The high proportion of disclosures of internal control problems in annual Section 404 filings without a prior disclosure in quarterly Section 302 filings suggests that in many cases it is the auditors who detect and/or classify a problem as material enough to warrant public disclosure. The empirical evidence is useful for the debate about the role of auditors in internal control testing and reporting.

For more information on this study, please contact K. Raghunandan (raghu@fiu.edu).

Munsif, V., K. Raghunandan and D. V. Rama. 2013. Early warnings of internal control problems: Additional evidence. Auditing: A Journal of Practice and Theory 32(2): 171-188.

Sections 404 and 302 of SOX deal with annual and quarterly reporting on internal controls, respectively. There are some other differences between the requirements arising from the two sections. However, the SEC notes that “disclosure controls and procedures” (the topic of Section 302) are closely related to “internal control over financial reporting” (the topic of Section 404). Many users view the Section 302 rules as requiring prior disclosure about material weaknesses in internal controls in quarterly Section 302 filings before such problems are disclosed in annual Section 404 filings.  However, many companies do not provide such early warning in their Section 302 filings. This study addresses the following questions: How frequent are such early warnings? What are the factors associated with such early warning disclosures?

The data are from the fourth and fifth year of Section 404 reporting (i.e., fiscal years ending between November 15, 2007 to November 14, 2009).  Excluded are: firms in the financial sector (SIC codes 60-67) and foreign firms.  The sample includes 6,040 observations—2,927 accelerated and 3,113 non-accelerated filers—for 2007. The sample for fiscal year 2008 includes 2,796 accelerated filers and 3,195 non-accelerated filers.

• The proportion of accelerated filers (with adverse Section 404 reports) that have early warnings (in Section 302 certifications in previous quarters of the same fiscal year) is less than 50 percent even in the fourth and fifth years of Section 404 reporting. 
• Non-accelerated filers were more likely to have early warnings than accelerated filers in 2008; however, the difference is not significant in 2007.
• Early warning is more likely for firms with (a) a higher number of material weaknesses in internal control, (b) a new CFO, (c) more audit committee members, and (d) more frequent audit committee meetings.  

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