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  • Jennifer M Mueller-Phillips
    Auditor Attestation under SOX Section 404 and Earnings...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Attestation under SOX Section 404 and Earnings Informativeness
    Practical Implications:

    Section 404 is one of the most controversial provisions of the Sarbanes-Oxley Act. Many studies have examined the negative consequences of adverse reports on internal control issued by the auditor. Other studies have looked at the cost of compliance of Section 404 and find that it is burdensome, disproportionately so for small companies. This study focuses on the benefits of internal control audits. Regulators have argued that the benefits of Section 404 are hard to measure because of the difficulty in quantifying the benefits. This study contributes to the debate on the benefits of Section 404 by documenting evidence that although compliance with Section 404’s requirements has been reported to be associated with high costs, the first-time internal control reports seem to have increased earnings informativeness. 

    Citation:

    Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).

    Keywords:
    earnings informativeness; internal control; Sarbanes-Oxley; Section 302; Section 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act (SOX) requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). This policy is intended to enhance the credibility of firms’ financial statements. Prior research suggests that audit characteristics that enhance the credibility of financial reporting are associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. This study examines the SEC’s and PCAOB’s expectation about the increased quality and reliability of financial reporting resulting from Section 404. By using a difference-in-differences approach, the authors compare the change in earnings informativeness for the test sample used with that for a control sample of non-accelerated filers. 

    Design/Method/ Approach:

    The authors used previous research and policy makers’ expectations to develop the following hypothesis for testing:

     

    H1: Earnings accompanied by the first-time clean SOX404 ICFR reports are more informative that the previous annual earnings that were not accompanied by ICFR.

     

    This hypothesis was tested by comparing earnings informativeness for the annual filings containing the first-time ICFR reports and the annual filings of the previous year. The sample consisted of two types of firms (1) accelerated filers with clean Section 404 reports for the current year and clean Section 302 management reports for the seven preceding quarters, and (2) non-accelerated filers with clean Section 302 management reports throughout the sample period. The sample period included firm year-ends between November 15, 2003 and November 15, 2005. The final sample consisted of 381 firms. 

    Findings:
    • Firms with first-time clean ICFR reports have higher earnings informativeness in SOX years than in the pre-SOX years when they received only financial statement audit reports.
    • The firms that benefited the most are those with higher likelihood of material weaknesses.
    • Firms with both low and high costs of compliance experience an increase in earnings informativeness. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
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  • Jennifer M Mueller-Phillips
    Early Warnings of Internal Control Problems: Additional...
    research summary posted May 25, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Early Warnings of Internal Control Problems: Additional Evidence
    Practical Implications:

    The results of this study raise many interesting questions. The fact that accelerated filers’ adverse internal control opinions continue to be a surprise over 50 percent of the time suggest that auditors continue to find internal control problems that management had not previously identified or had not evaluated as MWs. The results related to non-accelerated filers provide some interesting data related to the ongoing debate about the efficacy of Section 404(b) testing by auditors. The authors also note that examining the early warnings of non-accelerated filers tells us only about what management of these companies report; it does not give us insight into what auditors would report. The results also raise other interesting issues for future research.

    Citation:

    Munsif, V., K. Raghunandan, and D. V. Rama. 2013. Early Warnings of Internal Control Problems: Additional Evidence. Auditing 32 (2).

    Keywords:
    302; 404; internal control; SOX
    Purpose of the Study:

    This study extends the research of Hermanson and Ye (2009; hereafter, HY) that found in the first year of Sarbanes-Oxley Act (SOX) Section 404 reporting, there were many companies with “surprise” adverse internal control reports.  The authors of this study examine a more recent time period (using data from fiscal years 2007 and 2008) and include both accelerated and non-accelerated filers. Motivation for these two extensions of HY comes from the fact that internal control disclosures by public companies and their auditors continue to be of significant interest to legislators and regulators. 

    Design/Method/ Approach:

    Data was obtained from the Audit Analytics and Compustat databases, and from company filings available at the SEC website. This data was used to answer the following two research questions:

    RQ1: What is the proportion of accelerated filers with “surprise” disclosures of material weaknesses in internal control in the fourth and fifth years of Section 404 reporting?

    RQ2: Does the likelihood of “surprise” disclosures of material weaknesses in internal control differ for accelerated and non-accelerated filers?

    To address the research question about characteristics of firms with and without early warning disclosures, following HY, a logistic regression model was used. 

