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  • 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
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Material Control Weakness Corrections: The Enduring Effects...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses 
    Title:
    Material Control Weakness Corrections: The Enduring Effects of Trust in Management
    Practical Implications:

    Overall, the authors’ findings indicate that variations in the detail of disclosures of material control weaknesses alter trust in management, and these changes in trust have lasting implications for investors’ perceptions of risk associated with the disclosing firm.  

    Citation:

    Rose, A. M., J. M. Rose, and C. S. Norman. 2016. Material Control Weakness Corrections: The Enduring Effects of Trust Management. Behavioral Research in Accounting 28 (2): 41 – 53. 

    Keywords:
    control weakness, disclosure detail, investment risk, remediation, and trust.
    Purpose of the Study:

    Previous research has shown that trust is a key driver in the association between material weakness in internal control disclosures and perceptions of investment risk. If this is the case, the authors expect the effects of material weakness disclosures to persist as long as their effects on trust endure. In other words, when trust in management’s ability and intention to promote quality financial reporting is gained or lost, the changes in trust will influence the interpretation of evidence regarding management’s oversight of financial reporting activities, including correction of material control weaknesses. This paper specifically examines the effects of the remediation of material control weaknesses on investors’ risk assessments.  By studying investor judgment in a controlled laboratory setting, the authors examine how the content of control weakness disclosures can be expected to influence equity market responses to future control weakness corrections. 

    Design/Method/ Approach:

     The authors study investor judgment in a controlled laboratory setting. They also replicate a previous experiment completed by others, with new control weaknesses, to verify the generalizability of their results and extend their study to examine the effects of disclosure detail and control weakness pervasiveness on investor decisions made after remediation of control weaknesses. 

    Findings:
    • The authors find that when material weakness disclosures have specific and detailed discussion of the pervasiveness of the weaknesses, investors increase assessments of investment risk for less pervasive weaknesses and decrease assessments of risk for more pervasive weaknesses.
    • The authors find that providing detailed explanations that a control weakness is isolated increases risk assessments relative to not providing a detailed explanation; conversely, offering a detailed explanation that a weakness is very pervasive decreases assessments of investment risk relative to not offering a detailed explanation.
    • The authors find that the interactive effects of control weakness pervasiveness and explanation detail on risk assessments endure after remediation of control weaknesses, indicating that trust in management continues to influence risk assessments after control weaknesses are corrected. 
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Internal Control Opinion Shopping and Audit Market...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    Internal Control Opinion Shopping and Audit Market Competition.
    Practical Implications:

    The study results are important to regulators, practitioners, and academics. The findings show that internal controls opinion shopping appears to occur among firms that have clean internal control opinions prior to a restatement. In addition, clients have the incentive to manipulate the audit process, via internal control opinion shopping, due to the increased focus and oversight on internal controls reporting. Finally, auditor dismissals that occur late in the fiscal period are more likely to be associated with internal control opinion shopping.   

    Citation:

    Newton, N. J., J. S. Persellin, D. Wang, and M. S. Wilkins. 2016. Internal Control Opinion Shopping and Audit Market Competition. The Accounting Review 91 (2): 603623.

    Keywords:
    opinion shopping, internal control weaknesses, audit opinion, audit quality, audit market competition
    Purpose of the Study:

    This study evaluates three research questions related to opinion shopping using the internal controls environment. There have been historical concerns with the presence of audit opinion shopping. However, most studies use going concern opinions in assessing audit clients retention and dismissal behavior. This study expands the opinion shopping environment to internal control reporting. Going concern opinions typically have a low base rate of occurrence and have leading indicators (poor growth, bankruptcy indicators, etc.). Internal control opinions do not have similar indicators that give rise to a warning of an adverse internal control opinion. From this background, the authors investigate: 1) whether internal control opinion shopping exist; 2) how audit market competition influences internal control opinion shopping; and 3) does the timing of an auditor dismissal indicate opinion shopping motivations.  

    This study also provides an avenue to evaluate opinion shopping in the period after the passage of the Sarbanes-Oxley Act. In addition, it highlights the unintended consequences of increased audit market competition. Finally, it lends support to recent regulatory concern over the decrease in material weakness assessments that may not be the caused by improved internal control environments.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit opinion and audit client data is from Compustat, Audit Analytics, and the Center for Research in Security Prices (CRSP). The sample period starts in 2005, the year after the implementation of SOX Section 404, and ends in 2011.

    Findings:
    • The authors find that audit clients are successful at internal control opinion shopping. The results show that clients would have received adverse internal control opinions at a higher rate if they made different auditor retention or dismissal choices.
    • When assessing the type of audit firm changes, the results suggest that opinion shopping may be more prevalent for audit clients that do not need the services of a Big 4 auditor.
    • Using three proxies for audit market concentration, the authors find a higher likelihood of opinion shopping in markets with high concentration.
    • The authors also find that auditor dismissals that occur in the third fiscal quarter are more likely to be associated with opinion shopping compared to auditor dismissals occurring prior to the end of the second quarter, especially in competitive markets.
    • The authors performed supplemental analyses to determine the association between internal control opinion shopping and going concern opinion shopping. They find that internal control opinions are less predictable and therefore more valuable than going concern opinions. They did find evidence of going concern opinion shopping in the pre-SOX period but not in the post-SOX period. This gives rise to the possibility that going concern reporting has a reduced role in auditor retention decisions after the introduction of SOX.
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Internal control deficiencies in tax reporting: A detailed...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses 
    Title:
    Internal control deficiencies in tax reporting: A detailed view.
    Practical Implications:

    The authors use a unique data set to shed light on characteristics which lead to material weaknesses, specifically in tax-related accounts relative to other accounts. The data (obtained from several international accounting firms) allows the authors to determine which characteristics of tax-related internal control deficiencies are different from other deficiencies, prevent them from being remediated, and cause them to rise to the level of a material weakness. Results suggest that tax deficiencies, relative to other account-specific deficiencies, are less likely to be remediated, more severe, and more likely to cause a financial misstatement. Tax-related deficiencies are less likely to get remediated by year-end if discovered by the auditor, if the control was deficient in design, or if the control pertained to monitoring. This paper underscores the importance of auditor involvement in internal control reporting in taxes.

