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  • Jennifer M Mueller-Phillips
    A Risk Model to Opine on Internal Control.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses 
    Title:
    A Risk Model to Opine on Internal Control.
    Practical Implications:

    The auditor needs a different model for audits of internal control. The auditor needs to apply two different models in an integrated audit, the original model for the opinion on the financial statements and a different model for the opinion on internal controls.

    The author believes standard setters should sponsor research on an appropriate risk model for audits of internal control. Even before the research is completed, the standards could be enhanced in the following ways:
    • indicate that the original audit risk model is intended for use only in financial statement audits, not internal control audits;
    • write standards that consistently use risk terminology and are clear as to which risk they are discussing; and
    • provide guidance on the use of models in integrated audits.

    Citation:

    Akresh, A. D. 2010. A Risk Model to Opine on Internal Control. Accounting Horizons 24 (1): 65-78.

    Keywords:
    audit risk model, inherent risk, integrated audit, internal control, opinion, risk of material misstatement, risk of material weakness
    Purpose of the Study:

    The audit risk model has provided a conceptual framework for audits of financial statements for more than 40 years. Despite practical difficulties in implementation and criticisms of its theoretical foundation, the model has been fairly effective in helping auditors analyze risks and use that analysis to determine the nature, timing, and extent of audit procedures in audits of financial statements. In recent years, some auditors have tried to apply the audit risk model to audits of internal control, usually performed as parts of integrated audits. An integrated audit is an engagement where the auditor provides an opinion on the financial statements and an opinion on the effectiveness of internal control over financial reporting. It is integrated in the sense that the auditor tries to use some of the same procedures to meet both objectives.

    While the audit risk model was designed for audits of financial statements, it was not designed for audits of internal control. Audits of internal control are audits of processes rather than audits of outputs (financial statements). In addition, opinions on internal control do not rely on analytical procedures or on substantive tests of details. Because of this conceptual difference, the author asserts that audit risk model, as originally formulated, does not work as a coherent conceptual framework for audits of internal control. The need for a different risk model for internal control audits is not currently recognized in the auditing standards or in the auditing literature.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    For an integrated audit, the auditor would use the two models sequentially. The auditor would use the internal control risk model as a framework to determine the extent of control tests. Then the auditor would use the financial statement audit risk model as a framework to determine the extent of substantive testing.

    Future research could determine a more specific model based on how auditors perform these audits. Some research questions include, for example:

    • What models and approaches are currently used in practice? How does current practice compare with the model proposed and other models?
    • Are models useful in providing a conceptual framework for integrated audits?
    • What are the current practices for the auditor’s evaluation of inherent risk? How do those practices compare with risk models?  
    • How do auditors assess design and implementation of internal controls in light of inherent risk without considering operating effectiveness?
    • What are the current practices for the auditor’s evaluation of design, implementation, and operating effectiveness of the control environment? Are those practices adequate to effectively use in a risk model?
    Category:
    Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Material Weaknesses, Assessing Risk of Material Misstatement, Fraud Risk Models, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    An Analysis of Multiple Consecutive Years of Material...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses 
    Title:
    An Analysis of Multiple Consecutive Years of Material Weaknesses in Internal Control.
    Practical Implications:

    The findings offer three important contributions to the existing literature. First, they indicate that MW reported in multiple consecutive years have a progressively larger and statistically significant negative impact on CE when firms that partially remediate are excluded from the sample. That is, the market notices that some firms are slow to remediate MW, whereas other firms take timely remediation steps to address MW. Second, the study shows that the number and specific types of MW are significant factors in understanding the relation between MW and CE. In fact, even if a firm does not remediate all MW in a given year, the market views favorably a reduction in the number of MW (i.e., partial remediation). Third, given the richness of the dataset, the current study helps to reconcile conflicting results in the prior literature on the effects of MW.

    Citation:

    Gordon, L. A., and A. L. Wilford. 2012. An Analysis of Multiple Consecutive Years of Material Weaknesses in Internal Control. Accounting Review 87 (6): 2027-2060.

    Keywords:
    cost of equity, internal control, material weaknesses, monitoring, remediation
    Purpose of the Study:

    The corporate scandals in the United States around the turn of the 21st century (e.g., Enron, WorldCom, Tyco, etc.) culminated in the passage of the Sarbanes-Oxley Act of 2002 (SOX). This Act requires firms to report material weaknesses in internal control (hereafter, MW) related to the reliability of financial reporting to the Securities and Exchange Commission (SEC). The SOX reporting requirements have given rise to a plethora of research, much of which has focused on the impact of MW on a firm’s cost of equity (hereafter, CE).

    The primary objective of the current study is to reexamine the relation between MW and CE. The authors direct particular emphasis to examining the way non-remediation of MW in multiple consecutive years affects CE, as well as the impact of remediation of MW on CE. They utilize a dataset that contains a large sample of second-year MW non-remediation cases, as well as third-, fourth-, and fifth-year non-remediation cases. Thus, this study differentiates between firms that report MW in only one year and firms that report MW in two or more consecutive years. The current study also considers the number of MW in each year, as well as the specific types of MW. 

