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    Management Reporting on Internal Control and Accruals...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 11.0 Audit Quality and Quality Control, 15.0 International Matters 
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    Title:
    Management Reporting on Internal Control and Accruals Quality: Insights from a ‘‘Comply-or-Explain’’ Internal Control Regime
    Practical Implications:

        The findings of this study are relevant in light of the major internal control reforms that have taken place in the past years around the world and the ongoing global debate on the costs and effectiveness of internal control regulations. More specifically, the finding on the type of explanations given for noncompliance suggests that explanations for deviations currently suffer from an unsatisfactory level of information quality and a low level of shareholder monitoring. In other words, it appears that in practice the explain-option of the comply-or-explain principle is being implemented in a different manner than regulators intended which is informative to the international debate on internal control regulation.

    For more information on this study, please contact Ann Vanstraelen.
     

    Citation:

     Van de Poel, K. and A. Vanstraelen. 2011. Management Reporting on Internal Control and Accruals Quality: Insights from a ‘‘Comply-or-Explain’’ Internal Control Regime.  Auditing: A Journal of Practice & Theory 30 (3):  181-209. 

    Keywords:
    comply-or-explain; internal control; accruals quality; SOX.
    Purpose of the Study:

    Internal control regulation remains a hot topic globally among academics, regulators, and practitioners in terms of costs and effectiveness. Due to the difference in internal control regulations in various countries, management’s incentives are varied across regulatory regimes specifically in relation to financial reporting. As the majority of research has primarily focused in the U.S. rules-based setting, this study seeks to move beyond that by taking a look at an international internal control regime. The purpose of this paper is to complement prior research examining the association between U.S. SOX 302 and 404 internal control regulations and financial reporting quality by considering an alternative internal control regulatory setting. In particular, the authors focus on the Dutch setting, which provides an interesting research context for two reasons. First, as in most E.U. member states, the Dutch setting is characterized by the
    “comply-or-explain” principle for corporate governance regulation which means management either has to comply with the applicable internal control regulations of the Member State or explain and report why they do not comply. Second, the Dutch internal control regulation is one of the few exceptions among ‘‘comply-or-explain’’-based corporate governance codes that include an unaudited management statement of effective internal controls in addition to a description of the internal control system while others only recommend that management communicate to shareholders how they manage risk and internal controls which lends more similarity to the U.S. setting.
     

    Design/Method/ Approach:

    Using this particular setting, the authors examine whether there is an association between internal control reporting and financial reporting quality measured by the magnitude of abnormal accruals. The authors base their study on all Dutch-listed firms (excluding financial institutions) in the period 2004–2005, where 2004 was the first effective year of the Dutch governance code. They perform a content analysis of the internal control chapter in the annual reports and code the description of the internal control system and whether company management provides a statement of effective internal controls. The authors utilize the information from their content analysis to determine whether company management actually stating that internal controls are effective and whether the description of the internal control system has an impact on the level of industry-adjusted abnormal total accruals, industry-adjusted abnormal working capital accruals, and discretionary accruals which all proxy for accruals quality.

    Findings:
    • The authors find that the provision of a description of the internal control system, to which most E.U. countries have limited their internal control regulations, does not provide information about the quality of financial reporting as measured by the magnitude of abnormal accruals.
    • The authors find evidence of a positive association between a statement of effective internal controls and accruals quality in the Dutch setting.
    • The authors find that a relatively small proportion of firms give a management statement of effective internal controls. Specifically, in 2005 only 38 percent of the companies give a management statement of effective internal controls, while 32 percent of the companies give a statement in a weaker form, 22 percent of the companies give an explanation for noncompliance, and 8 percent of the companies do not give any explanation at all. The cited reasons for noncompliance further appear to often be generic and do not provide much insight into possible risk areas of the internal control systems.
       
    Category:
    Audit Quality & Quality Control, Internal Control, International Matters