AUDITING:A JOURNAL OF PRACTICE&THEORY
V ol.25,No.2
November2006
pp.1–23
The Impact of SOX Section404Internal Control Quality Asssment on Audit
Delay in the SOX Era
Michael L.Ettredge,Chan Li,and Lili Sun
SUMMARY:This study analyzes the impact of internal control quality on audit delay
following the implementation of the Sarbanes-Oxley Act(2002)(SOX).Unlike prior stud-
ies of audit delay that obtain information about internal control strength via surveys,or
u fairly crude proxies for internal control quality,our study employs external auditor
dullahan
readingasssments of internal control overfinancial reporting(ICOFR)that are publicly dis-
clod in SEC10-Kfilings under SOX Section404.Thus,the empirical evidence pro-
vided in this study is both timely and ,not subject to small sample bias or
weak proxies).Consistent with our expectation,wefind that the prence of material
weakness in ICOFR is associated with longer delays.The types of material weaknessarbor day
also matter.Compared to specific material weakness,general material weakness is
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associated with longer delays.Additional analys indicate that companies with control
problems in personnel,process and procedure,gregation of duties,and closing
process experience longer delays.
After controlling for other impact factors,this study also documents a significant increa in audit delay associated with the fulfillment of the SOX Section404ICOFR
asssment requirement.This suggests that Section404asssments have made it
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more difficult forfirms to comply with the SEC’s desire to shorten10-Kfiling deadlines.
Ourfinding thus supports and helps explain the SEC’s decisions in2004and2005to
defer scheduled reductions in10-Kfiling deadlines(from75days to60days)for large,
acceleratedfilers.
Keywords:audit delay;internal control;SOX404;filing deadline.
INTRODUCTION
D ue to recent high-profile accounting scandals,regulators and investors have become
more concerned with the timeliness as well as quality offinancial reporting.Section 409of the Sarbanes-Oxley Act(SOX)authorizes the SEC to compel reportingfirms to rapidly disclo to the public any information about material changes in theirfinancial condition or operations.As a result,the SEC has phad-in accelerated deadlines forfiling Form10-Ks(from90days to75days,and then to60days)over a three year period starting in2003(SEC2002).However,in August2004and again in December2005,the SEC postponed the implementation of the accelerated60-day Form10-Kfiling deadline,becau
Michael L.Ettredge is a Professor at the University of Kansas,Chan Li is a doctoral student at the University of Kansas,and Lili Sun is an Assistant Professor at Rutgers University-Newark.
Submitted:September2005
Accepted:June2006
1
2Ettredge,Li,and Sun Auditing:A Journal of Practice &Theory,November 2006
reporting firms are finding it difficult to meet the new dates.Among various obstacles,an important one is the SOX Section 404requirement of an internal control over financial reporting (ICOFR)asssment by both management and the external auditors.This provi-sion has itlf been subject to SEC-mandated delays in implementation.Thus,there is need for a rigorous and timely study of the association between audit delay and SOX Section 404compliance.This study rves this purpo.
The importance of audit delay rearch is well recognized.Audit delay affects the timeliness of accounting information,which is a key to promoting investors’confidence in capital markets.1Regulat
ors need to understand the determinants of audit delay before they can effectively implement rules to reduce it (Leventis et al.2005).Accordingly,this study investigates the following rearch questions.First,what is the impact of the SOX Section 404asssments on audit delay?It has been widely reported in the business press that SOX and its Section 404ICOFR asssments cau auditing and filing delays.However,no rigorous study has dintangled the impact of Section 404itlf from that of SOX in general and other delay factors.This study attempts to fill this void.Second,we investigate whether the reported characteristics of ICOFR (e.g.,existence of ICOFR material weakness)and the type of material weakness (general or specific)affect audit delay.Due to lack of data,prior rearch us either survey data (Ashton et al.1987)or a proxy,such as earnings restatements (Kinney and McDaniel 1993)to analyze the association between internal con-trol quality and audit delays.The SOX Section 404requirement of ICOFR asssments now provides publicly available measures of internal control quality.This enables us to provide reliable and timely evidence using a large number of sample firms,a recent time period,and direct,external measures of ICOFR,which we view as an important type of internal control.
This study’s sample is derived from all firms that file Section 404reports from January 2005to June 2005and that are covered by the Audit Analytics Databa.Consistent with prior literature (e.g.,Ettred
ge et al.2000;Leventis et al.2005),audit delay is measured as the length of time from a company’s fiscal year-end to the date the auditors sign their report.To examine the impact of SOX Section 404upon audit delay,we perform OLS regressions to compare the sample firms’audit delays in fiscal year ,the first fiscal-year for which Section 404ICOFR disclosure is required,with their audit delays in fiscal year 2003.To analyze the impact of internal control quality upon audit delays,OLS regression analys are conducted to compare audit delay between the subsample of firms with effective ICOFR and the subsample with material weakness in year 2004.To examine the differential impact of types of material weakness,we conduct regression analysis to compare audit delay between the subsample of firms reporting general material weakness and tho that report specific material weakness.Additional regression analys are per-formed to examine the impact upon audit delay of different types of control problems categorized under the Committee of Sponsoring Organization’s (COSO)framework.
