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  • Jennifer M Mueller-Phillips
    Material Control Weakness Corrections: The Enduring Effects...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Material Control Weakness Corrections: The Enduring Effects of Trust in Management
    Practical Implications:

    Overall, the authors’ findings indicate that variations in the detail of disclosures of material control weaknesses alter trust in management, and these changes in trust have lasting implications for investors’ perceptions of risk associated with the disclosing firm.  

    Citation:

    Rose, A. M., J. M. Rose, and C. S. Norman. 2016. Material Control Weakness Corrections: The Enduring Effects of Trust Management. Behavioral Research in Accounting 28 (2): 41 – 53. 

    Keywords:
    control weakness, disclosure detail, investment risk, remediation, and trust.
    Purpose of the Study:

    Previous research has shown that trust is a key driver in the association between material weakness in internal control disclosures and perceptions of investment risk. If this is the case, the authors expect the effects of material weakness disclosures to persist as long as their effects on trust endure. In other words, when trust in management’s ability and intention to promote quality financial reporting is gained or lost, the changes in trust will influence the interpretation of evidence regarding management’s oversight of financial reporting activities, including correction of material control weaknesses. This paper specifically examines the effects of the remediation of material control weaknesses on investors’ risk assessments.  By studying investor judgment in a controlled laboratory setting, the authors examine how the content of control weakness disclosures can be expected to influence equity market responses to future control weakness corrections. 

    Design/Method/ Approach:

     The authors study investor judgment in a controlled laboratory setting. They also replicate a previous experiment completed by others, with new control weaknesses, to verify the generalizability of their results and extend their study to examine the effects of disclosure detail and control weakness pervasiveness on investor decisions made after remediation of control weaknesses. 

    Findings:
    • The authors find that when material weakness disclosures have specific and detailed discussion of the pervasiveness of the weaknesses, investors increase assessments of investment risk for less pervasive weaknesses and decrease assessments of risk for more pervasive weaknesses.
    • The authors find that providing detailed explanations that a control weakness is isolated increases risk assessments relative to not providing a detailed explanation; conversely, offering a detailed explanation that a weakness is very pervasive decreases assessments of investment risk relative to not offering a detailed explanation.
    • The authors find that the interactive effects of control weakness pervasiveness and explanation detail on risk assessments endure after remediation of control weaknesses, indicating that trust in management continues to influence risk assessments after control weaknesses are corrected. 
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Management control system design, ownership, and performance...
    research summary posted November 14, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Management control system design, ownership, and performance in professional service organizations
    Practical Implications:

    This study provides some of the first empirical evidence of the characteristics of efficient MCS design for PHOs. This evidence has the potential to assist primary healthcare owners, managers and their advisors to better understand the relationship between ownership and MCS design and thereby improve the effectiveness and efficiency of delivery of primary care. 

    Citation:

    King, R. and P. Clarkson. 2015. Management control system design, ownership, and performance in professional service organizations. Accounting, Organizations and Society 45: 24-39. 

    Keywords:
    Control systems, ownership, TCE, and primary healthcare organizations.
    Purpose of the Study:

    The authors investigate the implications for organizational performance of the interplay between ownership and management control system (MCS) design in professional service organizations. The setting for the investigation is the primary healthcare sector in Australia, specifically primary healthcare organizations (PHOs). PHOs are small ‘for profit’ organizations where general practitioners (GPs) provide a first point of contact with the healthcare system. These organizations present a significant control challenge because GPs work independently to produce an intangible output and have preferences that conflict with bureaucracy. Despite professional belief, the authors find variation in the level of GP ownership across PHOs. The performance implications of this variation have not been investigated to date; furthermore, whether differences in the MCS design can mitigate these differences can also be investigated. 

    Design/Method/ Approach:

    The authors structure the analysis around Transaction Cost Economics (TCE), a holistic MCS design theory that allows for the possibility of misalignment and resultant performance effects and employ data from an online survey of practice managers.

