depth and variety of accounting expertise, among other benefits. If companies are downsizing and eliminating employees with internal control responsibilities, control strength may be deteriorating at the same time fraud risk is increasing. As a result, internal control strength may deteriorate.

    It is important for companies and those charged with governance to understand the impact of investing in internal control personnel. While the authors expect internal control strength to be increasing in the level of investment in IC personnel, it is not clear whether the investment in IC personnel is positively or negatively related to the likelihood that a firm discloses an ICW. It is important to understand whether a higher level of investment in IC personnel is positively or negatively related to the likelihood of reporting ICWs, and whether changes in the level of IC personnel have any impact on changes in the likelihood of disclosing ICWs.

    Design/Method/ Approach:

    The authors hand-collect data on IC personnel and ICWs of Korean-listed firms for the period from 2005 to 2008. The financial data are collected from the KIS-Value database. The final sample sizes used for H1 and H2 are 5,402 and 176 firm-year observations, respectively. The average size of sample firms (LNTA) is 25.33, which is equivalent to 101 billion Korean Won ($84 million).

    Findings:
    • Investment in IC personnel is associated with the strength of internal control systems.
    • Firms with a greater investment in IC personnel are less likely to report material weaknesses in internal controls.
    • At the department level, the ratio of IC personnel (both the raw ratio and industry- and year-mean-adjusted ratio) working in the finance department out of the total number of employees of the firm is negatively associated with the disclosure of ICWs.
    • Changes in IC personnel are strongly related to the likelihood of disclosing ICWs. For example, if a firm reduces (increases) IC personnel during the year, the firm is more (less) likely to disclose an ICW at the end of the year.
    • Changes in IC personnel are related to the likelihood that firms remediate the ICW.
    • The disclosures of both personnel-related ICWs and non-personnel-related ICWs are weakly related to the ratio of, or the change in the ratio of, IC personnel. These findings are particularly important because they show that the investment in IC personnel can even affect non-personnel-related ICWs.
    • The quality of IC personnel is associated with the likelihood of disclosing ICWs and remediating previously disclosed ICWs, in addition to the quantity of the IC personnel, even though the data on quality are noisy.
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Internal Control Material Weaknesses and CFO Compensation.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.07 Executive Compensation 
    Title:
    Internal Control Material Weaknesses and CFO Compensation.
    Practical Implications:

    The results emphasize the importance of the composition of the compensation committee. Specifically, results suggest that boards should consider appointing financial experts to serve not only on the audit committee but also on the compensation committee, as it would improve the oversight of the CFO. The results reveal that CFOs are held accountable not only for their managerial duties as reflected in firm financial performance, but also for their fiduciary duties associated with accurate financial reporting and high-quality internal controls.

    Citation:

    Hoitash, R., Hoitash, U., & Johnstone, K. M. 2012. Internal Control Material Weaknesses and CFO Compensation. Contemporary Accounting Research 29 (3): 768-803.

    Keywords:
    executive compensation, CFO compensation, material weakness, internal controls
    Purpose of the Study:

    The purpose of this paper is to help fill the void in the literature by examining the association between internal control material weakness (ICMW) disclosures and CFO compensation. Under the Sarbanes-Oxley Act of 2002 chief executive officers (CEOs) and chief financial officers (CFOs) are required to establish, maintain, and evaluate internal control effectiveness and to report on this evaluation in both quarterly and annual financial statements. CFOs play a leading role in the oversight of internal control compliance, and research shows that in the post-SOX period CFOs are being held more accountable for their actions. As a result, CFO compensation outcomes are likely to depend in part on reported internal control quality.

    In recent years there has been a trend toward including nonfinancial performance measures in compensation decisions, particularly given the fact that internal control information has become readily available with the implementation of SOX. Therefore, the tests will detect an association between internal control quality and CFO compensation outcomes only if boards and compensation committees incorporate this new nonfinancial performance measure into their compensation decisions.

    Design/Method/ Approach:

    The authors obtain compensation data from ExecuComp, firm characteristic data from COMPUSTAT, and internal control quality data from Audit Analytics. A final sample of 604 firms from the fiscal year 2005 was developed. The authors conduct ordinary least squares regressions in which they use as the dependent variable the change in various components of CFO compensation: total compensation, bonus, equity, and salary. 