    Citation:

    Graham, L. and J.C. Bedard. 2015. Internal Control Deficiencies in Tax Reporting: A Detailed View. Accounting Horizons 29 (4): 917-942.

    Keywords:
    Sarbanes-Oxley Section 404, internal controls, control activities, taxes, internal audit
    Purpose of the Study:

    The authors take advantage of a unique data source to attempt to glean information on tax-related internal control deficiencies. They analyze the characteristics of these deficiencies relative to other account-specific deficiencies to develop an understanding of the nature of tax control deficiencies. The authors then investigate the characteristics of tax-related deficiencies which lead to material weaknesses.

    Design/Method/ Approach:

    The authors collected data on approximately 2,500 account-specific internal control deficiencies from 74 public company engagements during 2004 and 2005. The data came from several international public accounting firms. The authors use archival regression analysis to analyze factors which cause significant differences between tax-related and other account-specific deficiencies, tax-related remediated and unremediated deficiencies, and tax-related material weaknesses and control deficiencies.

    Findings:

    The authors find:  

    • Relative to other accounts, tax internal control deficiencies are less likely to be remediated before year-end, more likely to be severe, and more likely to cause a financial statement misstatement.  
    • Remediation for tax internal control deficiencies is less likely when detected by the auditor.
    • Remediation failure is more prevalent for poorly designed controls, controls over the tax provision, and monitoring controls.  
    • Tax provisions and deferred tax controls have a higher potential for producing misstatements.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses
  • 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
    Material Weakness Remediation and Earnings Quality: A...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency.
    Practical Implications:

    Combining the remediation and earnings quality analyses, the results imply that investors should be most concerned about MWs in information technology, segregation of duties, account reconciliations, taxation, revenues, and inventory. These types occur frequently and are slow to remediate; thus, their effects on financial reporting linger longer than others. Their link to near-term earnings quality is evident, as their remediation reduces abnormal accruals, and/or their lack of remediation in the following year further increases accruals. In general, these results suggest that financial statement users should adopt a more granular view of remediation, as successful remediation of some specific MWs can signal improvement in the quality of disclosed financial information even if other MWs remain unremediated.

    Citation:

    Bedard, J. C., R. Hoitash, U. Hoitash, and K. Westermann. 2012. Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency. Auditing: A Journal of Practice & Theory 31 (1): 57-78.

    Keywords:
    internal control, material weakness, remediation, Sarbanes-Oxley Section 404
    Purpose of the Study:

    This paper investigates the remediation likelihood of specific types of Sarbanes-Oxley (SOX) Section 404 material weaknesses (MWs) in internal control over financial reporting, and the association between remediation of specific types of MW with changes in earnings quality. This detailed look at remediation is important because companies disclose many types of control problems under Section 404, which likely vary in remediation difficulty as well as in impact on the financial reports. Because the goal of Section 404 is to improve financial reporting, it is important to identify specific areas in which control problems are less tractable and more influential. However, no study yet provides a detailed, comprehensive analysis of remediation by specific MW type. The authors first examine remediation rates by specific MW type, and investigate the association of MW type remediation with constraints identified by prior research. Next, they investigate which MW types have greater influence on earnings quality, by associating remediation of specific types with reductions in abnormal accruals. 

    Design/Method/ Approach:

    The authors obtain data on Section 404 MW from 20042006 from the AA database. They gather auditor information from AA, financial data from Compustat, and institutional ownership from Thomson Financial. The authors’ final sample consists of 567 observations that reported Section 404 MWs in either 2004 or 2005, representing 496 companies.

    Findings:
    • Finer classification does provide greater insight in showing that all specific entity-level MW types exhibit lower remediation likelihood.
    • Companies with fewer resources are less likely to remediate problems that involve large capital investments.
    • Companies with weaker governance are less likely to remediate problems linked by past research to earnings management.
    • Most companies with repeated disclosure of ineffective controls engaged in some successful remediation activity following initial disclosure, as only 3 percent had no success in remediating any MW types.
    • Certain types of MW have a greater impact on earnings quality, both when disclosed and when remediated, including some entity-level and some account-specific MW types. For most of these types, remediation reverses the higher abnormal accruals observed on disclosure. However, if remediation does not occur within a year from disclosure, abnormal accruals continue to increase for virtually all MW types.
    • Information technology and segregation of duties problems share an element of personnel reallocation, as the definition of information technology issues shown in includes specific reference to segregation of duties. Remediating such problems could involve hiring new workers, changing assignments or workflows, and thus could take more time than the remediation of other MW types. However, earnings quality is shown to increase in those companies that invest in solutions to these problems and reassign personnel appropriately.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, 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
    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

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