    Findings:
    • The authors find that a lack of fit between MCS design and ownership will result in reduced organizational performance. 
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses
  • Jennifer M Mueller-Phillips
    Do SOX 404 Control Audits and Management Assessments Improve...
    research summary posted September 13, 2016 by Jennifer M Mueller-Phillips, tagged 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:
    Do SOX 404 Control Audits and Management Assessments Improve Overall Internal Control System Quality?
    Practical Implications:

     The authors’ findings are important because they indicate that AS5 may be less effective at improving ICQ than AS2 and provides some evidence that declining material weakness rates under AS5 do not indicate improving ICQ. The findings also suggest that SOX 404(a) management assessments are not an acceptable substitute to ICFR audits for improving ICQ. The results suggest that more rigorous SOX 404(b) audits under Auditing Standard No. 2 had real benefits in terms of improved overall internal control system quality and unaudited accruals quality; however, attempts to reduce ICFR audit costs via reduced requirements of Auditing Standard No. 5 may have resulted in lower material weakness disclosure rates and lower overall internal control system quality.

    Citation:

    Schroeder, J. H. and M. L. Shepardson. 2016. Do Sox 404 Control Audits and Management Assessments Improve Overall Control System Quality? The Accounting Review 91 (5): 1513-1541.

    Keywords:
    internal control quality, SOX Section 404, internal control audits, and PCAOB Auditing Standard No. 5 (AS5)
    Purpose of the Study:

    In this study, the authors address whether audits and management assessments of internal controls over financial reporting (ICFR) required by Section 404 of the Sarbanes-Oxley Act are associated with maintained improvements to an entity’s overall internal control system quality (ICQ). Stakeholders and researchers continue to question whether benefits of ICFR audits justify high costs, and regulators and researchers alike have questioned whether control audits under the current auditing standard provide accurate material weakness disclosures. In 2013, the PCAOB disclosed that 15 percent of 2010 inspected internal control audits were ineffective, suggesting that declining material weakness disclosures may not signal improving ICQ and that the current control auditing standard may be insufficient for inducing ICO improvements. The authors believe that the maintained improvement in overall ICQ due to control audits and management assessments is important and largely unexplored. 

    Design/Method/ Approach:

    The authors address the question using a ten-year period that includes three control disclosure regulation changes; initial implementation of ICFR audits, a 2007 reduction in control auditing requirements and implementation of unaudited management assessments for small firms. The authors use unaudited quarterly accruals quality in future periods subsequent to ICFR audits and management assessments to identify sustained improvements in overall control system quality. They use two research designs to estimate the effects of control regulation regime changes and perform analyses on all firms for which they have the requisite data, as well as a size-restricted sample of firms with less than $150 million in market capitalization. 

    Findings:
    • The authors find that UAQ improves after AS2 control audit implementation, providing evidence that AS2-based control audits are associated with maintained improvements to overall ICO.
    • The authors find that in the sample of accelerated filers that UAQ decreased between the pre- and post-AS5 periods, providing evidence that the auditing standards change led to a deterioration in ICQ.
    • Using the difference-in-differences design, the authors find that accelerated filer UAQ deteriorated relative to non-accelerated filers subsequent to implementation of AS% for accelerated filers and SOX 404(a) for non-accelerated filers. Combined results are consistent with the difference-in-differences being causes, at least in part, by ICO decline related to AS5.
    • The authors find little evidence that SOX 404(a) management assessments affect UAQ, but they do find a significant decrease in the likelihood of material misstatement subsequent to SOX 404(a) implementation. 
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Internal Control Opinion Shopping and Audit Market...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 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:
    Internal Control Opinion Shopping and Audit Market Competition.
    Practical Implications:

    The study results are important to regulators, practitioners, and academics. The findings show that internal controls opinion shopping appears to occur among firms that have clean internal control opinions prior to a restatement. In addition, clients have the incentive to manipulate the audit process, via internal control opinion shopping, due to the increased focus and oversight on internal controls reporting. Finally, auditor dismissals that occur late in the fiscal period are more likely to be associated with internal control opinion shopping.   