    Findings:
    • The basic finding is that the change in CFO total compensation, bonus compensation, and equity compensation, but not base salary, are each negatively associated with ICMW disclosures.
    • These results are economically significant. ICMW disclosures are associated on average with a 14.9 percent decrease in CFO bonus (as a percentage of salary) compared to the prior year.
    • Although the CEO is also responsible for certifying internal control reports, robustness tests reveal no significant association between ICMW disclosures and changes in any of the CEO compensation measures.
    • Account specific ICMWs (as opposed to general, company-wide ICMWs) drive the effects on CFO compensation, which highlights the importance of CFO-specific job responsibilities in relation to compensation outcomes.
    • Results also reveal that CFOs at firms with stronger corporate governance experience larger bonus compensation decreases upon an ICMW disclosure compared to CFOs at ICMW-disclosing firms with weaker corporate governance.
    • CFOs in firms with greater cost of misreporting experience larger declines in bonus compensation and total compensation compared to CFOs in firms with lower costs of misreporting.
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Executive Compensation, Impact of SOX, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Auditor Reporting under Section 404: The Association between...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions.
    Practical Implications:

    The uncertainties surrounding material weaknesses, the difficulty of auditing around some types of weaknesses, and the fact that the auditor must explain why it issued a clean report on the financial statements when it had issued a MWO, may cause the auditor to become conservative in its GCO decision, which is fairly ambiguous to start with. The study has particular relevance for policy makers and a need for a broader evaluation of the effects of SOX 404.

    Citation:

    Goh, B. W., Krishnan, J., & Li, D. 2013. Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions. Contemporary Accounting Research 30 (3): 970-995.

    Keywords:
    internal control, going concern, material weakness, ligation risk, SOX 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) requires companies’ independent auditors to provide an opinion on their clients’ internal control over financial reporting, in addition to the opinion on their clients’ financial. The purpose of Section 404 was primarily to provide information on the internal controls, thus enhancing investor understanding of the quality of firms’ financial reporting. The PCAOB also issued AS2 and AS5, which require an “integrated audit of internal control and financial statements” because the “objectives of and work involved in performing both an attestation of management’s assessment of internal control and an audit of the financial statements are closely interrelated.

    In this paper, the authors explore the association between the two audit opinions by examining whether the issuance of an adverse internal control material weakness opinion (MWO) influences, other things equal, the issuance of a going concern audit opinion (GCO) for financially stressed companies. Although the two opinions are the result of an integrated audit process, they serve different purposes. The GCO reflects the auditor’s view of the financial condition of its client, indicating whether (in the auditor’s opinion) the client will continue to be a going concern for a period of 12 months beyond the financial year end. The MWO reflects the auditor’s opinion on whether there are material weaknesses in internal control and therefore the likelihood that material misstatements in the financial statements will not be detected or prevented. Despite this difference, the two opinions could be connected.

    Design/Method/ Approach:

    The authors examine the association between the MWO and the GCO, using a sample of 1,110 financially stressed firms that reported internal control and audit opinions under SOX Section 404. They start with all public firms on COMPUSTAT with year-ends from 2004 to 2009, for which the authors could compute the Altman financial distress Z-score.  

    Findings:
    • The results suggest that the MWO issued under SOX Section 404 does increase the likelihood of a GCO, while the existence of material weaknesses in the Section 302 disclosures does not. Thus, auditors seem to respond to the uncertainties surrounding a material weakness by issuing a GCO only when they have to issue a MWO.
    • Fifty-six percent of the material weaknesses are classified as company-level weaknesses.
    • If an auditor is aware that the client is in the process of remediating the weakness, it is less likely to issue a GCO.
    • Firms with MWOs raise less capital in the subsequent financial year than firms without
      MWOs, providing some evidence that the issuance of a MWO does impair the firm’s ability to raise capital.
    • To examine whether it is the material weakness opinion rather than the presence of the material weakness that drives auditor behavior, the authors examine whether Section 302 material weakness disclosures are similarly associated with the GCO, but find no association.
    • Heightened concerns about litigation may be driving auditors to issue the GCO when they also issue a MWO.
    Category:
    Accountants' Reporting, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality, Litigation Risk, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Effect of Enterprise Systems Implementation on the Firm...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control 
    Title:
    The Effect of Enterprise Systems Implementation on the Firm Information Environment.
    Practical Implications:

    Enterprise systems (ES) require a substantial investment and are fraught with technical and business risks. However, the authors find a positive association between enterprise system implementations and subsequent increases in the likelihood of management forecast issuance and the accuracy of the forecasts. Systems provide management with information to make day-to-day operational decisions.

    Citation:

    Dorantes, C., Li, C., Peters, G. F., & Richardson, V. J. 2013. The Effect of Enterprise Systems Implementation on the Firm Information Environment. Contemporary Accounting Research 30 (4): 1427-1461.