Our results indicate a significant increa in audit delays likely due to the implemen-tation of the SOX Section 404in 2004.This suggests that Section 404procedures create difficulties for firms trying to comply with the SEC’s shortened 10-K filing deadlines.Our findings thus explain and support the SEC’s decisions in 2004and 2005to defer for one year (most recently to December 15,2006)the 60-d
ay Form 10-K filing deadline for large,accelerated filers (i.e.,public float of $700million or more).We find that the prence of 1Late disclosure of accounting information is associated with various adver conquences,such as lower ab-normal returns (Givoly and Palmon 1982;Chambers and Penman 1984;Kross and Schroeder 1984),and a higher degree of information asymmetry (Hakansson 1977;Bamber et al.1993).
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The Impact of SOX Section404Internal Control Quality Asssment3 material weakness in ICOFR is associated with longer audit delay,and that length of delay varies among the types of material weakness.In particular,‘‘general’’(firm-wide)material weakness is associated with longer delay than‘‘specific’’material ,specific to particular accounts or transactions).In addition,wefind that material weakness related to certain control problems including‘‘personnel,’’‘‘process and procedure,’’‘‘gregation of duties,’’and‘‘closing process’’are associated with longer delay.
Our results are robust after excluding small acceleratedfilers which have ud the45-day extension granted by SEC tofile SOX404reports.Additional analysis on non-404-filers’audit delay change from year2003to2004suggests that the increa in audit delay documented in this study is due to Section404itlf,not due to SOX in its entirety. Additional analysisfinds no association between volun
tary,early disclosure of ICOFR ma-terial weakness and subquent reduction in audit delay.
The rest of the paper is organized into four ctions.The cond ction compris study background and hypothes development.The third ction discuss rearch method and data lection.The fourth ction prents results,and the last ction prents conclu-sions,limitations,and future rearch.
BACKGROUND AND HYPOTHESES
Background on SOX Section404我搭车
After the Enron and WorldCom accounting scandals,Congress pasd the landmark SOX Act in2002to restore investor confidence.Section404is one of the most significant provisions of the Act.It requires managers to asss and report on their companies’ICOFR, and requires external auditors to attest and report on the asssments made by client man-agers,as well as providing their own reports on the ICOFR.The main purpo of Section 404is to satisfy the need of investors to have confidence not only in thefinancial reports issued by a company,but also in the underlying process and controls that are an integral part of producing tho reports.
Shortly after the passage of SOX,the SEC established SOX404implementation dates that apply to companies other than registered investment companies(SEC2003).Current SEC guidelines require a company that is an‘‘acceleratedfiler’’(publicfloat of$75million or more)to comply with the requirement for ICOFR asssments in itsfirstfiscal year ending on or after November15,2004.A company that is not an acceleratedfiler(public float less than$75million)must begin to comply with the annual asssments for itsfirst fiscal year ending on or after July15,2007.
Obrvers argue that compliance with SOX404is not likely to be cost beneficial for small companies.The SEC has three times delayed the404compliance date for smaller filers.Under a recent rule(SEC2005),small acceleratedfilers(public equityfloats of less than$700million)have been granted45additional days tofile their complete404reports. In April2006,the SEC’s Advisory Committee on Smaller Public Companies recommended to the full SEC that micro-cap companies(market capitalization below$128million)be exempted from the Section404requirements,and small-cap companies(market capitali-zation greater than$128million but less than$787million)be exempted from external auditor involvement in the Section404process.
Hypothes Development
Ourfirst rearch question is whether the ICOFR disclosure requirements under SOX Section404increa audit delays,and if so,by how much?The answer to this question will provide information about the amount of additional time needed to‘‘audit’’the internal controls.We expect that ICOFR asssments increa audit delays for the following reasons.
Auditing:A Journal of Practice&Theory,November2006
4Ettredge,Li,and Sun
Auditing:A Journal of Practice &Theory,November 2006
SOX Section 404compliance requires companies to undertake a considerable amount of preparation.Under SOX Section 404,public companies need to design,document,an-alyze and test their ICOFR.In effect,they must create elaborate internal control procedure manuals,and update them whenever process change (Calabro 2004).Not all companies initially have been up to the task.For instance,many companies admitted in their 2004SOX 404lf asssments,that a variety of internal control areas are in need of remediation,such as financial process,computer controls,internal audit effectiveness,audit committee oversight,anti-fraud programs,etc.(Taub 2004).According to a survey by business mon-itoring and audit software maker ACL Services,and th
e Center for Continuous Auditing,which was undertaken less than five months prior to the initial SOX 404filing deadlines,nearly 50percent of respondents at that time had not completed a majority of their 404preparations,with eight percent of respondents not even completing 20percent of the required preparations (Taub 2004).Companies’lack of readiness for initial Section 404asssments should lead to audit delays.
