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  • 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
  • Jennifer M Mueller-Phillips
    The Role of the Internal Audit Function in the Disclosure of...
    research summary posted March 4, 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Role of the Internal Audit Function in the Disclosure of Material Weaknesses
    Practical Implications:

    Results indicate that the education level of IAF staff and the extent to which the IAF incorporates quality assurance techniques into fieldwork, audits activities related to financial reporting, and monitors the remediation of previously identified control problems are negatively associated with MW disclosures.

    The timing of Section 404 work and the nature of follow-up monitoring suggest that these aspects of IAF quality help prevent the existence of MWs. The IAF practices of grading audit engagements and coordinating with external auditors are both positively associated with MW disclosures. The positive relations suggest that these activities increase the effectiveness of Section 404 compliance processes and thereby increase the likelihood that extant MWs will be detected and disclosed. Together, this study’s results have important implications for managers responsible for determining IAF staffing and the structure of IAF activities, external auditors who perform Section 404 work, and standard-setters who provide Section 404 guidance. Moreover, the evidence that the IAF affects the financial reporting process lends support to the requirement that NYSE-listed companies maintain an internal audit function

    For more information on this study, please contact Shu Lin.

    Citation:

    Lin, S., M. Pizzini, M. Vargus, and I. R. Bardhan. 2011. The Role of the Internal Audit Function in the Disclosure of Material Weaknesses. The Accounting Review 86 (1): 287-323. 

    Keywords:
    internal audit function; material weakness; corporate governance; internal control over financial reporting
    Purpose of the Study:

    This study investigates the role that a firm’s internal audit function (IAF) plays in the disclosure of material weaknesses reported under Section 404 of the Sarbanes-Oxley Act of 2002. Despite the IAF’s duties surrounding internal control over financial reporting (ICFR), few researchers have empirically investigated the IAF’s role in the financial reporting process. A notable exception is a recent study by Prawitt et al. (2009), which provides evidence that the IAF can improve reporting quality by mitigating potential weaknesses in incentive system design. This study complements theirs, in that the authors examine the association between the IAF and ICFR through prevention and detection of material weaknesses. Accordingly, it helps fill an important gap in the literature regarding the influence of the IAF on the quality of the financial reporting process.

    Design/Method/ Approach:

    To examine the relation between material weakness (MW) disclosures and various IAF attributes and activities, the authors conduct the tests using data on 214 firms that provided detailed responses to the IIA’s Global Auditing Information Network (GAIN) survey for 2003–2004. 45 firms that disclosed at least one MW under SOX Section 404 are identified.

    The researchers draw on Prawitt et al. (2009) and professional guidance to develop measures of IAF quality (AICPA 1991; IIA 2008). These suggest that IAF quality measures encompass (1) competence, (2) objectivity, (3) relative investment in the IAF, and (4) the nature and scope of IAF activities. The authors group the first three measures together as IAF attributes because these three address the characteristics of organizations performing internal audit activities. The last construct, the nature and scope of IAF activities, captures IAF practices that are guided by Performance Standards.

    Findings:

    The sample contains a high concentration of firms in regulated industries, and the sample firms are significantly larger, older, and more profitable than those in the Compustat universe. Approximately 21 percent of our sample firms disclosed at least one material weakness during the period November 2004 through December 2006.

    Univariate tests of differences between the partitions indicate that material weakness firms are more likely to have internal auditors that issue grades in their audit reports, and have fewer financial reporting activities audited by their internal auditors. Consistent with prior research, material weakness firms have significantly higher incidences of restructuring activities and losses, lower cash flows from operations, and higher bankruptcy risk.

    There is significant correlation between IAF attributes and activities, and little support for associations between MW disclosures and the IAF quality attributes of competence, objectivity, and IAF investment. However, there is a strong support for associations between MW disclosures and the following IAF activities. Firms with IAFs that follow-up on extant control problems are significantly less likely to report a material weakness. It is also found that firms are significantly more likely to report a material weakness when the IAF coordinates audit activities with the external auditors.

    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Influence of Auditor and Client Section 404 Processes on...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 07.0 Internal Control, 07.04 Assessing Remediation of Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Influence of Auditor and Client Section 404 Processes on Remediation of Internal Control Deficiencies at All Levels of Severity
    Practical Implications:

    Overall, this study suggests that remediation of detected ICFR problems prior to the balance sheet date is one benefit of Section 404 activity to stakeholders. This study’s finding of lower remediation of auditor-discovered ICDs implies that client personnel missed the control flaw in their own Section 404(a) process, so may lack the expertise to remediate the problem. This calls into question the current policy of relying on Section 404(a) alone for non-accelerated filer (most public companies). Further, this study’s results on client processes imply that the most important factors affecting remediation are not who directly manages the process, but rather the client’s organization of the process in making an early start and coordinating the effort with IT personnel.

