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    Changes in Corporate Governance Associated with the...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 13.0 Governance, 13.01 Board/Audit Committee Composition 
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    Title:
    Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation
    Practical Implications:

    The results of this study support the audit committee regulations under SOX and the board independence regulations of the listing exchanges. These results are important to regulators as they show that improvements in audit committee influence, competence, and incentives are each positively associated with ICMW remediation. In addition, the results reveal that improvements in these audit committee characteristics are most strongly associated with the remediation of ICMWs relating to control activities and monitoring, but not to ICMWs across the other COSO categories. Lastly, the results are important to management as they highlight the importance of hands-on day-to-day leadership by management in addressing situations involving the revelation and remediation of material negative events.

    For more information on this study, please contact Karla Johnstone.
     

    Citation:

    Johnstone, K., C. Li, and K. H. Rupley. 2011. Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation.  Contemporary Accounting Research 28 (1):  331-383. 

    Keywords:
    internal controls; material weaknesses; corporate governance; materiality; remediation.
    Purpose of the Study:

    Section 404 of the SOX requires public firms and their external auditors to report on the effectiveness of firms’ internal controls over financial reporting (ICOFR) or to reveal the presence of internal control material weaknesses (ICMWs). Other sections in SOX and listing requirements of the NYSE and NASDAQ also contain regulations intended to improve the conduct and oversight of boards of directors, audit committees, and top management. The purpose of this paper is to propose and test a conceptual model of the process that firms use to remediate negative events in general, and ICMWs specifically, with a focus on the role of governance structure changes (including turnover of and improvements in the characteristics of boards of directors, audit committees, and top management). Specifically, the authors examine what actions companies take in changing corporate governance in an attempt to regain equilibrium upon occurrence of a negative event and how do these changes impact the likelihood that a material weakness is remediated.

    Design/Method/ Approach:

    The authors utilize a conceptual model which includes two primary phases, the first of which concerns the association between the disclosure of ICMWs and turnover of boards of directors, audit committees, and top management. The second phase of the model concerns the association between the remediation of ICMWs and both outright turnover of and changes in the particular characteristics of boards of directors, audit committees, and top management. The first phase utilizes an ICMW sample of firms with December fiscal year ends from 2004 through 2007 that report ICMWs in their SOX Section 404 reports and a control sample which received unqualified SOX 404 Reports and examines the association between ICMW disclosure and governance changes. The second model utilizes a similar sample, but only includes firms which disclose ICMWs in 2004-2006 as it is required that firms need a year to remediate.  This second model estimates the association between ICMW and governance structure changes.

    Findings:
    • The authors find that that the disclosure of ICMWs is positively associated with subsequent turnover of members of boards of directors, audit committees, and top management, including both CEOs and CFOs. As such, the authors infer that the incentives to make significant structural changes in governance following the revelation of an ICMW appear to outweigh the disincentives, and firms revealing an ICMW act in a similar manner to firms revealing other material negative events such as fraud or restatements.
    • Furthermore, the authors show that remediation is positively associated with turnover of audit committee members, but not turnover of board members, CEOs, or CFOs.
    • Additionally, the results reveal that ICMW remediation is positively associated with an increase in the proportion of independent directors on the board, an increase in the percentage of independent directors who also serve on other boards, changes involving having an audit committee member chairing the board, improvements in audit committee member financial expertise, an increase in the percentage of shareholdings of audit committee members, changes toward CFOs with greater accounting expertise, greater CFO-specific work experience, and improvements in CEO reputation.
    • Lastly, the results reveal that ICMW remediation is negatively associated with a greater number of ICMWs and the presence of general ICMWs (those having pervasive effects on financial reporting) rather than specific ICMWs.
       
    Category:
    Governance, Internal Control
    Sub-category:
    Assessing Remediation of Weaknesses, Board/Audit Committee Composition, Reporting Material Weaknesses