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  • Jennifer M Mueller-Phillips
    Do SOX 404 Control Audits and Management Assessments Improve...
    research summary posted September 13, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Do SOX 404 Control Audits and Management Assessments Improve Overall Internal Control System Quality?
    Practical Implications:

     The authors’ findings are important because they indicate that AS5 may be less effective at improving ICQ than AS2 and provides some evidence that declining material weakness rates under AS5 do not indicate improving ICQ. The findings also suggest that SOX 404(a) management assessments are not an acceptable substitute to ICFR audits for improving ICQ. The results suggest that more rigorous SOX 404(b) audits under Auditing Standard No. 2 had real benefits in terms of improved overall internal control system quality and unaudited accruals quality; however, attempts to reduce ICFR audit costs via reduced requirements of Auditing Standard No. 5 may have resulted in lower material weakness disclosure rates and lower overall internal control system quality.

    Citation:

    Schroeder, J. H. and M. L. Shepardson. 2016. Do Sox 404 Control Audits and Management Assessments Improve Overall Control System Quality? The Accounting Review 91 (5): 1513-1541.

    Keywords:
    internal control quality, SOX Section 404, internal control audits, and PCAOB Auditing Standard No. 5 (AS5)
    Purpose of the Study:

    In this study, the authors address whether audits and management assessments of internal controls over financial reporting (ICFR) required by Section 404 of the Sarbanes-Oxley Act are associated with maintained improvements to an entity’s overall internal control system quality (ICQ). Stakeholders and researchers continue to question whether benefits of ICFR audits justify high costs, and regulators and researchers alike have questioned whether control audits under the current auditing standard provide accurate material weakness disclosures. In 2013, the PCAOB disclosed that 15 percent of 2010 inspected internal control audits were ineffective, suggesting that declining material weakness disclosures may not signal improving ICQ and that the current control auditing standard may be insufficient for inducing ICO improvements. The authors believe that the maintained improvement in overall ICQ due to control audits and management assessments is important and largely unexplored. 

    Design/Method/ Approach:

    The authors address the question using a ten-year period that includes three control disclosure regulation changes; initial implementation of ICFR audits, a 2007 reduction in control auditing requirements and implementation of unaudited management assessments for small firms. The authors use unaudited quarterly accruals quality in future periods subsequent to ICFR audits and management assessments to identify sustained improvements in overall control system quality. They use two research designs to estimate the effects of control regulation regime changes and perform analyses on all firms for which they have the requisite data, as well as a size-restricted sample of firms with less than $150 million in market capitalization. 

    Findings:
    • The authors find that UAQ improves after AS2 control audit implementation, providing evidence that AS2-based control audits are associated with maintained improvements to overall ICO.
    • The authors find that in the sample of accelerated filers that UAQ decreased between the pre- and post-AS5 periods, providing evidence that the auditing standards change led to a deterioration in ICQ.
    • Using the difference-in-differences design, the authors find that accelerated filer UAQ deteriorated relative to non-accelerated filers subsequent to implementation of AS% for accelerated filers and SOX 404(a) for non-accelerated filers. Combined results are consistent with the difference-in-differences being causes, at least in part, by ICO decline related to AS5.
    • The authors find little evidence that SOX 404(a) management assessments affect UAQ, but they do find a significant decrease in the likelihood of material misstatement subsequent to SOX 404(a) implementation. 
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Real Earnings Management before and after Reporting SOX 404...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Real Earnings Management before and after Reporting SOX 404 Material Weaknesses.
    Practical Implications:

    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.

    Citation:

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

    Keywords:
    internal control, material weakness, real earnings management
    Purpose of the Study:

    This study investigates whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The authors compare companies with effective internal controls to companies with existing material weaknesses, specifically looking at manipulation of real activities (particularly inventory overproduction). Such activity would suggest that companies strive to mitigate the expected negative reaction to disclosed material weaknesses by engagement in real earnings management.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies from 2004 to 2012. These company-years are split into three categories: 1) first year of internal control material weakness 2) years in which material weaknesses were disclosed as remediated 3) years in which material weaknesses were disclosed as nonremediated, and 4) company-years with effective internal controls. The authors observe differences in the extent of inventory management after controlling for various other predictors of real earnings management.

    Findings:

    The authors find:

    • Manipulation of real operational activities is associated with both the first-time existence of a material weakness and the subsequent disclosure of the material weakness.
    • Inventory overproduction is employed as an earnings management method before and after material weakness disclosure, and especially when the company has previously had poor financial performance.
    • Companies appear to cut discretionary expenditures when they have material weaknesses and when they have previously had poor financial performance.
    • Reduction in discretionary expenses is also used in the year when companies disclose and remediate material weaknesses.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    Earnings Management, Impact of 404 on Fees and Financial Reporting Quality
  • 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
    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
    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
    Does Ineffective Internal Control over Financial Reporting...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management.
    Practical Implications:

    This is first paper to examine the broad effect of ineffective ICFR on firm operations, and to establish a more direct link between MWIC over inventory and managers’ inventory management decisions. These results provide strong evidence that despite being largely unremarked upon as a potential benefit by managers or regulators, maintaining effective ICFR can provide an economically meaningful benefit to their firms’ operations. To the extent that there is a disconnect between actual and perceived benefits to maintaining effective ICFR, the recent regulatory move to exempt certain firms from internal control disclosure regulation may be premature. For a large sample of publicly traded firms, the authors provide evidence that the lack of proper inventory acquisition, tracking, or valuation systems has a direct impact on firms’ operating performance.