    Findings:
    • The proportions of accelerated filer firms with MW disclosures in their Section 404(b) reports, that had disclosed one or more such MWs in Section 302 certifications in prior quarters of the same fiscal year, are only 40 percent and 39 percent in 2007 and 2008 respectively.
    • In the case of non-accelerated filer firms, the proportions of firms with such early warning disclosures are 20 percent and 56 percent in 2007 and 2008, respectively.
    • A regression model indicates that prior warning disclosures are more likely for firms with (1) more ICWs, (2) a new CFO, (3) more audit committee members, and (4) more frequent audit committee meetings.
    • In 2008, non-accelerated filers were more likely than accelerated filers to have early warning disclosures. 
    Category:
    Accountants' Reporting, Internal Control, Standard Setting
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404, Reporting Material Weaknesses
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  • Jennifer M Mueller-Phillips
    Detection and Severity Classifications of Sarbanes-Oxley...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.04 Assessing Remediation of Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Detection and Severity Classifications of Sarbanes-Oxley Section 404 Internal Control Deficiencies
    Practical Implications:

    The results of this study support the value of auditor involvement at two stages of the ICFR assessment process (detection and classification), and contribute to understanding of factors associated with client and auditor performance in both stages. The study also provides direct evidence on the “yield” of detection methods used by auditors. This issue is at the heart of the debate on the value of auditor involvement in assessing and testing internal controls. Lastly, the findings of this study imply that the recent exemption of Section 404(b) for smaller U.S. public companies could result in failure to fully realize potential improvements in financial reporting quality in that sector of the market.

    For more information on this study, please contact Jean Bedard.
     

    Citation:

    Bedard, J. C. and L. Graham. 2011. Detection and Severity Classifications of Sarbanes-Oxley Section 404 Internal Control Deficiencies.  The Accounting Review 86 (3):  825-855. 

    Keywords:
    internal controls; Sarbanes-Oxley Section 404; risk assessment; materiality
    Purpose of the Study:

    In the aftermath of large company failures (Enron and WorldCom), Congress enacted the Sarbanes-Oxley Act (SOX) and, more specifically, Section 404 to improve the reliability of information provided by public companies to the financial markets by requiring company management and auditors to test internal control over financial reporting (ICFR) and to disclose severe control flaws that are not remediated as of the balance sheet date. Prior research uses publicly available annual report data to distinguish characteristics of companies disclosing ineffective controls (i.e., at least one MW) under Section 404, or quarterly management reports under Section 302  but does not address the full extent of detected control flaws, how those problems are detected, or how auditors determine which problems are disclosed. This study extends prior research and investigates detection and severity classification of internal control deficiencies (ICD) under Section 404 to determine (1) the relative contribution of clients and auditors to ICD detection and (2) the factors are associated with the auditor’s severity classifications of detected ICD.

    Design/Method/ Approach:

    The authors obtained proprietary data from several large audit firms, under confidentiality agreements that limit the ability of the authors to results separate results by firm or firm size. The authors asked that each firm randomly select from 2004–2005 engagements of smaller accelerated filers (with revenues of about $1 billion or less) in non-regulated industries allowing them to increase generalizability to the large number of U.S. public companies. Contact personnel from participating firms helped the authors develop a spreadsheet to be completed by engagement teams, containing both company-level and control-level information. The authors first examine the overall percentage of ICD detected by clients/auditors and also model the factors associated with likelihood of client detection. In addition, because auditors are sometimes aware of the client’s preliminary classification of ICD, the authors test whether auditors override those classifications by judging ICD to be more severe. Lastly, the authors test expectations regarding factors associated with severity classification of ICD.

    Findings:
    • The authors find that clients detect fewer ICD than auditors, and are less likely to detect severe and pervasive ICD and therefore infer that many of the control flaws most likely to affect financial reporting would not be found in a client-driven process such as Section 302.
    • Furthermore, the analysis shows that the use of a large accounting firm consultant for Section 404(a) work is associated with improved client detection
    • The authors find that control tests provide initial evidence on a large proportion of ICD, including most MW and entity-level problems viewed as more serious by financial report users which affirms auditors’ Section 404 control testing as an important source of detecting control deficiencies.
    • The authors find that clients tend to classify ICD as less severe, but auditors frequently override those classifications.
    • Lastly, the authors find higher severity associated with:
    1. greater knowledge and independence in the client’s Section 404(a) process;
    2. more objective evidence (e.g., an existing misstatement);
    3. control flaws other than documentation problems (e.g., inappropriate design);
    4. certain types of entity-level ICD (e.g.,  Control Environment);
    5. certain types of account-specific ICD (revenue and tax), consistent with the regulatory climate of the period.
       
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Assessing Material Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Impact of 404
  • Jennifer M Mueller-Phillips
    Do Small Firms Benefit from Auditor Attestation of Internal...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 12.0 Accountants’ Reports and Reporting, 12.07 Attestation Services in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do Small Firms Benefit from Auditor Attestation of Internal Control Effectiveness?
    Practical Implications:

    This study can inform regulators, investors, and others of the potential consequences of exempting non-accelerated filers from Section 404(b) of SOX. The results of this study support the notion that an auditor’s opinion on the effectiveness of internal control over financial reporting adds value beyond certifications provided by management. Additionally, the results of the study support the notion that investors in small public firms regard auditors’ assessment of the effectiveness of internal controls as adding value via higher revenue quality relative to firms that are not required to submit themselves to additional scrutiny by their auditors. Thus, firms contemplating exiting accelerated status may want to consider that such a move may have an adverse effect on firm valuation.

