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    Internal Controls and Conditional Conservatism
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
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    Title:
    Internal Controls and Conditional Conservatism
    Practical Implications:

    This study provides insights to regulators given potentially conflicting perspectives as to the benefits of financial reporting conservatism. Regulators view conservatism as allowing the deliberate understatement of assets or income and/or the deliberate overstatement of liabilities or expenses, rendering financial statements not neutral and, therefore, jeopardizing the quality of reliability and unbiasedness desired by the conceptual framework. In contrast, the benefits of conservatism lie in the agency conflict conservatism whereby it reduces managers’ ability and incentives to overstate earnings and net assets by requiring higher verification standards for gain recognition and reduces managers’ ability to withhold information on expected losses. As the results suggest that strong internal controls facilitate conservatism, this may increase concern among regulators opposed to accounting conservatism.

    For more information on this study, please contact Beng Wee Goh.
     

    Citation:

    Goh, B. W. and D. Li. 2011. Internal Controls and Conditional Conservatism.  The Accounting Review 86 (3):  975-1005. 

    Keywords:
    internal controls; conservatism; material weaknesses; Sarbanes-Oxley Act.
    Purpose of the Study:

    In 2002, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) to improve the quality of financial reporting and to restore investor confidence in the reliability of financial statements. An important aspect of SOX is its internal control reporting requirements, which allow investors to be informed about the quality of a firm’s internal controls. Given the importance of the internal control provisions as a means to improve the governance of firms, this study extends the literature on the reporting effects of strong versus weak internal controls by examining how the quality of internal controls is related to conservatism in financial reporting. Specifically, the authors examine whether material weakness (MW) firms that subsequently remediate their weaknesses exhibit different levels of conservatism from MW firms that continue to have these weaknesses. The authors define conservatism as the higher degree of verification to recognize good news as gains than to recognize bad news as losses and place emphasis here because it has been argued to provide several governance benefits, such as reducing agency conflicts and improving managerial investment decisions, enhancing the efficiency of debt contracts, and reducing litigation costs.

    Design/Method/ Approach:

    The authors identify 1,098 firms that, under either SOX 302 or SOX 404, disclose at least one MW from January 2003 to November 2005 and focus on firms that disclosed MWs because the reporting of MWs is mandatory, whereas the reporting of significant deficiencies and control deficiencies is not. The authors examine the fiscal years 2000 and 2001 to test whether there is a relationship between internal control quality and conservatism because these years just precede the enactment of SOX and, hence, avoid any confounding effects due to SOX. Therefore, the authors rely on the assumption that MWs exist within the firm even before their disclosures from January 2003 to November 2005. The authors utilize three measures of conservatism that are commonly used in the literature to capture the asymmetric timeliness in the recognition of economic losses: (1) persistence of earnings changes, (2) accrual-based loss recognition, and (3) the timeliness of earnings to news. In their second analysis the authors focus solely on the MW sample of firms because remediation is required in their test of whether remediating firms exhibit a difference in conservatism when compared to those that fail to remediate.

    Findings:
    • The results using all three measures of conservatism noted above are consistent with a positive relation between internal control quality and conservatism. Specifically, the authors find that MW firms exhibit lower conservatism than control firms without such weaknesses. Results using all three measures of conservatism are consistent with a positive relation between internal control quality and conservatism.
    • Furthermore, the authors show that MW firms that subsequently remediate their weaknesses (i.e., show an improvement in internal control quality) exhibit greater conservatism than MW firms that continue to have these weaknesses.

    Therefore, the authors’ results are consistent with strong internal controls serving as a mechanism that facilitates conservatism.

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