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    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 
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    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