    Design/Method/ Approach:

    The authors draw their sample from the Audit Analytics database, which includes all SOX Section 404 auditor assessment reports (24,806) filed with the SEC during the time period of November 2004 (the effective date for accelerated filers reporting under Section 404) through December 2009. The final sample is composed of 16,946 observations, which includes 1,140 observations with MW and 15,806 observations without MW (the control sample).

    Findings:

    The findings provide evidence that MW negatively impact a firm’s CE. The authors also find evidence of the value associated with remediation of MW. Specifically, the current study shows that the market penalty imposed upon a firm’s CE, in the absence of any remediation of MW, increases in relation to the number of consecutive years in which the firm reports MW. However, the results from the current study also show that the market views favorably a reduction in the number of MW reported (i.e., partial remediation). In other words, remediation is not an all-or-nothing proposition. Due to the use of a much larger and richer dataset, the current study helps to reconcile the mixed findings in earlier studies that examine the association between MW and CE.

    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses
  • 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
    Audit Fees after Remediation of Internal Control Weaknesses
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of 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:
    Audit Fees after Remediation of Internal Control Weaknesses
    Practical Implications:

    The results of this study are important for companies and regulators that are trying to understand the true costs for firms with an adverse report on internal control. It further informs the continuing debate regarding Section 404 of SOX and provides some evidence that these premiums can be as high as 30 (20) percent in the first(second) year after remediation when compared to firms that only have clean Section 404 reports. Lastly, this provides opportunities for future research investigating how long it takes audit fees to return the level of companies that only receive clean opinions and whether or not this premium relates to additional audit work or a risk premium.

    Citation:

    Munsif, V., K. Raghunandan, D. V. Rama, and M. Singhvi. 2011. Audit Fees after Remediation of Internal Control Weaknesses.  Accounting Horizons 25 (1):  87-105. 

    Keywords:
    internal controls; audit fees; material weakness; remediation
    Purpose of the Study:

    Firms that receive an adverse report on internal control under Section 404 of SOX typically experience significant costs, such as a higher cost of capital. Additionally, these companies reporting material weaknesses also tend pay higher audit fees which is consistent with the belief that ineffective internal controls leads to a higher propensity for misstatements. Conversely, it is logical to expect that these higher fees will return to normalized levels if the weakness is remediated; however, recent evidence in regards to control problems disclosed pursuant to Section 302 of SOX has been contrary to this belief. This study attempts to provide clarification to these findings and investigates whether audit fees return to previous levels after the remediation of material weaknesses disclosed under Section 404 of SOX. It is important to recognize that in contrast to prior research which examines fees in the year of (or year prior to) remediation, this study examines the audit fees in the years following the remediation  in order to determine if the higher fees that the company pays in year of disclosure remain at a premium even two or three years after remediation.

    Design/Method/ Approach:

    The authors use data on SEC registrants and collect information on audit fees and Section 404 disclosures for the first four years of internal control reporting (2004-2007). The authors exclude financial sector companies, as well as, foreign firms and compare audit fees over the four year period of analysis for SEC registrants with fiscal year-ends from November 15 through May 31 of the following calendar year. The authors examine audit fees in years subsequent to the remediation of internal control weaknesses in order to determine whether auditors continue to view firms that had ever received an adverse Section 404 opinion as being “tainted,” such that even after remediating the problem, firms continue to pay an audit fee premium.

    Findings:

    The authors find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years of internal control reporting. The authors also show that general weaknesses have a higher effect on audit fees than only account-specific internal control weaknesses.

    Category:
    Internal Control, Accountants' Reporting
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Consequences of Adverse 404 Opinions
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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
    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
    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
    Changes in Corporate Governance Associated with the...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation
    Practical Implications:

    The results of this study support the audit committee regulations under SOX and the board independence regulations of the listing exchanges. These results are important to regulators as they show that improvements in audit committee influence, competence, and incentives are each positively associated with ICMW remediation. In addition, the results reveal that improvements in these audit committee characteristics are most strongly associated with the remediation of ICMWs relating to control activities and monitoring, but not to ICMWs across the other COSO categories. Lastly, the results are important to management as they highlight the importance of hands-on day-to-day leadership by management in addressing situations involving the revelation and remediation of material negative events.

    For more information on this study, please contact Karla Johnstone.
     

    Citation:

    Johnstone, K., C. Li, and K. H. Rupley. 2011. Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation.  Contemporary Accounting Research 28 (1):  331-383. 