    Citation:

    Feng, Mei, Li, C., McVay, S. E., & Skaife, H. 2015. Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management. Accounting Review 90 (2): 529-557.

    Keywords:
    firm operations, internal control over financial reporting, inventory management
    Purpose of the Study:

    For the past decade, managers and regulators have debated the costs and benefits of Section 404 of the Sarbanes-Oxley Act, which requires disclosure of the effectiveness of internal control over financial reporting (ICFR). Managers appear to recognize that they provide higher-quality information as a result of effective ICFR, but they do not appear to recognize that they may also be using higher-quality information to make better operational decisions when they maintain effective ICFR because some controls play both operational and financial reporting roles.

    The purpose of this study is to assess the implications of ICFR for firm operations. When a firm fails to have adequate systems to control inventory purchase, tracking, and valuation, there is a greater likelihood of a mismatch between inventory supply and demand, leading to poorer operating performance. The authors investigate whether ineffective internal control (MWIC) over financial reporting has implications for firm operations by examining the association between inventory related material weaknesses in internal control over financial reporting and firms’ inventory management. 

    Design/Method/ Approach:

    The sample is comprised of 8,953 accelerated filer firm-years with available data on internal control effectiveness from 2004 to 2009 from the WRDS-based Audit Analytics and Compustat databases. Audit Analytics includes both the evaluation of ICFR as effective or ineffective, as well as the underlying reason(s) for any material weaknesses in internal control. The authors conduct multiple empirical analyses on the sample.

    Findings:
    • Firms with inventory-related MWIC, as identified in firms’ required internal control reports, have systematically slower inventory turnover and have a higher likelihood and magnitude of inventory impairments.
    • Inventory turnover ratios increase after firms remediate their inventory-tracking MWIC. Sales, gross margin, and cash flows from operations also improve when the weaknesses are remediated.
    • Importantly, the authors do not find an increase in inventory turnover ratios following the remediation of other types of MWIC.
    • The results of the inventory turnover and inventory impairment tests provide evidence that ineffective ICFR related to inventory has adverse consequences for inventory management, leading to less profitable operations.
    • Firms that correct their inventory-related MWIC report significant increases in sales, gross margin, and operating cash flows after remediation. Moreover, once firms remediate their inventory-related MWIC, the authors find that their gross profit and operating income are no longer significantly different from firms with effective ICFR.
    • The average return on assets is lower for firms with MWIC and that the remediation of MWIC is associated with higher future return on assets.
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Does SOX 404 Have Teeth? Consequences of the Failure to...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    enforcement, internal controls, restatements, Sarbanes-Oxley Act, SOX 404
    Purpose of the Study:

    In this paper, the authors examine several potential consequences of failing to report existing control weaknesses as required by Section 404 of the Sarbanes-Oxley Act of 2002. The investigation is motivated largely by recent concerns about the reliability of SOX 404 reports and related evidence of firms claiming to have effective internal controls over financial reporting when they instead have material weaknesses in those controls. Understanding the consequences of such reporting failures is important because it bears on managers’ and auditors’ incentives to detect and disclose internal control weaknesses and, thus, on the effectiveness of SOX 404 in achieving its intended goal of boosting investor confidence in the reliability of financial reports. This importance is underscored by the high costs of control audits, which have made these requirements the most controversial aspect of SOX. Under SOX 404, firms and their auditors are required to provide formal opinions on the effectiveness of internal controls over financial reporting within the annual 10-K filing. However, concerns have begun to emerge about the reliability of SOX 404 reports, and the effectiveness of SOX 404 in providing advance warning of potential accounting problems remains unclear.

    Design/Method/ Approach:

    The authors use Audit Analytics to create a full sample of 659 observations of firms that are subject to SOX 404 and that also have restatements. The full sample includes 134 firms that reported the existence of material weaknesses prior to their restatements and 525 that did not. The authors extracted all restatements for U.S. incorporated firms announced by the end of 2010 that include annual reporting periods ending after the effective date of SOX 404 (November 14, 2004).