    Citation:

    Newton, N. J., J. S. Persellin, D. Wang, and M. S. Wilkins. 2016. Internal Control Opinion Shopping and Audit Market Competition. The Accounting Review 91 (2): 603623.

    Keywords:
    opinion shopping, internal control weaknesses, audit opinion, audit quality, audit market competition
    Purpose of the Study:

    This study evaluates three research questions related to opinion shopping using the internal controls environment. There have been historical concerns with the presence of audit opinion shopping. However, most studies use going concern opinions in assessing audit clients retention and dismissal behavior. This study expands the opinion shopping environment to internal control reporting. Going concern opinions typically have a low base rate of occurrence and have leading indicators (poor growth, bankruptcy indicators, etc.). Internal control opinions do not have similar indicators that give rise to a warning of an adverse internal control opinion. From this background, the authors investigate: 1) whether internal control opinion shopping exist; 2) how audit market competition influences internal control opinion shopping; and 3) does the timing of an auditor dismissal indicate opinion shopping motivations.  

    This study also provides an avenue to evaluate opinion shopping in the period after the passage of the Sarbanes-Oxley Act. In addition, it highlights the unintended consequences of increased audit market competition. Finally, it lends support to recent regulatory concern over the decrease in material weakness assessments that may not be the caused by improved internal control environments.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit opinion and audit client data is from Compustat, Audit Analytics, and the Center for Research in Security Prices (CRSP). The sample period starts in 2005, the year after the implementation of SOX Section 404, and ends in 2011.

    Findings:
    • The authors find that audit clients are successful at internal control opinion shopping. The results show that clients would have received adverse internal control opinions at a higher rate if they made different auditor retention or dismissal choices.
    • When assessing the type of audit firm changes, the results suggest that opinion shopping may be more prevalent for audit clients that do not need the services of a Big 4 auditor.
    • Using three proxies for audit market concentration, the authors find a higher likelihood of opinion shopping in markets with high concentration.
    • The authors also find that auditor dismissals that occur in the third fiscal quarter are more likely to be associated with opinion shopping compared to auditor dismissals occurring prior to the end of the second quarter, especially in competitive markets.
    • The authors performed supplemental analyses to determine the association between internal control opinion shopping and going concern opinion shopping. They find that internal control opinions are less predictable and therefore more valuable than going concern opinions. They did find evidence of going concern opinion shopping in the pre-SOX period but not in the post-SOX period. This gives rise to the possibility that going concern reporting has a reduced role in auditor retention decisions after the introduction of SOX.
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Real Earnings Management before and after Reporting SOX 404...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Real Earnings Management before and after Reporting SOX 404 Material Weaknesses.
    Practical Implications:

    The authors identify a setting where there is a greater risk of value reduction for stockholders. Specifically, they find that companies which have material weaknesses in internal controls are more likely to engage in real earnings management, through inventory management and reducing discretionary expenditures. While these activities are allowed by GAAP, the findings of this paper suggest management may take actions that are detrimental to firm value.

    Citation:

    Jarvinen, T. and E. Myllymaki. 2016. Read Earnings Management before and after Reporting SOX 404 Material Weaknesses. Accounting Horizons 30 (1): 119-141.

    Keywords:
    internal control, material weakness, real earnings management
    Purpose of the Study:

    This study investigates whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The authors compare companies with effective internal controls to companies with existing material weaknesses, specifically looking at manipulation of real activities (particularly inventory overproduction). Such activity would suggest that companies strive to mitigate the expected negative reaction to disclosed material weaknesses by engagement in real earnings management.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies from 2004 to 2012. These company-years are split into three categories: 1) first year of internal control material weakness 2) years in which material weaknesses were disclosed as remediated 3) years in which material weaknesses were disclosed as nonremediated, and 4) company-years with effective internal controls. The authors observe differences in the extent of inventory management after controlling for various other predictors of real earnings management.