    Keywords:
    information technology, knowledge management, earnings forecasting, financial disclosure
    Purpose of the Study:

    The authors examine the relation between the implementation of enterprise systems (ES) and improvements in the firm’s information environment. ES are commercialized information systems that integrate and automate business processes across an entity’s value chain located within and across organizations. ES are purported to improve a firm’s internal information environment by enhancing the transparency of operations across business units with related improvements in managerial decision making. The authors test whether ES implementations improve the manager’s information environment by examining a product of management’s access to internal information, namely the quality of management forecasts. ES represent an increasingly popular technology investment in many worldwide organizations. However, as one of companies’ largest IT investments, ES implementation involves dramatic costs (e.g., time, money, and internal resources) and extraordinary technical and business risks. These conditions raise the importance of documenting the benefits of information technology investments.

    The authors study a distinct management decision-making outcome, namely management earnings forecast. Management forecast represents a key voluntary disclosure mechanism that managers use to mitigate information asymmetry problems and to improve a firm’s reputation for transparent and credible reporting. Management generally bases the forecasts on accounting and nonaccounting information provided by the firm’s internal systems. Thus, the issuance and quality of management forecasts have direct links to the firm’s internal information quality, which provides the authors a distinct measurable outcome of the firm’s information system.

    Design/Method/ Approach:

    The authors collected ES implementation media announcements between 1995 and 2008 from Lexis-Nexis Academic’s Wire Service Reports. Among the 781 ES implementation observations, COMPUSTAT covered 587 firms. The final test sample consists of 353 unique firm ES implementations. Enterprise Resource Planning systems (ERP) and other types of ES, such as Supply Chain Management systems (SCM), and Customer Relationship Management systems (CRM) are included in the sample.

    Findings:
    • After ES implementation, ES firms are more likely to issue management forecasts and issue more accurate forecasts than the matched control sample.
    • ES implementers have 1.24 times the odds of issuing forecasts than the matched-control sample after the ES implementation period.
    • ES implementers also have 36 percent smaller forecasts errors (as deflated by stock price) after the implementation period compared to the matched-control sample.
    • The authors find no difference in forecast issuance and accuracy between the two groups prior to the ES implementation periods.
    • Improvements in management forecasts are due to improvements in the firm's internal information environment rather than to enhancements in management's ability to manage earnings.
    • ES improves the internal information environment for management decision making, it is not clear how the presence of ES changes the procedural logic of managerial decisions such as those related to production scheduling.
    • The results provide no support for the contention that ES enhance the ability of managers to manage earnings. In fact, for several earnings management proxies, the tests are consistent with a decrease in earnings management after the ES implementation.
    Category:
    Internal Control
  • 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
    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
  • Jennifer M Mueller-Phillips
    How Do Auditors Address Control Deficiencies that Bias...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.01 Scope of Testing, 07.02 Assessing Material Weaknesses, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    How Do Auditors Address Control Deficiencies that Bias Accounting Estimates?
    Practical Implications:

    For practice, the authors provide evidence about the relation between control deficiencies and substantive tests in the integrated audit. A significant minority of senior auditors attempt to identify bias in an accounting estimate with increased sampling from the biased estimation process, though they have been told that the estimation process is biased. The authors provide theory consistent empirical evidence that auditors often reach questionable, optimistic judgments about the capability of audit evidence to address control deficiencies. Auditors will often revert to what they know best, and it is difficult to get people to look beyond the familiar, regardless of experience level.

    Citation:

    Mauldin, E. G., & Wolfe, C. J. 2014. How Do Auditors Address Control Deficiencies that Bias Accounting Estimates? Contemporary Accounting Research 31 (3): 658-680.

    Keywords:
    accounting estimates, scarcity, control deficiencies, internal control
    Purpose of the Study:

    According to professional standards, auditors must integrate the internal control and financial statement audits. Revised risk assessment standards were issued, in part, to improve the integration of controls into the financial statement audit. However, PCAOB inspections find that auditors sometimes do not appropriately change the nature, timing, and/or extent of their substantive tests in response to clients’ internal controls. Auditors often have difficulty modifying substantive tests when responding to identified control deficiencies.

    To shed light on the underlying reasons for this difficulty, the authors of this design a contextually rich experimental case and examine how auditors map a control deficiency into modifications of substantive tests. The authors examine control deficiencies that cause errors of omission in an estimation process, resulting in an incomplete and biased estimation process. The focus is on whether auditors recognize the insufficiency of reviewing the biased estimation process and how they select alternative tests to replace or supplement such review.