    Findings:
    • The likelihood of receiving an Accounting and Auditing Enforcement Release (AAER) following a restatement is similar regardless of whether firms had reported their control weaknesses or instead claimed that their controls were effective prior to the restatement. 
    • The prior acknowledgment of control weaknesses increases the likelihood of receiving an AAER by about 6 percent.
    • The authors find no evidence of vigorous public enforcement of SOX 404; instead, the evidence is suggestive of the opposite: that reported control weaknesses aid the SEC in identifying cases where potential enforcement actions are likely to succeed and make it difficult for management to claim they were unaware of the problems that led to the restatement.
    • Class action lawsuits are 5 to 10 percent more likely when firms report internal control weaknesses prior to restatements. This is true even when the authors remove lawsuits that are later dismissed.
    • The top management turnover is 15 to 26 percent more likely at firms that report control weaknesses prior to their restatements. This result holds for both CEOs and CFOs.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Restatements
  • Jennifer M Mueller-Phillips
    The effect of Auditing Standard No. 5 on audit fees
    research summary posted March 11, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    The effect of Auditing Standard No. 5 on audit fees
    Practical Implications:

    The results provide support for regulators’ expectations about AS5’s overall fee-saving (but not their expectations of greater savings for smaller, less complex companies). The authors conclude that overall, there was a reduction in audit fee under the AS5 standard, but mainly for complex firms.

    For more information on this study, please contact Jagan Krishnan.

    Citation:

    Krishnan, J., J. Krishnan, and H. Song. 2011. The effect of Auditing Standard No. 5 on audit fees. Auditing: A Journal of Practice & Theory 30(4): 1-27.

    Keywords:
    audit fee; AS5; audit quality; PCAOB; SOX 404.
    Purpose of the Study:

    In light of the controversy over implementation cost surrounding Auditing Standard No. 2 (AS2), the PCAOB responded by superseding AS2 with Auditing Standard No. 5 (AS5), An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, effective for fiscal years ending November 15, 2007.  This paper examines the effect of the change from AS2 to AS5 on audit fees. The paper seeks to answer the following questions:

    • Were audit fees lower in the first two years of adoption of AS5 (other things being equal) compared to AS2?
    • More specifically, did AS5 have an impact on audit fees for firms with material weaknesses in internal control?
    • Was there was a difference in fee changes across client size/complexity groups?
    Design/Method/ Approach:

    The study’s primary tests are based on a comparison of audit fees in 2006 (the last year of AS2 audits) with audit fees in 2007–2008 (the first two years of AS5 audits) for a sample of ‘‘stable’’ auditor-client relationships.  Thus, the sample period was 2006-2008. The authors employ a longitudinal sample of firms (the ‘‘full sample’’) that had the same auditor over the four-year period 2005–2008, thus including a year prior to the sample period. Additionally, the study examines the fee trends for a ‘‘clean sample’’ consisting of firms that had clean ICFR opinions throughout our sample period.            

    Findings:

    Overall, the authors find AS5 had a statistically negative effect on audit fees.

    • After controlling for previously identified covariates of audit fees, the authors find audit fees were lower in the first two years of AS5 implementation as compared with the last year of AS2 (4.11 percent and 3.92 percent, based on the median firm, for the full and clean samples, respectively)
    • Consistent with previous work, this study finds that firms with adverse opinions on internal control pay higher fees than those with clean opinions. However, the premium paid by client with adverse opinions is smaller under AS5 than under AS2, which is consistent with a reduction in over auditing or over-conservatism in reporting material weaknesses.
    • Contrary to the expectation that less complex firms would benefit from AS5, this study reports a reduction in audit fee under the AS5 standard mainly for complex firms.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Changes in Audit Standards, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    The Persistence in the Association between Section 404...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality
    Practical Implications:

    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

    Citation:

    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.

    Keywords:
    material weakness; misstatement; financial reporting quality; internal control remediation.
    Purpose of the Study:

    As is asserted in the study’s introduction, “This study investigates whether Section 404 material weakness (MW404s) disclosures are predictive of future financial reporting quality.

    • Whether or not the low financial reporting quality of MW404 companies persists into the post-MW404 period.
    • It is intuitive to assume that the low financial reporting quality of MW404 companies persists into the post-MW404 period.
    • Because MWs in internal controls carry a threat that material misstatements are not detected in a timely manner, the current study relies on the view that an incidence of a misstatement indicates a failure in a company’s internal controls
    Design/Method/ Approach:

    “The data used in this study consist of company-year observations of listed companies located in the U.S. covering the years 2005–2008… The data concerning the auditor’s attestation report on internal controls over financial reporting (Section 404), management’s disclosure controls reporting (Section 302), financial statement restatements, and auditor information are obtained from the Audit Analytics database. The financial statement data are obtained from the Thomson Financial database, and the audit committee variables from the Corporate Governance Quotient data.”

    The study draws its conclusions by dividing the data into companies with qualified internal control audit opinions and companies with unqualified internal control audit opinions. 

    Findings:

    The study’s conclusion asserts, “The empirical findings indicate that companies in the post-MW404 period are more likely to have undiscovered misstatements in their financial statements than companies that never had MW404s. Specifically, the effect is estimated to persist for two fiscal years, over which time the magnitude of the effect decreases non-linearly with decreasing speed. The finding of persistence is further supported by a number of sensitivity tests (propensity score matching, among others) and the quarterly investigation of misstatements and 302 weakness disclosures.”

    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality

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