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  • Jennifer M Mueller-Phillips
    An Intertemporal Analysis of Audit Fees and Section 404...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 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:
    An Intertemporal Analysis of Audit Fees and Section 404 Material Weaknesses
    Practical Implications:

    The findings suggest that audit fees respond to audit risk changes in the post-SOX environment, however this response is not immediate. These findings have important practical implications for audit regulators and for practicing auditors. These findings imply that audit firms are slow to reduce audit fees in the wake of remediation, which may be due to the documentation requirements imposed by PCAOB Auditing Standard No. 2 (“AS 2”). Notably, the PCAOB issued Auditing Standard No. 5 (“AS 5”) to supersede AS 2 in 2007 in an effort to improve implementation of the internal control requirements. In particular, AS 5 provided refinements to AS 2 meant to make the audit more scalable to a particular client and their corresponding risks. The findings presented in this study could be used as a baseline for evaluating whether AS 5 increased the responsiveness between audit fees and the underlying client risks. Audit practitioners must balance engagement risk management with public perceptions in order to maintain their reputations in the market for audit services. The findings presented here imply that audit fees are the most persistent in the presence of more severe material internal control weaknesses, consistent with predictions extending from the audit risk model.

    For more information on this study, please contact Matthew Hoag.

    Citation:

    Hoag, M. L. and C. W. Hollingsworth. 2011. An intertemporal analysis of audit fees and section 404 material weaknesses. Auditing: A Journal of Practice and Theory 30 (2): 173-200

    Keywords:
    SOX Section 404, internal control opinion, remediation of a material weakness, audit fees
    Purpose of the Study:

    In 2002, the Sarbanes-Oxley Act (“SOX”) was passed, which dramatically changed the financial reporting landscape following a wave of high-profile corporate frauds. Section 404 of SOX was perhaps the most significant reform, requiring that company management report on the effectiveness of internal control over financial reporting (404a), and requiring that the company’s external auditor complete a comprehensive evaluation of the internal controls and render an opinion on their effectiveness (404b). The mandated evaluation(s) of internal controls come at a significant cost to filers, as the initial evidence evaluated post-SOX pointed to a significant increase in audit fees for those companies subject to the provisions of SOX 404. These findings fueled criticism of Section 404 by opponents who argue the costs imposed an overwhelming burden on companies.

    This study investigates the impact of Section 404 on audit fees beyond the initial years of implementation. Specifically, it entails a longitudinal empirical examination of audit fees post-SOX within the theoretical context of the audit risk model. Audit fees should reflect both audit risk and audit effort. Using information provided through the newly mandated internal control opinions, this study tests how audit fees respond following either (1) the remediation of or (2) the failure to remediate internal control weaknesses by a company. The findings presented in this study should be of interest to audit industry regulators, academics performing audit fee research post-SOX, and to audit practitioners.

    Design/Method/ Approach:

    The sample is comprised from the population of accelerated filers subject to the provisions of SOX Section 404 spanning 2004 through 2007. The final sample consists of more than 13,500 company-year observations obtained from the Audit Analytics and Compustat databases with non-missing data necessary to perform the hypotheses tests. These tests employ OLS regression using a traditional audit fee model commonly used in audit pricing research and the test variables for varying types of Section 404 internal control opinions.

    Findings:
    • Using a levels model, audit fees are found to be consistently and significantly higher both in the presence of a material weakness in internal control and for companies that remediate a previous material weakness.
    • In a changes model, the findings suggest that audit fees decline significantly in each of the first two years after the remediation of a material weakness. Thus, the remediation of a material weakness leads to lower audit fees, but the corresponding decline does not occur immediately.
    • Three years after remediating a material weakness in internal control, a company still pays a 19 percent audit fee premium as compared to a company that never reported a material weakness. However, this premium does not differ significantly from the premium paid by these same companies in the year prior to the implementation of SOX 404, suggesting that auditors recognized these companies entailed heightened audit risk even prior to performing the internal control evaluation.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality
  • 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
    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
    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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  • Jennifer M Mueller-Phillips
    Auditor Reporting under Section 404: The Association between...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 07.0 Internal Control, 07.03 Reporting Material 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:
    Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions.
    Practical Implications:

    The uncertainties surrounding material weaknesses, the difficulty of auditing around some types of weaknesses, and the fact that the auditor must explain why it issued a clean report on the financial statements when it had issued a MWO, may cause the auditor to become conservative in its GCO decision, which is fairly ambiguous to start with. The study has particular relevance for policy makers and a need for a broader evaluation of the effects of SOX 404.

    Citation:

    Goh, B. W., Krishnan, J., & Li, D. 2013. Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions. Contemporary Accounting Research 30 (3): 970-995.

    Keywords:
    internal control, going concern, material weakness, ligation risk, SOX 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) requires companies’ independent auditors to provide an opinion on their clients’ internal control over financial reporting, in addition to the opinion on their clients’ financial. The purpose of Section 404 was primarily to provide information on the internal controls, thus enhancing investor understanding of the quality of firms’ financial reporting. The PCAOB also issued AS2 and AS5, which require an “integrated audit of internal control and financial statements” because the “objectives of and work involved in performing both an attestation of management’s assessment of internal control and an audit of the financial statements are closely interrelated.

    In this paper, the authors explore the association between the two audit opinions by examining whether the issuance of an adverse internal control material weakness opinion (MWO) influences, other things equal, the issuance of a going concern audit opinion (GCO) for financially stressed companies. Although the two opinions are the result of an integrated audit process, they serve different purposes. The GCO reflects the auditor’s view of the financial condition of its client, indicating whether (in the auditor’s opinion) the client will continue to be a going concern for a period of 12 months beyond the financial year end. The MWO reflects the auditor’s opinion on whether there are material weaknesses in internal control and therefore the likelihood that material misstatements in the financial statements will not be detected or prevented. Despite this difference, the two opinions could be connected.

    Design/Method/ Approach:

    The authors examine the association between the MWO and the GCO, using a sample of 1,110 financially stressed firms that reported internal control and audit opinions under SOX Section 404. They start with all public firms on COMPUSTAT with year-ends from 2004 to 2009, for which the authors could compute the Altman financial distress Z-score.  

    Findings:
    • The results suggest that the MWO issued under SOX Section 404 does increase the likelihood of a GCO, while the existence of material weaknesses in the Section 302 disclosures does not. Thus, auditors seem to respond to the uncertainties surrounding a material weakness by issuing a GCO only when they have to issue a MWO.
    • Fifty-six percent of the material weaknesses are classified as company-level weaknesses.
    • If an auditor is aware that the client is in the process of remediating the weakness, it is less likely to issue a GCO.
    • Firms with MWOs raise less capital in the subsequent financial year than firms without
      MWOs, providing some evidence that the issuance of a MWO does impair the firm’s ability to raise capital.
    • To examine whether it is the material weakness opinion rather than the presence of the material weakness that drives auditor behavior, the authors examine whether Section 302 material weakness disclosures are similarly associated with the GCO, but find no association.
    • Heightened concerns about litigation may be driving auditors to issue the GCO when they also issue a MWO.
    Category:
    Accountants' Reporting, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality, Litigation Risk, Reporting 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
    Does Ineffective Internal Control over Financial Reporting...
    research summary posted July 23, 2015 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:
    Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management.
    Practical Implications:

    This is first paper to examine the broad effect of ineffective ICFR on firm operations, and to establish a more direct link between MWIC over inventory and managers’ inventory management decisions. These results provide strong evidence that despite being largely unremarked upon as a potential benefit by managers or regulators, maintaining effective ICFR can provide an economically meaningful benefit to their firms’ operations. To the extent that there is a disconnect between actual and perceived benefits to maintaining effective ICFR, the recent regulatory move to exempt certain firms from internal control disclosure regulation may be premature. For a large sample of publicly traded firms, the authors provide evidence that the lack of proper inventory acquisition, tracking, or valuation systems has a direct impact on firms’ operating performance.

    Citation:

    Feng, Mei, Li, C., McVay, S. E., & Skaife, H. 2015. Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management. Accounting Review 90 (2): 529-557.

    Keywords:
    firm operations, internal control over financial reporting, inventory management
    Purpose of the Study:

    For the past decade, managers and regulators have debated the costs and benefits of Section 404 of the Sarbanes-Oxley Act, which requires disclosure of the effectiveness of internal control over financial reporting (ICFR). Managers appear to recognize that they provide higher-quality information as a result of effective ICFR, but they do not appear to recognize that they may also be using higher-quality information to make better operational decisions when they maintain effective ICFR because some controls play both operational and financial reporting roles.

    The purpose of this study is to assess the implications of ICFR for firm operations. When a firm fails to have adequate systems to control inventory purchase, tracking, and valuation, there is a greater likelihood of a mismatch between inventory supply and demand, leading to poorer operating performance. The authors investigate whether ineffective internal control (MWIC) over financial reporting has implications for firm operations by examining the association between inventory related material weaknesses in internal control over financial reporting and firms’ inventory management. 

    Design/Method/ Approach:

    The sample is comprised of 8,953 accelerated filer firm-years with available data on internal control effectiveness from 2004 to 2009 from the WRDS-based Audit Analytics and Compustat databases. Audit Analytics includes both the evaluation of ICFR as effective or ineffective, as well as the underlying reason(s) for any material weaknesses in internal control. The authors conduct multiple empirical analyses on the sample.

    Findings:
    • Firms with inventory-related MWIC, as identified in firms’ required internal control reports, have systematically slower inventory turnover and have a higher likelihood and magnitude of inventory impairments.
    • Inventory turnover ratios increase after firms remediate their inventory-tracking MWIC. Sales, gross margin, and cash flows from operations also improve when the weaknesses are remediated.
    • Importantly, the authors do not find an increase in inventory turnover ratios following the remediation of other types of MWIC.
    • The results of the inventory turnover and inventory impairment tests provide evidence that ineffective ICFR related to inventory has adverse consequences for inventory management, leading to less profitable operations.
    • Firms that correct their inventory-related MWIC report significant increases in sales, gross margin, and operating cash flows after remediation. Moreover, once firms remediate their inventory-related MWIC, the authors find that their gross profit and operating income are no longer significantly different from firms with effective ICFR.
    • The average return on assets is lower for firms with MWIC and that the remediation of MWIC is associated with higher future return on assets.
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Does SOX 404 Have Teeth? Consequences of the Failure to...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses.
    Practical Implications:

    The evidence showing that, all else equal, SEC sanctions following restatements are no more likely for firms that previously claimed to have effective internal controls (and, in some cases, are less likely) suggests that public enforcement of SOX 404 is unlikely to provide strong incentives to detect and disclose existing weaknesses. Also, the results showing that penalties stemming from various private mechanisms are more likely for firms that report their internal control weaknesses in advance of restatements suggests the existence of possible disincentives to detect and disclose existing weaknesses. Together, these results offer a potential explanation for why the majority of restatements occur at firms that previously claimed to have effective controls.

    Citation:

    Rice, S. C., Weber, D. P., & Wu, Biyu. 2015. Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses. Accounting Review 90 (3): 1169-1200.

    Keywords:
    enforcement, internal controls, restatements, Sarbanes-Oxley Act, SOX 404
    Purpose of the Study:

    In this paper, the authors examine several potential consequences of failing to report existing control weaknesses as required by Section 404 of the Sarbanes-Oxley Act of 2002. The investigation is motivated largely by recent concerns about the reliability of SOX 404 reports and related evidence of firms claiming to have effective internal controls over financial reporting when they instead have material weaknesses in those controls. Understanding the consequences of such reporting failures is important because it bears on managers’ and auditors’ incentives to detect and disclose internal control weaknesses and, thus, on the effectiveness of SOX 404 in achieving its intended goal of boosting investor confidence in the reliability of financial reports. This importance is underscored by the high costs of control audits, which have made these requirements the most controversial aspect of SOX. Under SOX 404, firms and their auditors are required to provide formal opinions on the effectiveness of internal controls over financial reporting within the annual 10-K filing. However, concerns have begun to emerge about the reliability of SOX 404 reports, and the effectiveness of SOX 404 in providing advance warning of potential accounting problems remains unclear.

    Design/Method/ Approach:

    The authors use Audit Analytics to create a full sample of 659 observations of firms that are subject to SOX 404 and that also have restatements. The full sample includes 134 firms that reported the existence of material weaknesses prior to their restatements and 525 that did not. The authors extracted all restatements for U.S. incorporated firms announced by the end of 2010 that include annual reporting periods ending after the effective date of SOX 404 (November 14, 2004).

    Findings:
    • The likelihood of receiving an Accounting and Auditing Enforcement Release (AAER) following a restatement is similar regardless of whether firms had reported their control weaknesses or instead claimed that their controls were effective prior to the restatement. 
    • The prior acknowledgment of control weaknesses increases the likelihood of receiving an AAER by about 6 percent.
    • The authors find no evidence of vigorous public enforcement of SOX 404; instead, the evidence is suggestive of the opposite: that reported control weaknesses aid the SEC in identifying cases where potential enforcement actions are likely to succeed and make it difficult for management to claim they were unaware of the problems that led to the restatement.
    • Class action lawsuits are 5 to 10 percent more likely when firms report internal control weaknesses prior to restatements. This is true even when the authors remove lawsuits that are later dismissed.
    • The top management turnover is 15 to 26 percent more likely at firms that report control weaknesses prior to their restatements. This result holds for both CEOs and CFOs.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Restatements
  • Jennifer M Mueller-Phillips
    Home Country Investor Protection, Ownership Structure and...
    research summary posted July 29, 2015 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:
    Home Country Investor Protection, Ownership Structure and Cross-Listed Firms’ Compliance with SOX-Mandated Internal Control Disclosures.
    Practical Implications:

    The results carry important implications for regulators, investors, and researchers. The findings suggest both firm-level corporate governance and home country investor protection still matter in explaining the disclosure behavior of cross-listed firms. Hence, it may be warranted for U.S. securities regulators to devote more resources to monitoring the financial disclosure quality of CONTROL_WEDGE firms from weak investor protection countries. The results suggest that U.S. investors should pay closer attention to the financial disclosure quality of cross-listed firms, especially CONTROL_WEDGE firms from weak investor protection countries. This is important because the recent accounting frauds involving cross-listed firms suggest that U.S. investors might not have paid sufficient attention to the disclosure quality, and as a result suffered significant economic losses after the revelation of the accounting frauds.

    Citation:

    Gong, G., Ke, B., & Yu, Y. 2013. Home Country Investor Protection, Ownership Structure and Cross-Listed Firms' Compliance with SOX-Mandated Internal Control Deficiency Disclosures. Contemporary Accounting Research 30 (4): 1490-1523. 

    Keywords:
    investor protection, Sarbanes-Oxley, internal controls
    Purpose of the Study:

    The objective of this study is to assess the effects of home country investor protection and ownership structure on the Sarbanes-Oxley Act (SOX)mandated internal control deficiency (ICD) disclosures by foreign firms that are listed on the U.S. stock exchanges (hereafter referred to as cross-listed firms). In this study, the authors focus on SOX-mandated internal control disclosure provisions, because internal control systems play a crucial role in ensuring the reliability of financial reporting. It is widely recognized that material internal control weaknesses give management the flexibility to manipulate financial reporting to conceal their expropriation activities. In addition, the SOX-mandated internal control disclosure provisions are regarded as the most costly and controversial provisions of SOX. Therefore, it is important to analyze cross-listed firms’ compliance with SOX-mandated ICD disclosure requirements.

    The authors focus on the ICD disclosures during the Section 302 reporting regime and examine whether cross-listed firms whose management is the controlling shareholder of the firm and holds greater voting rights than cash flow rights (denoted as CONTROL_WEDGE firms) have a higher likelihood of misreporting ICDs than other cross-listed firms, especially for cross-listed firms domiciled in weak investor protection countries where managers’ ICD misreporting faces fewer constraints.

    Design/Method/ Approach:

    The sample is restricted to cross-listed firms that are listed on the three major U.S. stock exchanges as of the end of 2002. The sample includes both American Depository Receipts (ADRs) and foreign firms directly listed on the U.S. stock. Using COMPUSTAT, SEC filings, CRSP, and Audit Analytics, the authors created a sample of 355 unique cross-listed firms, of which 41 firms disclosed at least one material weakness during the Section 302 reporting regime.

    Findings:

    For cross-listed firms domiciled in weak investor protection countries, the authors find the following results: 

    • CONTROL_WEDGE firms have a higher likelihood of ICD misreporting than other firms during the Section 302 reporting regime. In addition, the likelihood of ICD misreporting is negatively associated with earnings quality during the Section 302 reporting regime.
    • The likelihood of ICD misreporting is positively associated with the likelihood of voluntary deregistration from the SEC prior to the Section 404 effective date.
    • For cross-listed firms that chose not to deregister, the likelihood of ICD misreporting is positively associated with the likelihood of reporting previously undisclosed ICDs during the Section 404 reporting regime.

    The authors do not find similar results for cross-listed firms domiciled in strong investor protection countries. Overall, the results are consistent with the hypothesis that management of CONTROL_WEDGE firms domiciled in weak investor protection countries is reluctant to disclose ICDs in order to protect its private control benefits. In addition, the results suggest that Section 404 is effective in weeding out cross-listed firms whose management has an incentive to hide ICDs or forcing cross-listed firms to truthfully reveal their ICDs.

     

    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    Internal Control Reporting and Audit Report Lags: Further...
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Control Reporting and Audit Report Lags: Further Evidence
    Practical Implications:
    • This study’s results, “provide empirical evidence about the extent of additional audit effort associated with clients’ internal control problems and the benefits of reduced audit report lag from remediation of such problems.
    • This study suggests, “that there are significant differences in the market for audit services for accelerated and non-accelerated firms, and underscores the need to separately analyze the two types of firms.”

    For more information on this study, please contact Vishal Munsif K.

    Citation:

    Vishal Munsif,K. Raghunandan,Dasaratha V. Rama (2012) Internal Control Reporting and Audit Report Lags: Further Evidence. AUDITING: A Journal of Practice & Theory: August 2012, Vol. 31, No. 3, pp. 203-218.

    Keywords:
    audit report lag; Section 404; internal control.
    Purpose of the Study:

    This study was performed as an examination of, “the association between internal control weaknesses and audit report lags for (1) a later time period; specifically, the fifth and sixth years of Section 404 reporting, and (2) both accelerated and non-accelerated filers.”

    As stated in its introduction, this study was motivated by several factors:

    • Additional evidence from future years would be useful to determine the extent to which audit report lag is higher for clients with different types of Section 404 reports, particularly since report lags are strongly related to the extent of the auditor’s work.
    • There have been many changes in the audit environment since the first year of internal control audits. It is not clear how these changes could have impacted the audit lag for firms with material weaknesses.
    • Study constitutes an important extension of [prior literature], since the requirements of Section 404(a) for non-accelerated filers were not in place during the sample period of prior literature.
    • While many studies have examined issues related to internal control problems, research related to the remediation of discovered problems is relatively sparse
    Design/Method/ Approach:

    This study used a regression model to examine three research questions:

    • RQ1: What is the audit report lag associated with material weaknesses in internal control in years five and six of Section 404 reporting?
    • RQ2: Is the audit report lag associated with material weaknesses in internal control shorter for non-accelerated filers than for accelerated filers?
    • RQ3: Is the audit report lag for clients that remediated material internal control weaknesses:
    • (a) lower than for clients that did not remediate such weaknesses? (b) higher than for clients that did not report such problems in the prior year?

    Data was procured from the Audit Analytics database for information about Section 404 reports, auditor information, and audit report date for years 2008 and 2009. 

    Findings:
    • In 2008, the increase in audit report lag in the presence of material weaknesses in internal control is lower for non-accelerated filers as compared to accelerated filers
    • While the effect of a material internal control weakness on audit report lag is significantly lower in 2009 than in 2008 for accelerated filers, there is no such change for non-accelerated filers.
    • For firms remediating previously disclosed internal control problems, there is a significant decline in audit report lag; yet, the remediating firms continue to have higher reporting lags than firms that had clean Section404 opinions in both years.
    • At least with respect to the effect of internal control problems on audit report lag, the ‘‘small accelerated filers’’ (defined as those with market capitalization less than $250 million) are treated by the auditors as being (1) substantively similar to other accelerated filers, and (2) quite distinct from non-accelerated filers.
    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality