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    The Persistence in the Association between Section 404...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, last edited March 11, 2015, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
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    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