    Design/Method/ Approach:

    Eighty-seven auditors attending one Big 4 firm’s national training for experienced audit seniors participated in the study. The authors employ a between-participants experimental design with two treatments. The authors describe the treatments in sequence within the experimental task. They then randomly assign participants to experimental treatments and ask them to complete a case study. The evidence was collected prior to September of 2014.

    Findings:
    • A significant minority of senior auditors (33 percent) attempt to identify bias in an accounting estimate with increased sampling from the biased estimation process. Further, they do this after being told that the estimation process is biased.
    • Seeing the falsely favorable substantive test results, on average, does not influence auditors’ tendency to increase sample size.
    • A supplemental sample of 14 managers produces a pattern of responses similar to the main results.
    • When the bias is from externally prepared documents, the authors find that about one-half the auditors (54 percent) choose the more efficient alternative test, adjusting the estimate using documents.
    • When the bias is from management judgment inputs, the authors find that most auditors (63 percent) choose to adjust the estimate using documents, even though this alternative is less effective than developing an auditor-generated estimate.
    • The observed results are not driven by lack of experience with percentage-of-completion accounting.
    • Together, the results suggest that auditors often make inefficient or ineffective alternative test choices depending on the source of omission caused by the control deficiency.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Internal Control
    Sub-category:
    Assessing Material Weaknesses, Scope of Testing, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Equity Incentives and Internal Control Weaknesses.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.07 Executive Compensation, 14.10 CEO Compensation 
    Title:
    Equity Incentives and Internal Control Weaknesses.
    Practical Implications:

    The analysis shows that (1) equity incentives are more effective in reducing company-level control problems; (2) restricted equity provides greater incentives than unrestricted equity; and (3) CFO incentives have a more significant impact on the quality of internal control than CEO incentives. These insights have important implications for compensation committees who make compensation recommendations and the full board of directors who ratifies those recommendations. They suggest that both the level and type of equity incentives should be considered in compensation design to motivate managers to invest in strong internal controls.

    Citation:

    Balsam, S., Jiang, W., Lu, B. 2014. Equity Incentives and Internal Control Weaknesses. Contemporary Accounting Research 31 (1):178-201. 

    Keywords:
    Internal auditing, equity incentives, stock options, internal controls, material weakness (auditing), CEO compensation, CFO compensation, executive compensation
    Purpose of the Study:

    The authors address the empirical question of whether incentives associated with equity ownership induce managers to maintain strong internal controls. If managers believe adverse internal control opinions negatively affect the value of their equity holdings, equity incentives may provide the motivation for them to strengthen internal controls. The negative wealth consequences associated with the disclosure of internal control weaknesses suggest that equity-based incentives should motivate managers to develop and maintain effective internal controls over financial reporting, though some prior work has shown that equity incentives can lead to opportunistic actions by management. To the extent that lax internal controls provide the opportunity for earnings management, the link between accounting earning and share prices, along with the motivation provided by equity incentive to increase share prices, may provide an incentive for managers to want weaker internal controls. The study adds to the literature on equity incentives by focusing on specific aspect of managerial performance- the effectiveness of internal controls and the literature examining the determinants of internal control deficiencies. The results of the study provide insight into the role equity incentives play in improving the quality of internal control.

    Design/Method/ Approach:

    The study was conducted using a sample comprised of firms filing SOX Section 404 reports during 2004 and 2005. The authors obtained the data on internal control opinions from Audit Analytics, the financial data from COMPUSTAT, and the compensation and governance variables from Equilar Inc, yielding a sample of 569 firms. The control sample contained 3,798 observations. They used firm size, loss proportion and firm age to capture the level of investment in the internal control systems.

    Findings:
    • Equity incentives motivate managers to implement effective controls.
    • Evidence suggests that firms where the CEO and CFO have higher levels of equity incentives are less likely to have internal control problems.
    • The equity incentives of the CFO play a more significant role in determining internal control quality than those of the CEO.
    • The bonus is significantly lower, and salary significantly higher, as a percentage of total compensation, for firms with material internal control weaknesses.
    • Firms with material internal control weaknesses are smaller, younger, more likely to have had a loss, have more segments and are more likely to have experienced a restructuring, than firms without weaknesses.
    • Material weakness firms had fewer independent directors, smaller audit committees and boards, are less likely to engage a Big 4 auditor, had shorter auditor tenures, and were more likely to have experienced a recent auditor change.
    • Lax internal controls provide the opportunity for earnings management, which may allow managers to meet targets to maintain a higher share price than otherwise warranted. When the authors partition based upon type of opinion, they find that equity incentives are more effective in mitigating company-level internal control risk.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior, Executive Compensation, Reporting Material Weaknesses

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