    Findings:

    The authors find:

    • Manipulation of real operational activities is associated with both the first-time existence of a material weakness and the subsequent disclosure of the material weakness.
    • Inventory overproduction is employed as an earnings management method before and after material weakness disclosure, and especially when the company has previously had poor financial performance.
    • Companies appear to cut discretionary expenditures when they have material weaknesses and when they have previously had poor financial performance.
    • Reduction in discretionary expenses is also used in the year when companies disclose and remediate material weaknesses.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    Earnings Management, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Internal control deficiencies in tax reporting: A detailed...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal control deficiencies in tax reporting: A detailed view.
    Practical Implications:

    The authors use a unique data set to shed light on characteristics which lead to material weaknesses, specifically in tax-related accounts relative to other accounts. The data (obtained from several international accounting firms) allows the authors to determine which characteristics of tax-related internal control deficiencies are different from other deficiencies, prevent them from being remediated, and cause them to rise to the level of a material weakness. Results suggest that tax deficiencies, relative to other account-specific deficiencies, are less likely to be remediated, more severe, and more likely to cause a financial misstatement. Tax-related deficiencies are less likely to get remediated by year-end if discovered by the auditor, if the control was deficient in design, or if the control pertained to monitoring. This paper underscores the importance of auditor involvement in internal control reporting in taxes.

    Citation:

    Graham, L. and J.C. Bedard. 2015. Internal Control Deficiencies in Tax Reporting: A Detailed View. Accounting Horizons 29 (4): 917-942.

    Keywords:
    Sarbanes-Oxley Section 404, internal controls, control activities, taxes, internal audit
    Purpose of the Study:

    The authors take advantage of a unique data source to attempt to glean information on tax-related internal control deficiencies. They analyze the characteristics of these deficiencies relative to other account-specific deficiencies to develop an understanding of the nature of tax control deficiencies. The authors then investigate the characteristics of tax-related deficiencies which lead to material weaknesses.

    Design/Method/ Approach:

    The authors collected data on approximately 2,500 account-specific internal control deficiencies from 74 public company engagements during 2004 and 2005. The data came from several international public accounting firms. The authors use archival regression analysis to analyze factors which cause significant differences between tax-related and other account-specific deficiencies, tax-related remediated and unremediated deficiencies, and tax-related material weaknesses and control deficiencies.

    Findings:

    The authors find:  

    • Relative to other accounts, tax internal control deficiencies are less likely to be remediated before year-end, more likely to be severe, and more likely to cause a financial statement misstatement.  
    • Remediation for tax internal control deficiencies is less likely when detected by the auditor.
    • Remediation failure is more prevalent for poorly designed controls, controls over the tax provision, and monitoring controls.  
    • Tax provisions and deferred tax controls have a higher potential for producing misstatements.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    A Risk Model to Opine on Internal Control.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    A Risk Model to Opine on Internal Control.
    Practical Implications:

    The auditor needs a different model for audits of internal control. The auditor needs to apply two different models in an integrated audit, the original model for the opinion on the financial statements and a different model for the opinion on internal controls.

    The author believes standard setters should sponsor research on an appropriate risk model for audits of internal control. Even before the research is completed, the standards could be enhanced in the following ways:
    • indicate that the original audit risk model is intended for use only in financial statement audits, not internal control audits;
    • write standards that consistently use risk terminology and are clear as to which risk they are discussing; and
    • provide guidance on the use of models in integrated audits.

    Citation:

    Akresh, A. D. 2010. A Risk Model to Opine on Internal Control. Accounting Horizons 24 (1): 65-78.

    Keywords:
    audit risk model, inherent risk, integrated audit, internal control, opinion, risk of material misstatement, risk of material weakness
    Purpose of the Study:

    The audit risk model has provided a conceptual framework for audits of financial statements for more than 40 years. Despite practical difficulties in implementation and criticisms of its theoretical foundation, the model has been fairly effective in helping auditors analyze risks and use that analysis to determine the nature, timing, and extent of audit procedures in audits of financial statements. In recent years, some auditors have tried to apply the audit risk model to audits of internal control, usually performed as parts of integrated audits. An integrated audit is an engagement where the auditor provides an opinion on the financial statements and an opinion on the effectiveness of internal control over financial reporting. It is integrated in the sense that the auditor tries to use some of the same procedures to meet both objectives.

    While the audit risk model was designed for audits of financial statements, it was not designed for audits of internal control. Audits of internal control are audits of processes rather than audits of outputs (financial statements). In addition, opinions on internal control do not rely on analytical procedures or on substantive tests of details. Because of this conceptual difference, the author asserts that audit risk model, as originally formulated, does not work as a coherent conceptual framework for audits of internal control. The need for a different risk model for internal control audits is not currently recognized in the auditing standards or in the auditing literature.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    For an integrated audit, the auditor would use the two models sequentially. The auditor would use the internal control risk model as a framework to determine the extent of control tests. Then the auditor would use the financial statement audit risk model as a framework to determine the extent of substantive testing.

    Future research could determine a more specific model based on how auditors perform these audits. Some research questions include, for example:

    • What models and approaches are currently used in practice? How does current practice compare with the model proposed and other models?
    • Are models useful in providing a conceptual framework for integrated audits?
    • What are the current practices for the auditor’s evaluation of inherent risk? How do those practices compare with risk models?  
    • How do auditors assess design and implementation of internal controls in light of inherent risk without considering operating effectiveness?
    • What are the current practices for the auditor’s evaluation of design, implementation, and operating effectiveness of the control environment? Are those practices adequate to effectively use in a risk model?
    Category:
    Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Material Weaknesses, Assessing Risk of Material Misstatement, Fraud Risk Models, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Effect of Social Confrontation on Individuals'...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.06 Reporting Ethics Breaches – Self & Others, 06.0 Risk and Risk Management, Including Fraud Risk, 07.0 Internal Control in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effect of Social Confrontation on Individuals' Intentions to Internally Report Fraud.
    Practical Implications:

    The study contributes by contending and showing that for fraudulent financial reporting, reporting intentions to different internal report recipients are influenced by a particular situational antecedent: unsuccessful social confrontation. The authors believe that the research and related findings will be useful for audit committees and other senior executives concerned with the timely reporting of fraud. Such groups not only are responsible for establishing internal reporting channels, but also are responsible for training and communicating with employees about what to do should they discover wrongdoing such as fraud. The evidence on the effects of social confrontation on reporting intentions for two different internal report recipients should be helpful in training and communicating with employees regarding what to do in response to discovering fraud.

    Citation:

    Kaplan, S. E., K. R. Pope, and J. A. Samuels. 2010. The Effect of Social Confrontation on Individuals' Intentions to Internally Report Fraud. Behavioral Research in Accounting 22 (2): 51-67.

    Keywords:
    fraudulent financial reporting, misappropriation of assets, reporting intentions, social confrontation, transgressor, fraud
    Purpose of the Study:

    Fraud is a serious social and economic problem that adversely affects a broad range of stakeholders, including audit committee and board members, top managers, employees, auditors, creditors, shareholders, and pensioners. In their 2006 Report to the Nation on Occupational Fraud and Abuse, The Association of Certified Fraud Examiners (ACFE) estimates annual fraud losses to be approximately $652 billion, approximately 5 percent of the annual revenues of all U.S. organization. Curtailing fraud, however, is a particularly challenging problem facing organizations. Detecting fraud is difficult because those engaging in fraud generally attempt to conceal their behavior, fraud is not a predictable event, and auditors often have limited experience detecting fraud.

    The purpose of this paper is to report the results of an experimental study that provides evidence on the impact of an unsuccessful social confrontation with a supervisor, apparently engaging in fraud, on one’s reporting intentions to two different, legitimate internal report recipients.