    Keywords:
    internal controls; material weaknesses; corporate governance; materiality; remediation.
    Purpose of the Study:

    Section 404 of the SOX requires public firms and their external auditors to report on the effectiveness of firms’ internal controls over financial reporting (ICOFR) or to reveal the presence of internal control material weaknesses (ICMWs). Other sections in SOX and listing requirements of the NYSE and NASDAQ also contain regulations intended to improve the conduct and oversight of boards of directors, audit committees, and top management. The purpose of this paper is to propose and test a conceptual model of the process that firms use to remediate negative events in general, and ICMWs specifically, with a focus on the role of governance structure changes (including turnover of and improvements in the characteristics of boards of directors, audit committees, and top management). Specifically, the authors examine what actions companies take in changing corporate governance in an attempt to regain equilibrium upon occurrence of a negative event and how do these changes impact the likelihood that a material weakness is remediated.

    Design/Method/ Approach:

    The authors utilize a conceptual model which includes two primary phases, the first of which concerns the association between the disclosure of ICMWs and turnover of boards of directors, audit committees, and top management. The second phase of the model concerns the association between the remediation of ICMWs and both outright turnover of and changes in the particular characteristics of boards of directors, audit committees, and top management. The first phase utilizes an ICMW sample of firms with December fiscal year ends from 2004 through 2007 that report ICMWs in their SOX Section 404 reports and a control sample which received unqualified SOX 404 Reports and examines the association between ICMW disclosure and governance changes. The second model utilizes a similar sample, but only includes firms which disclose ICMWs in 2004-2006 as it is required that firms need a year to remediate.  This second model estimates the association between ICMW and governance structure changes.

    Findings:
    • The authors find that that the disclosure of ICMWs is positively associated with subsequent turnover of members of boards of directors, audit committees, and top management, including both CEOs and CFOs. As such, the authors infer that the incentives to make significant structural changes in governance following the revelation of an ICMW appear to outweigh the disincentives, and firms revealing an ICMW act in a similar manner to firms revealing other material negative events such as fraud or restatements.
    • Furthermore, the authors show that remediation is positively associated with turnover of audit committee members, but not turnover of board members, CEOs, or CFOs.
    • Additionally, the results reveal that ICMW remediation is positively associated with an increase in the proportion of independent directors on the board, an increase in the percentage of independent directors who also serve on other boards, changes involving having an audit committee member chairing the board, improvements in audit committee member financial expertise, an increase in the percentage of shareholdings of audit committee members, changes toward CFOs with greater accounting expertise, greater CFO-specific work experience, and improvements in CEO reputation.
    • Lastly, the results reveal that ICMW remediation is negatively associated with a greater number of ICMWs and the presence of general ICMWs (those having pervasive effects on financial reporting) rather than specific ICMWs.
       
    Category:
    Governance, Internal Control
    Sub-category:
    Assessing Remediation of Weaknesses, Board/Audit Committee Composition, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Early Warnings of Internal Control Problems: Additional...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses 
    Title:
    Early Warnings of Internal Control Problems: Additional Evidence
    Practical Implications:

    The high proportion of disclosures of internal control problems in annual Section 404 filings without a prior disclosure in quarterly Section 302 filings suggests that in many cases it is the auditors who detect and/or classify a problem as material enough to warrant public disclosure. The empirical evidence is useful for the debate about the role of auditors in internal control testing and reporting.

     

     

    For more information on this study, please contact K. Raghunandan (raghu@fiu.edu).

    Citation:

    Munsif, V., K. Raghunandan and D. V. Rama. 2013. Early warnings of internal control problems: Additional evidence. Auditing: A Journal of Practice and Theory 32(2): 171-188.

    Keywords:
    Internal control; Reporting material weaknesses; SOX; 404; 302.
    Purpose of the Study:

    Sections 404 and 302 of SOX deal with annual and quarterly reporting on internal controls, respectively. There are some other differences between the requirements arising from the two sections. However, the SEC notes that “disclosure controls and procedures” (the topic of Section 302) are closely related to “internal control over financial reporting” (the topic of Section 404). Many users view the Section 302 rules as requiring prior disclosure about material weaknesses in internal controls in quarterly Section 302 filings before such problems are disclosed in annual Section 404 filings.  However, many companies do not provide such early warning in their Section 302 filings. This study addresses the following questions: How frequent are such early warnings? What are the factors associated with such early warning disclosures?

    Design/Method/ Approach:

    The data are from the fourth and fifth year of Section 404 reporting (i.e., fiscal years ending between November 15, 2007 to November 14, 2009).  Excluded are: firms in the financial sector (SIC codes 60-67) and foreign firms.  The sample includes 6,040 observations—2,927 accelerated and 3,113 non-accelerated filers—for 2007. The sample for fiscal year 2008 includes 2,796 accelerated filers and 3,195 non-accelerated filers.

    Findings:
    • The proportion of accelerated filers (with adverse Section 404 reports) that have early warnings (in Section 302 certifications in previous quarters of the same fiscal year) is less than 50 percent even in the fourth and fifth years of Section 404 reporting. 
    • Non-accelerated filers were more likely to have early warnings than accelerated filers in 2008; however, the difference is not significant in 2007.
    • Early warning is more likely for firms with (a) a higher number of material weaknesses in internal control, (b) a new CFO, (c) more audit committee members, and (d) more frequent audit committee meetings.  
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses
  • 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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