Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    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 
    550 Views
    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