The authors identify a setting where there is a greater risk of value reduction for stockholders. Specifically, they find that companies which have material weaknesses in internal controls are more likely to engage in real earnings management, through inventory management and reducing discretionary expenditures. While these activities are allowed by GAAP, the findings of this paper suggest management may take actions that are detrimental to firm value.

Jarvinen, T. and E. Myllymaki. 2016. Read Earnings Management before and after Reporting SOX 404 Material Weaknesses. Accounting Horizons 30 (1): 119-141.

http://www.auditingresearchsummaries.org

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.

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.

http://www.auditingresearchsummaries.org

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.

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.

http://www.auditingresearchsummaries.org

The evidence showing that, all else equal, SEC sanctions following restatements are no more likely for firms that previously claimed to have effective internal controls (and, in some cases, are less likely) suggests that public enforcement of SOX 404 is unlikely to provide strong incentives to detect and disclose existing weaknesses. Also, the results showing that penalties stemming from various private mechanisms are more likely for firms that report their internal control weaknesses in advance of restatements suggests the existence of possible disincentives to detect and disclose existing weaknesses. Together, these results offer a potential explanation for why the majority of restatements occur at firms that previously claimed to have effective controls.

Rice, S. C., Weber, D. P., & Wu, Biyu. 2015. Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses. Accounting Review 90 (3): 1169-1200.

http://www.auditingresearchsummaries.org

This study asserts that, “overall, the findings of this study highlight the importance of discovering and disclosing material weaknesses in internal control over financial reporting.” Furthermore, in conclusion, this study states that:

• In the post-MW404 period, there is a greater likelihood of existing control problems remaining unacknowledged and, therefore, casting doubts on whether the decision to report effective internal controls was actually the correct one.
• Some entity-level MWs are more frequent in companies with undiscovered misstatements in the post-MW404 period compared to companies without undiscovered misstatements.
• The additional exploration reveals that the majority of the misstatement incidences in the post-MW404 period are unrelated to the previously disclosed account-specific MWs.
• It seems that the underlying driver of misstatements in the post-MW404 period is the unacknowledged pervasiveness of internal control problems. This study, hence, highlights the importance of discovering and disclosing material weaknesses.

For more information on this study, please contact Emma-Riikka Myllymaki

Emma-Riikka Myllymäki (2014) The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality. AUDITING: A Journal of Practice & Theory: February 2014, Vol. 33, No. 1, pp. 93-116.

http://www.auditingresearchsummaries.org