Adding a new reporting requirement for external auditors should also increa the time it takes to complete the audit,especially in the first year of implementation.The PCAOB (Standard No.2)requires auditors to conduct inquiries,obrvations,inspections of relevant documents,and specific evaluations of important control stages.The PCAOB also limits the extent to which external auditors can rely on the work of others,even though internal auditors may already have tested the process.Moreover,becau the external auditors are required to test any controls that have significant impact on companies’financial statements,they must be vigilant for weakness that may appear in a variety of process,ranging from how journal entries are consolidated and adjusted,to what information technology controls are implemented to protect companies’information systems (Calabro 2004).The extended audit work should lead to audit delays (Knechel and Payne 2001).In addition,there is some evidence that auditors,similar to their clients,were not ready for initial SOX 40
4asssments.The PCAOB’s inspection reports for Big 4auditors state that auditors relied on some companies’ICOFR controls,without proper testing of tho controls,which indicates the auditors were not ‘‘404ready.’’2
Anecdotal evidence from the business press supports our expectation of incread audit delay.Press accounts state that 404requirements have incread the time companies took to file their fiscal year 2004reports,and that the number of companies missing the filing deadline for annual reports therefore jumped in 2005(Richardson 2005;Hadi 2005).Bad on the above reasoning,our first hypothesis,in alternative form,is:
H1:Companies implementing the new internal control over financial reporting
(ICOFR)requirements experience incread audit delays,ceteris paribus .
In testing H1,we desire to u a benchmark for what might constitute a significant incremental delay.We employ 15calendar days as the benchmark for the following reasons.First,veral recent SEC reporting requirements are intended to shorten Form 10-K filing deadlines by increments of 15days (i.e.,from 90to 75days,and from 75days to 60days).Second,the SEC typically grants a 15-day extension to tho firms that file Form 12b-25,notifying the SEC of their inability to file the Form
10-K on time.Clearly the SEC considers 15days to be a meaningful increment of time for 10-K filing purpos.2We obtained the PCAOB’s inspection reports from the following website:/Inspections/Public Reports/index.aspx.
The Impact of SOX Section 404Internal Control Quality Asssment 5关于独立的英语作文
Auditing:A Journal of Practice &Theory,November 2006Our cond rearch question is whether the quality of ICOFR influences audit delay.In general,weak internal controls potentially allow accounting errors to occur and to go undetected.Auditors,therefore,need to extend their scope of work and perform additional substantive tests to compensate for the control weakness (Doss 2004;Leech 2004).The extended audit effort due to control weakness should lead to longer audit delay.Thus,we expect that firms who auditors asss ICOFR problems will exhibit delays in excess of tho encountered by all firms that implement Section 404.The PCAOB (Standard No.2)designates three types of ICOFR problems:a control deficiency,a significant deficiency,and a material weakness.Public companies are only required to disclo material weak-ness in their 404reports.3Thus the SOX 404reports only allow rearchers to determine whether or not material weakness exists,and if so its nature.Therefore,our initial mea-surement of ICOFR quality is the prence or abnce of material weakness.To test our expectation that weaker internal control is ass
ociated with longer delay,the cond alter-native hypothesis is:
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影子内阁H2:Companies with material weakness in their ICOFR experience longer audit
delays than companies with effective ICOFR,ceteris paribus .
Our third main rearch question is whether types of material weakness in ICOFR have an impact upon audit delay.A recent study by Ge and McVay (2005)obrves veral types of ICOFR material weakness disclod in firms’10-K filings after the implemen-tation of Section 404.Types of material weakness documented in their study vary from account-specific weakness (such as tho specific to revenue recognition or current ac-cruals)to general weakness (such as tho affecting personnel training,technology issues,control environment).Since the impact of each type of material weakness upon the financial reporting system can be different,the extended audit work needed to compensate for each type of material weakness may vary as well.
We develop two ts of material weakness categorizations.Our first classification scheme is bad upon the PCAOB’s Standard No.2and Moody’s recommendations (Doss 2004).The sources classify ICOFR material weakness into company-level control issues and specific control issues.Company-level controls refer to controls that ‘‘might have a pervasive effect on the achievem
ent of many overall objectives of the control criteria’’(PCAOB Standard No.2,para.52,163).We refer to control problems at the company level as ‘‘general’’material weakness,which include situations such as an ineffective control environment,an ineffective audit committee,an inadequate internal audit or risk asssment function,and an ineffective financial reporting process (PCAOB Standard No.2).Specific controls are tho that are ‘‘designed to achieve specific objectives of the control criteria’’(PCAOB Standard No.2,para.50,163).We refer to controls at a specific objective level as ‘‘specific’’material weakness.The relate to control problems over transaction-level process or specific account balances,such as inventory,accounts receivable,and legal proceedings (Doss 2004).
When a specific material weakness is identified,auditors can effectively audit around it by performing additional substantive procedures for the area in which the material weak-ness is identified.In contrast,a general material weakness is more rious (Doss 2004).It 3We measure material weakness as an adver auditor opinion on a client’s ICOFR.An auditor is required to issue an adver opinion on the ICOFR if one or more material weakness exist in the company’s ICOFR (PCAOB Standard No.2).