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

    Citation:

    Graham, L., and J.C. Bedard. 2013. The Influence of Auditor and Client Section 404 Processes on Remediation of Internal Control Deficiencies at All Levels of Severity. Auditing: A Journal of Practice & Theory 32(4): 45-69

    Keywords:
    Remediation; Sarbanes-Oxley Section 404; internal control deficiencies.
    Purpose of the Study:

    This paper investigates remediation of a comprehensive census of deficiencies in internal control over financial reporting (ICFR) detected in a sample of companies under Section 404 of the Sarbanes-Oxley Act. Internal control weaknesses have often been implicated in fraud and business failure. Section 404 was designed to improve corporate controls by requiring company management and external auditors to document, test and report ICFR. Research on the costs and benefits of Section 404 remains important, due to continued pressure to reduce financial regulation. Several prior studies examine remediation of publicly disclosed material weaknesses (MWs). However, auditors and company personnel detect many internal control deficiencies (ICDs), of which relatively few are MWs. Because publicly available data do not reveal non-MW ICDs, research has not yet considered the nature and extent of remediation activity that takes place behind the scenes. We study remediation of all ICDs, whether publicly reported or not, among companies with effective, as well as ineffective controls. We further address the issue of the benefits of Section 404(b) by measuring the impact of auditor activity in the remediation process. In addition, we directly examine the impact of whether, at the time of the auditor’s assessment, the flawed control had already failed to prevent a misstatement in the accounts.

    Design/Method/ Approach:

    This study is based on a sample of almost 4,000 ICDs detected by audit firm or client personnel in 76 engagements on 44 different companies in 2004–2005 (the first two years of compliance with SOX 404(b)), obtained from engagement teams at several large auditing firms. Sample companies have a mix of effective and ineffective control reports that is similar to the population as whole during that period. 

    Findings:
    • Prior research using publicly available finds substantial remediation of MWs from one reporting year to the next. In contrast, the authors of this paper find relatively low remediation within the year, between time of identification and the balance sheet date. Thus, a number of control flaws of varying severity remain to affect financial reporting quality in the following year.
    • The authors find higher remediation rates when there is an earlier start to control testing and better integration of the client’s IT personnel into the Section 404 process.
    • The authors also find lower remediation rates among auditor-discovered ICDs, detection through substantive tests (often performed late in the year or after year-end), and by the presence of a previously unknown misstatement that has already resulted from a control failure. The combination of auditor detection and an associated misstatement is particularly problematic, as this implies that not only did the client miss the problem in its own testing, but also the auditor has already linked it to an account misstatement, elevating its importance. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Assessing Remediation of Weaknesses, Impact of 404
  • Jennifer M Mueller-Phillips
    Determinants of the Persistence of Internal Control...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.04 Assessing Remediation of Weaknesses in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Determinants of the Persistence of Internal Control Weaknesses
    Practical Implications:

    Effective corporate governance of both the IT and non-IT domains is pivotal in establishing and maintaining strong internal controls over financial reporting. While credit agencies examine entity-level deficiencies as a possible indicator for downgrading a firm’s rating, account-level deficiencies are associated with long-term effects on internal control as well.

    Consideration of the types of MWs and the specific underlying deficiencies should be important to interested stakeholders: auditors, as they assess and evaluate risk and controls; rating agencies, as they evaluate credit worthiness; investors and analysts, as they evaluate the value of the firm; and management and audit committees, as they consider investments in controls.

    For more information on this study, please contact Marcia Weidenmier Watson.
     

    Citation:

    Klamm, B. K., K. W. Kobelsky, and M. W. Watson. Determinants of the Persistence of Internal Control Weaknesses. Accounting Horizons 26 (2): 307-333.

    Keywords:
    Sarbanes-Oxley Act of 2002; internal controls; information technology
    Purpose of the Study:

    This paper analyzes the degree to which material weaknesses (MWs) in internal control reported under the Sarbanes-Oxley Act of 2002 (SOX) affect the future reporting of MWs.

    Design/Method/ Approach:
    • The authors use SOX 404 reports filed between September 20, 2004, and December 31, 2009.
    • The authors examine information technology (IT) and non-IT MWs and their breakdown into specific IT-related entity-level, non-IT-related entity-level, and account-level deficiencies. They then examine the relationship of all of these to: (1) the future number of MWs and (2) the future number of years with an ineffective internal control report.
       
    Findings:
    • The presence and number of MW’s (IT and non-IT) deficiencies are all positively related to the future number of MWs as well as the future number of years in which MWs are reported.
    • Firms reporting account-level (non-IT entity-level) deficiencies have 129 percent (192) more future MWs than firms not reporting that type of control deficiency.
    • Firms reporting an IT entity-level control deficiency also report 127 percent more future MWs than firms not reporting that type of deficiency.
    • The presence of specific entity-level deficiencies relating to training, senior management, and IT control environment in the first year reporting a MW are associated with the future reporting of MWs.
    • The presence of an IT control environment deficiency has the largest effect of all deficiencies, so that firms reporting it have nearly twice as many future MWs and take 56 percent longer to fully resolve MWs than other firms.
    • The analyses also reveal a negative relation between the future number of years of MWs and Big 6 auditor affiliation and ROA, indicating that auditor expertise, as well as financial resources, helps a firm eliminate MWs more quickly.
    • There is also a positive relation between complexity, as measured by the number of firm operating segments and acquisitions, and future MWs, indicating that firms with greater scope face a greater challenge in eliminating control weaknesses.
       
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Assessing Remediation of Weaknesses, Impact of SOX
  • 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
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    Audit Fees after Remediation of Internal Control Weaknesses
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 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:
    Audit Fees after Remediation of Internal Control Weaknesses
    Practical Implications:

    The results of this study are important for companies and regulators that are trying to understand the true costs for firms with an adverse report on internal control. It further informs the continuing debate regarding Section 404 of SOX and provides some evidence that these premiums can be as high as 30 (20) percent in the first(second) year after remediation when compared to firms that only have clean Section 404 reports. Lastly, this provides opportunities for future research investigating how long it takes audit fees to return the level of companies that only receive clean opinions and whether or not this premium relates to additional audit work or a risk premium.

    Citation:

    Munsif, V., K. Raghunandan, D. V. Rama, and M. Singhvi. 2011. Audit Fees after Remediation of Internal Control Weaknesses.  Accounting Horizons 25 (1):  87-105. 

    Keywords:
    internal controls; audit fees; material weakness; remediation
    Purpose of the Study:

    Firms that receive an adverse report on internal control under Section 404 of SOX typically experience significant costs, such as a higher cost of capital. Additionally, these companies reporting material weaknesses also tend pay higher audit fees which is consistent with the belief that ineffective internal controls leads to a higher propensity for misstatements. Conversely, it is logical to expect that these higher fees will return to normalized levels if the weakness is remediated; however, recent evidence in regards to control problems disclosed pursuant to Section 302 of SOX has been contrary to this belief. This study attempts to provide clarification to these findings and investigates whether audit fees return to previous levels after the remediation of material weaknesses disclosed under Section 404 of SOX. It is important to recognize that in contrast to prior research which examines fees in the year of (or year prior to) remediation, this study examines the audit fees in the years following the remediation  in order to determine if the higher fees that the company pays in year of disclosure remain at a premium even two or three years after remediation.

    Design/Method/ Approach:

    The authors use data on SEC registrants and collect information on audit fees and Section 404 disclosures for the first four years of internal control reporting (2004-2007). The authors exclude financial sector companies, as well as, foreign firms and compare audit fees over the four year period of analysis for SEC registrants with fiscal year-ends from November 15 through May 31 of the following calendar year. The authors examine audit fees in years subsequent to the remediation of internal control weaknesses in order to determine whether auditors continue to view firms that had ever received an adverse Section 404 opinion as being “tainted,” such that even after remediating the problem, firms continue to pay an audit fee premium.

    Findings:

    The authors find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years of internal control reporting. The authors also show that general weaknesses have a higher effect on audit fees than only account-specific internal control weaknesses.

    Category:
    Internal Control, Accountants' Reporting
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Consequences of Adverse 404 Opinions
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  • Jennifer M Mueller-Phillips
    The Failure to Remediate Previously Disclosed Material...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 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:
    The Failure to Remediate Previously Disclosed Material Weaknesses in Internal Controls
    Practical Implications:

    These findings are particularly important for CPA firms doing consulting. By better understanding the cost associated with failure to remediate, firms can better negotiate fees and demonstrate the value they add in helping firms to remediate material weaknesses.

    Citation:

    Hammersley, J.S., L.A. Myers and J. Zhou. 2012. The Failure to Remediate Previously Disclosed Material Weaknesses in Internal Controls. Auditing: A Journal of Practice and Theory. (31) 2: 73–111.

    Keywords:
    Material weaknesses; internal controls; remediation; Sarbanes-Oxley Act
    Purpose of the Study:

    This paper looks at firms that have disclosed a material weakness in their internal control systems and compares firms that remediate the weakness by the next reporting period to those that do not. Specifically, the paper explores the characteristics of firms that do not remediate and the consequences those firms face.

    Design/Method/ Approach:

    The authors use data from Audit Analytics to identify firms that report a material weakness in 2006 and then match those firms to Compustat and I/B/E/S databases to ensure that firms which lack the data necessary to compare firms that remediate to firms that do not are dropped from the sample.

    Findings:

    The main results of this study pertain to (1) characteristics of firms that do not remediate and (2) consequences to not remediating and are as follows:

    Firms do not remediate when:

    • The problem is more pervasive
    • When their operations are more complex

    Firms that do not remediate are more likely to face (among other things):

    • Increased audit feeds
    • Increased risk of auditor resignation
    • Increased cost of equity capital
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses
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