    Citation:

    Krishnan, G. V., and W. Yu. 2012. Do Small Firms Benefit from Auditor Attestation of Internal Control Effectiveness? Auditing: A Journal of Practice and Theory 31(4): 115-137.

    Keywords:
    Dodd-Frank Act; SOX 404; revenue quality; non-accelerated filers; valuation
    Purpose of the Study:

    Several sections of the Sarbanes-Oxley Act of 2002 (SOX) mandate disclosure of information on the effectiveness of internal control over financial reporting (ICFR):

    • Section 302 requires the CEO and CFO to certify 10-K and 10-Q reports, and establish and maintain internal controls.
    • Section 404(a) requires each company’s annual report to include an internal control report containing management’s assessment of the effectiveness of ICFR (management report).
    • Section 404(b) requires companies to have the auditor evaluate the effectiveness of the internal controls.

    Accelerated filers (public companies with a public float of at least $75 million) and non-accelerated filers are both subject to the provisions of Section 302 and 404(a), but the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 permanently exempts non-accelerated filers from the provisions of Section 404(b). Therefore, the purpose of the study was to examine whether the provisions of Section 404(b) add value incremental to those in Sections 302 and 404(a) for small firms. The authors specifically examined whether there was a difference in the revenue quality (which is discretionary or abnormal revenue) between accelerated filers who are subject to auditor attestation of ICFR and non-accelerated filers. They also examines whether there was a difference in the investor valuation of accelerated filers relative to non-accelerated filers.
     

    Design/Method/ Approach:

    The authors used data between the years 2007 and 2009 from publicly-traded companies. The authors identified accelerated and non-accelerated filers that had beginning assets between $25 million and $125 million. The authors fit this data to a model that estimated discretionary revenues for these firms.

    Findings:
    • On average, discretionary (abnormal) revenues were lower by about 1.5 percent of total assets for accelerated filers relative to non-accelerated filers.
    • After excluding observations that had control deficiencies, the authors found that the discretionary revenues were lower by about 1.9 percent for accelerated filers relative to non-accelerated filers.
    • The authors evaluated firms that had changed from being accelerated filers to non-accelerated filers and found that discretionary revenues had increased by about 1 percent of total assets following the change from accelerated filer to non-accelerated filer.
    • The authors matched non-accelerated filers with accelerated filers by the ratio of audit fees over total assets and found that discretionary revenues were smaller for accelerated filers relative to non-accelerated filers.
    • The book value of equity of accelerated filers was valued more by investors relative to the book value of equity of non-accelerated filers.
       
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Attestation Services, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    Auditor Realignments Accompanying Implementation of SOX 404...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements
    Practical Implications:

    The results of this study are important for showing the impact of SOX requirements on the audit environment.  The evidence suggests that ICFR opinions provide clients with information to assess the effectiveness of auditors.  After adverse internal control opinions, clients dismiss auditors in order to obtain higher quality audits, measured by switches to Big 4 and industry specialist auditors.  However, only industry specialist auditors are associated with remediation of adverse reports. 

    Citation:

    Ettredge, M., J. Heintz, C. Li, and S. Scholz. 2011. Auditor realignments accompanying implementation of SOX 404 ICFR reporting requirements. Accounting Horizons 25 (1): 17-39.

    Keywords:
    auditor realignments; dismissals; internal control; SOX Section 404; remediation
    Purpose of the Study:

    This study was motivated by the increased frequency of client dismissals of auditors since the implementation of SOX in 2002.  The added requirement that auditors opine on the client’s internal control over financial reporting (ICFR) brought concern among financial statement users that clients would seek more compliant auditors decreasing the quality of the audit.  This paper studies the impact of adverse auditors’ opinions on clients’ internal controls to determine whether:

    • Clients dismiss auditors after receiving an adverse SOX 404 ICFR opinion.
    • Clients dismiss auditors to improve financial reporting by obtaining a higher-quality auditor.
    • Dismissals and hiring a new auditor are associated with subsequent improved ICFR opinions.
    Design/Method/ Approach:

    The authors study accelerated filers from November 2004 through December 2007 and obtain data on ICFR opinions, auditor dismissals, and auditor switches.  Higher audit quality is measured as changes to Big 4 and industry specialist auditors. 

    Findings:
    • Companies receiving adverse ICFR opinions are more likely to dismiss their auditor in the subsequent year.
    • Companies that dismiss their auditor after an adverse ICFR opinion are more likely to hire Big 4 and industry specialist auditors.
    • Remediation of adverse reports is only associated with clients that switch to an industry specialist auditor.
    Category:
    Standard Setting, Internal Control
    Sub-category:
    Impact of 404, Impact of SOX, Impact of 404 on Fees and Financial Reporting Quality
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