    Design/Method/ Approach:

    The experiment involved a 2 x 2 design. Participants were evening M.B.A. students from a major university. A total of 96 participants completed the instrument. Among these participants, the mean age was 28.1 years, and mean work experience was over six years. Two-thirds of the participants were male. The evidence was gathered prior to September 2010.  

    Findings:

    The findings indicate that participants’ reporting intentions were jointly influenced by social confrontation and the reporting channel. Specifically, reporting intentions to the supervisor’s supervisor were stronger than reporting intentions to the internal auditor following an unsuccessful social confrontation with the transgressor. In contrast, participants’ reporting intentions to the supervisor’s supervisor were not stronger than reporting intentions to the internal auditor when social confrontation had not occurred. This pattern was also observed when controlling for social desirability bias. Further, the effect of social confrontation on reporting intentions did not vary across the two different fraudulent acts. The results, based on two different fraudulent acts, allow the authors to generalize beyond a hypothetical study that included only one fraudulent act. Overall, the authors view the results as consistent with participants increasing their consideration of the report recipient’s power as the witness' exposure to risk increased. That is, following an unsuccessful social confrontation with the transgressor, the witness lost anonymity, which also increased the witness’ exposure to risk and potential retaliation from the transgressor. Further, the results suggest that increasing one’s emphasis on the report recipient’s power following an unsuccessful social confrontation may extend to various kinds of fraud.

    Category:
    Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Reporting Ethics Breaches - Self & Others
  • Jennifer M Mueller-Phillips
    Material Weakness Remediation and Earnings Quality: A...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of 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:
    Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency.
    Practical Implications:

    Combining the remediation and earnings quality analyses, the results imply that investors should be most concerned about MWs in information technology, segregation of duties, account reconciliations, taxation, revenues, and inventory. These types occur frequently and are slow to remediate; thus, their effects on financial reporting linger longer than others. Their link to near-term earnings quality is evident, as their remediation reduces abnormal accruals, and/or their lack of remediation in the following year further increases accruals. In general, these results suggest that financial statement users should adopt a more granular view of remediation, as successful remediation of some specific MWs can signal improvement in the quality of disclosed financial information even if other MWs remain unremediated.

    Citation:

    Bedard, J. C., R. Hoitash, U. Hoitash, and K. Westermann. 2012. Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency. Auditing: A Journal of Practice & Theory 31 (1): 57-78.

    Keywords:
    internal control, material weakness, remediation, Sarbanes-Oxley Section 404
    Purpose of the Study:

    This paper investigates the remediation likelihood of specific types of Sarbanes-Oxley (SOX) Section 404 material weaknesses (MWs) in internal control over financial reporting, and the association between remediation of specific types of MW with changes in earnings quality. This detailed look at remediation is important because companies disclose many types of control problems under Section 404, which likely vary in remediation difficulty as well as in impact on the financial reports. Because the goal of Section 404 is to improve financial reporting, it is important to identify specific areas in which control problems are less tractable and more influential. However, no study yet provides a detailed, comprehensive analysis of remediation by specific MW type. The authors first examine remediation rates by specific MW type, and investigate the association of MW type remediation with constraints identified by prior research. Next, they investigate which MW types have greater influence on earnings quality, by associating remediation of specific types with reductions in abnormal accruals. 

    Design/Method/ Approach:

    The authors obtain data on Section 404 MW from 20042006 from the AA database. They gather auditor information from AA, financial data from Compustat, and institutional ownership from Thomson Financial. The authors’ final sample consists of 567 observations that reported Section 404 MWs in either 2004 or 2005, representing 496 companies.

