The effect of internal control deficiencies on the usefulness of earnings in executive compensation

Since SOX 404 disclosures are informative about earnings, and due to the widespread practice of using earnings-based measures in executive compensation, this study examines whether reports of internal control material weaknesses (ICMW) under SOX 404 influence firms' reliance on earnings in tying executive pay to performance. Using 391 (366) firm-year observations with reported ICMW and 3648 (3138) firm-year observations for CEOs (CFOs) reporting NOMW under SOX 404, we find a decreased strength in the association between earnings and executives' (CEO and CFO) compensation when the firm reports an ICMW, and as the number of reported ICMW increases. In addition, we find this decreased weight on earnings for the more severe Company-Level than Account- Specific material weaknesses. Our study suggests that the ICMW report under SOX 404 provides incremental information for executive compensation beyond that contained in reported earnings.