Does it pay to remediate? An analysis of the internal and external benefits of remediation

We examine the internal and external benefits associated with the remediation, or correction, of material weaknesses in internal controls over financial reporting. We document that firms that remediate material weaknesses exhibit higher performance and reporting quality than firms that never reported any weaknesses. These results suggest that the remediation of material weaknesses, an indication of an improved internal control system, is associated with internal benefits. Moreover, we find that remediating firms experience significantly lower audit fees and betas (i.e. external costs) than non-material weakness firms. However, these lower external costs are contingent on a firm's level of performance and information quality. These results suggest that remediation offers firms a chance to re-examine and correct their internal controls and this leads to better performance and information quality. Furthermore, external stakeholders are not necessarily swayed by remediation alone but need to observe tangible evidence of the corrected internal control system before reassessing a firm's risk downward.     

Analysts' Cash Flow Forecasts,Audit Effort,and Audit Opinions on Internal Control

We examine the economic impact of analysts’ cash flow forecasts by looking at how external auditors respond to financial analysts’ issuance of cash flow forecasts. Using a differences‐in‐differences approach, we find that financial analysts’ initiation of cash flow forecasts leads to reduced auditor fees and audit report lags. Moreover, after cash flow forecast initiation, firms report fewer Section 404(b) internal control weakness disclosures. These findings suggest that cash flow forecasts constrain earnings manipulation and improve management accounting behavior, thereby reducing inherent and control risk and strengthening firms’ internal control over financial reporting.     

Characteristics of non-audit services and financial restatements in Malaysia

Various types of purchased non-audit services (NAS) and their recurring nature affect the likelihood of financial statement restatements in Malaysia. Based on 953 firm-year observations during the period 2007–2009, evidence of a negative relationship between non-audit fees and financial statement restatements is provided. The purchase of both tax-related and audit-related NAS decreases the likelihood of restatements. Recurring (as opposed to non-recurring) tax-related and audit-related NAS are negatively and significantly related to the likelihood of restatements. These findings support our hypothesis that both types of NAS and their recurrence provide knowledge spillover, which enhances audit and financial reporting quality. When considering institutional settings, we find that politically connected firms are more likely to require financial restatements than non-politically connected firms, while audit committee independence and the purchase of tax-related, recurring tax-related and other NAS decrease this likelihood. The purchase of audit-related and recurring audit-related NAS and non-recurring other NAS decreases the likelihood of restatements for non-politically connected firms.     

财务报告内部控制审计收费的影响因素——基于中国内地在美上市公司的实证研究

本文以中国内地在美国上市的公司为样本,研究了财务报告内部控制审计收费的影响因素及影响方式。研究发现,公司规模、会计师事务所的声誉与审计收费显著正相关;公司财务报告内部控制的复杂性与审计收费正相关,而且,在会计师事务所看来,相对于有传统的常规业务流程的公司,没有传统的常规业务流程的公司的财务报告内部控制更复杂。研究还发现,由于风险导向审计模式的应用、SOX法案特定的制度安排以及财务报告内部控制的特性,公司财务报告内部控制失效的风险与审计收费之间并不是以往研究结论和常识中的正相关,而是显著负相关,即上一年披露了财务报告内部控制重大缺陷的公司的审计收费反而低,产生了"极反效应"。     

The role of voluntary internal control reporting in earnings quality: Evidence from China

Using discretionary accruals to proxy for earnings quality, this study investigates whether and how the first voluntary internal control reporting in 2007 is associated with earnings quality in China. We find that earnings quality is higher in 2007, yet not in 2006, for public companies issuing a first-time voluntary unqualified internal control report, compared with listed firms not issuing an internal control report. Our findings are consistent with a signalling of performance explanation and inconsistent with a signalling of effectiveness explanation. We also find that earnings quality is lower for public companies issuing an internal control report mentioning a weakness, compared with public companies not issuing an internal control report. Overall, our study suggests that public companies conduct diligent self-assessments when issuing a first-time voluntary unqualified internal control report. Consequently, there is an improvement in earnings quality.     

The Impact of Financial Reporting Quality on Debt Contracting: Evidence from Internal Control Weakness Reports

We examine the effect of financial reporting quality on the trade‐off between monitoring mechanisms used by lenders. We rely on Sarbanes‐Oxley internal control reports to measure financial reporting quality. We find that when a firm experiences a material internal control weakness, lenders decrease their use of financial covenants and financial‐ratio‐based performance pricing provisions and substitute them with alternatives, such as price and security protections and credit‐rating‐based performance pricing provisions. We also find that changes in debt contract design following internal control weaknesses are substantially different from those following restatements, where lenders impose tighter monitoring on managers’ actions, but do not decrease their use of financial statement numbers.     

财务报表重述与财务报告内部控制评价——基于戴尔公司案例的分析

本文在回顾相关文献的基础上,以戴尔公司为案例对象,讨论了因供应商大额支付款项错报、准备金不当会计处理造成的财务报表重述事项,并将财务报表重述与财务报告内部控制重大缺陷联系起来,分析了戴尔公司财务报告内部控制管理层评价及审计师报告,最后从正确看待财务报表重述与重大缺陷的关系、正确理解和应用管理层的评价报告和审计师的审计意见、充分理解 "内部控制是一个过程"的理念等方面进行了评述,以期为我国上市公司更好实施内部控制规范提供借鉴。     

The Impact of Disclosures of Internal Control Weaknesses and Remediations on Investors' Perceptions of Earnings Quality

We hypothesize and find that firms making SOX‐mandated disclosures of material weaknesses in internal control over financial reporting (ICOFR) exhibit lower investor‐perceived earnings quality (IPEQ) than nondisclosers. We measure IPEQ using e‐loading, a market‐returns–based representation of earnings quality developed by Ecker, Francis, Kim, Olsson, and Schipper (2006). Firms do not exhibit decreases in IPEQ after initially disclosing material weaknesses. This is consistent with investors having anticipated ICOFR strength based on observable firm characteristics. However, firms exhibit increases in IPEQ after receiving their first clean audit reports that confirm the remediation of previously disclosed weaknesses. This indicates that, although investors do not find initial weakness disclosures to be incrementally informative, SOX motivates firms to remediate weak controls and provides a venue for credible remediation disclosures, thus enhancing investors' perception of financial reporting reliability. These findings are consistent with the existence of regulatory benefits associated with SOX's internal control disclosure and audit requirements.     

Trust and Financial Reporting Quality

Using unique survey data from Great Place to Work® Institute, we investigate the association of intraorganizational trust (i.e., employees’ trust in management) with three aspects of financial reporting: accruals quality, misstatements, and internal control quality. We find that trust is associated with better accrual quality, lower likelihood of financial statement misstatements, and lower likelihood of internal control material weakness disclosures. However, these effects are not uniform across all companies. Consistent with trust improving financial reporting quality through improved information production and information sharing, we find that trust is significantly associated with financial reporting quality in relatively decentralized firms, but not in firms that are relatively centralized. Our results are robust to several analyses that attempt to control for potential alternative explanations.     

CFOs’ and public accountants’ perceptions of material weaknesses in internal control areas as required by Section 404 of the Sarbanes-Oxley act

One of the most controversial aspects of the Sarbanes-Oxley Act of 2002 (SOA) is related to Section 404, which requires management to assess the entity’s internal controls, and then its independent auditor to attest and report on management’s assessment. The auditing standard governing this requirement was promulgated by the Public Company Accounting Oversight Board (PCAOB). Its title is Auditing Standard (AS) No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements [Public Company Accounting Oversight Board (PCAOB) (2004). An audit of internal control over financial reporting performed in conjunction with an audit of financial statements. Auditing Standard No. 2, Washington, DC: PCAOB]. AS No. 2 requires, among other things, that management must disclose any “material weaknesses” in internal controls. However, absent any guidance other than definitions from the PCAOB, management and independent auditors are left to their own judgment to define and recognize “material weakness in internal control” or “significant deficiency” while implementing AS No. 2. The research question, then, becomes to what extent, if any, are weaknesses in internal control over financial reporting consistently assessed, recognized and agreed upon by both parties? Or does their professional judgment and point of view cause different perceptions? Most of the Section 404 research has focused on the characteristics of the material weaknesses disclosed (and the capital market or other impacts of reported material weaknesses). This study, in contrast, is behavioral in context, and examines the perceptions of CFOs and CPAs as to whether they believe an internal control material weakness exists under four independent scenarios. The results indicate that the CPAs were significantly more conservative in their assessments in two of the four cases.     

Does internal control over financial reporting really alleviate agency conflicts?

This study investigates whether internal control over financial reporting (ICFR) alleviates the managerial expropriation of corporate resources. We do this by examining the potential effects of material weaknesses in internal control on the values of corporate cash holdings and capital expenditures. Our findings suggest that ICFR facilitates the scrutiny and discipline of capital markets and thus alleviates the agency problems. Our results support the premise that high financial reporting quality impairs managers’ abilities to use corporate resources in a self‐serving manner.     

Do Control Effectiveness Disclosures Require SOX 404(b) Internal Control Audits? A Natural Experiment with Small U.S. Public Companies

We use incremental and joint implementation of multiple SOX‐based control effectiveness disclosure and audit mandates to assess relative performance of alternatives for small U.S. public companies. Using data from several low‐ and high‐effort management disclosure and audit regimes implemented from 2003 to 2008, we find substantial and statistically significant increases in material weakness disclosure rates for small firms undergoing initial SOX 404(b) internal control audits, but find quantitatively and statistically similar increases for initial management reports of small firms exempt from such audits. As to audit cost, fees more than double for initial 404(b) audits in 2004 and remain high, while 404(b)‐exempt firms’ fees grow about 10% annually. Our results support the view that, for small firms, management internal control reports and traditional financial audits may be a cost effective disclosure alternative to full application of SOX 404(b). Also, our results suggest that, even without management reports on internal control, analysis of the cause of known accounting mistakes may yield substantial material weakness disclosures.     

在美上市公司内部控制重大缺陷认定、披露及对我国企业的借鉴

本文研究了《萨班斯—奥克斯利法案》执行初期在美国上市的公司财务报告内部控制重大缺陷的认定及披露。研究发现,许多重大缺陷是根据内部控制审计准则指出的表明公司内部控制可能存在重大缺陷的重要迹象来认定的;其他的则通过重大缺陷的定义来认定。披露的内部控制重大缺陷涉及到COSO《内部控制—整合框架》五要素的几乎所有内容,以及资产负债表和利润表的几乎所有项目。仅有部分公司披露导致交易或账户层面重大缺陷的企业层面内部控制重大缺陷,同时,仅有部分公司披露受账户或交易层面内部控制重大缺陷影响的所有账户。本文最后分析了在美上市公司重大缺陷认定及披露对我国上市公司执行《企业内部控制基本规范》及其配套指引的借鉴。     

Is there a relation between audit fee cuts during the global financial crisis and banks’ financial reporting quality?

As a result of the global financial crisis (GFC), several audit clients were able to negotiate lower audit fees for the years 2008 and 2009. However, the PCAOB has expressed concern that lower audit fees might lead to lower audit effort and lower audit quality and financial reporting quality. This study examines the relation between audit fee cuts and banks’ financial reporting quality. Specifically, we focus on earnings management via loan loss provisions (LLP), the relation between current period LLP and future loan charge-offs, i.e., LLP validity, and the timely recognition of loan losses. For banks audited by Big 4 auditors, we find that income-increasing abnormal LLP are decreasing in audit fee cuts and LLP validity is increasing in audit fee cuts. For banks audited by non-Big 4 auditors, LLP validity is higher for banks that received a fee cut of more than 25% relative to other banks audited by non-Big 4 auditors. We do not observe an association between timely loan loss recognition and cuts in audit fees except for banks audited by non-Big 4 auditors and exempt from internal control audits where a fee cut of more than 25% is associated with less timely loan loss recognition. Overall, the findings suggest that Big 4 auditors constrained earnings management via LLP in banks that received cuts in audit fees. Our findings have important implications for regulators, investors, and others.     

Auditor Independence,Non‐Audit Services,and Restatements: Was the U.S. Government Right?*

Do fees for non‐audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes‐Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non‐audit services. Assuming that restatements of previously issued financial statements reflect low‐quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non‐audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.     

Internal control quality and relationship‐specific investments by suppliers and customers

This paper investigates the association between the quality of internal control over financial reporting (ICOFR) and relationship‐specific investments by suppliers/customers. I find a significant negative association between the disclosure of a material weakness (MW) in ICOFR and changes in the relationship‐specific investments of suppliers/customers. Relationship‐specific investments of suppliers/customers have a stronger negative association with inventory‐related MW. The negative association between MW disclosures and the relationship‐specific investments of suppliers/customers is stronger when economic dependence between the firms and the suppliers/customers is more important and when the suppliers/customers have greater bargaining power. Also, suppliers/customers significantly increase their relationship‐specific investments following the remediation of ineffective ICOFR. Overall, my findings show that a firm's quality of ICOFR affects the relationship‐specific investment decisions of suppliers/customers.     

The implications of ineffective internal control and SOX 404 reporting for financial analysts

The mandatory reporting of firms’ internal control effectiveness continues to be debated by equity market participants, U.S. regulatory agencies and oversight committees. We investigate the implications of material weaknesses in internal control and SOX 404 required reporting of such for financial analysts because analysts are important intermediaries in the U.S. capital market and it is not known whether analysts’ forecasts or coverage decisions are affected by firms’ internal control problems or reporting, respectively. Results of our empirical tests indicate that analysts provide less accurate forecasts and there is greater forecast dispersion for firms with ineffective internal control. We also find that firms that disclose internal control problems have less analyst coverage and that analyst following declines after the material weakness in internal control is disclosed. The results are robust to controlling for potential self-selection bias and management earnings guidance. Our study documents the consequences of ineffective internal control for an important class of financial statement users and suggests the required reporting on the effectiveness of internal control is beneficial to understanding the properties of analysts’ forecasts.     

Dynamic internal control performance over financial reporting and external financing

In this paper, we present a theoretical model and empirical evidence on the effects of dynamic internal control performance on external financing choices of a company. Using both within-sample and difference-in-difference analysis, we find that after issuing internal control weakness (i.e. ICW) reports under SOX 404, the ICW companies rely more on debt financing and less on equity financing than in previous periods. This effect is more pronounced for the companies with low ex ante probability of internal control weakness. In addition, we show that after correcting the previously reported ICWs, these ICW companies rely more on equity as opposed to debt financing. This result is more pronounced for smaller companies. Our findings suggest that increased (decreased) information asymmetry induced by ineffective (effective) internal control over financial reporting leads a company to follow specific external financing choices to meet its financial deficits.     

Do management reports on internal control over financial reporting improve financial reporting?

Sections 404a and 404b of the Sarbanes–Oxley Act require management and external auditors, respectively, to report on the adequacy of a company’s internal control over financial reporting (ICFR). Larger public firms were first required to file a management report and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the attestation requirement. We investigate the distinct effect of management reports on financial reporting quality. We find that management reports on ICFR improve reporting quality and demonstrate that there are financial reporting benefits from the management report requirement on its own without attestation.     

上市银行内部控制实质性漏洞披露现状研究——基于民生银行的案例分析

由于现有政策指引和理论研究中"实质性漏洞"概念的缺失,使得我国上市银行实质性漏洞信息披露极其匮乏。本文以民生银行为例,分析了我国上市银行内部控制中的实质性漏洞信息披露现状,发现年报中各部分披露的内部控制信息含量差异较大并且存在特定年度突然增多或减少的现象,内部控制自我评价报告和内部控制审核报告缺乏统一的评价审核依据,内部控制中的实质性漏洞倾向于同职责划分的缺失和不恰当的授权、培训的缺乏、不适当的对账有关,最常见的账户特定式实质性漏洞主要与风险资产的管理不当有关。本文建议通过建立完善的实质性漏洞信息披露机制、进一步明确实质性漏洞信息披露相关主体的职责、加强内部控制实质性漏洞信息披露的监管等措施,提高和改善实质性漏洞信息披露的质量。