    Findings:
    • Finer classification does provide greater insight in showing that all specific entity-level MW types exhibit lower remediation likelihood.
    • Companies with fewer resources are less likely to remediate problems that involve large capital investments.
    • Companies with weaker governance are less likely to remediate problems linked by past research to earnings management.
    • Most companies with repeated disclosure of ineffective controls engaged in some successful remediation activity following initial disclosure, as only 3 percent had no success in remediating any MW types.
    • Certain types of MW have a greater impact on earnings quality, both when disclosed and when remediated, including some entity-level and some account-specific MW types. For most of these types, remediation reverses the higher abnormal accruals observed on disclosure. However, if remediation does not occur within a year from disclosure, abnormal accruals continue to increase for virtually all MW types.
    • Information technology and segregation of duties problems share an element of personnel reallocation, as the definition of information technology issues shown in includes specific reference to segregation of duties. Remediating such problems could involve hiring new workers, changing assignments or workflows, and thus could take more time than the remediation of other MW types. However, earnings quality is shown to increase in those companies that invest in solutions to these problems and reassign personnel appropriately.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    An Analysis of Multiple Consecutive Years of Material...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    An Analysis of Multiple Consecutive Years of Material Weaknesses in Internal Control.
    Practical Implications:

    The findings offer three important contributions to the existing literature. First, they indicate that MW reported in multiple consecutive years have a progressively larger and statistically significant negative impact on CE when firms that partially remediate are excluded from the sample. That is, the market notices that some firms are slow to remediate MW, whereas other firms take timely remediation steps to address MW. Second, the study shows that the number and specific types of MW are significant factors in understanding the relation between MW and CE. In fact, even if a firm does not remediate all MW in a given year, the market views favorably a reduction in the number of MW (i.e., partial remediation). Third, given the richness of the dataset, the current study helps to reconcile conflicting results in the prior literature on the effects of MW.

    Citation:

    Gordon, L. A., and A. L. Wilford. 2012. An Analysis of Multiple Consecutive Years of Material Weaknesses in Internal Control. Accounting Review 87 (6): 2027-2060.

    Keywords:
    cost of equity, internal control, material weaknesses, monitoring, remediation
    Purpose of the Study:

    The corporate scandals in the United States around the turn of the 21st century (e.g., Enron, WorldCom, Tyco, etc.) culminated in the passage of the Sarbanes-Oxley Act of 2002 (SOX). This Act requires firms to report material weaknesses in internal control (hereafter, MW) related to the reliability of financial reporting to the Securities and Exchange Commission (SEC). The SOX reporting requirements have given rise to a plethora of research, much of which has focused on the impact of MW on a firm’s cost of equity (hereafter, CE).

    The primary objective of the current study is to reexamine the relation between MW and CE. The authors direct particular emphasis to examining the way non-remediation of MW in multiple consecutive years affects CE, as well as the impact of remediation of MW on CE. They utilize a dataset that contains a large sample of second-year MW non-remediation cases, as well as third-, fourth-, and fifth-year non-remediation cases. Thus, this study differentiates between firms that report MW in only one year and firms that report MW in two or more consecutive years. The current study also considers the number of MW in each year, as well as the specific types of MW. 

    Design/Method/ Approach:

    The authors draw their sample from the Audit Analytics database, which includes all SOX Section 404 auditor assessment reports (24,806) filed with the SEC during the time period of November 2004 (the effective date for accelerated filers reporting under Section 404) through December 2009. The final sample is composed of 16,946 observations, which includes 1,140 observations with MW and 15,806 observations without MW (the control sample).

    Findings:

    The findings provide evidence that MW negatively impact a firm’s CE. The authors also find evidence of the value associated with remediation of MW. Specifically, the current study shows that the market penalty imposed upon a firm’s CE, in the absence of any remediation of MW, increases in relation to the number of consecutive years in which the firm reports MW. However, the results from the current study also show that the market views favorably a reduction in the number of MW reported (i.e., partial remediation). In other words, remediation is not an all-or-nothing proposition. Due to the use of a much larger and richer dataset, the current study helps to reconcile the mixed findings in earlier studies that examine the association between MW and CE.

    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses