Determinants of weakness in internal control
over financial reporting*
Jeffrey Doyle
College of Business
Utah State University
3500 Old Main Hill六陈
Logan, UT 84322
continued storyjeffrey.doyle@usu.edu
Weili Ge
University of Washington Business School
University of Washington
成绩英文
Mackenzie Hall, Box 353200
Seattle, WA 98195奥斯卡 皮斯托瑞斯>salty是什么意思
Sarah McVay
Stern School of Business
New York University
44 West Fourth Street, Suite 10–94
New York, NY 10012
u.edu
诚信在我心中May 15, 2006
* We would like to thank an anonymous reviewer, Eli Bartov, Donal Byard, Patty Dechow, Ilia Dichev, Mei Feng, Nader Hafzalla, Gene Imhoff, Kalin Kolev, Andy Leone (the discussant), Feng Li, Russ Lundholm, Suzanne Morsfield, Kyle Peterson, Stephen Ryan, Cathy Shakespeare, and Jerry Zimme
rman (the editor) for their helpful comments and suggestions. This paper has also benefited from comments by workshop participants at the 2005 4-School Conference at Columbia University, the 2005 AAA Midwest Regional Meeting, the 2005 AAA Annual Meeting, and the University of Michigan. Professor Doyle acknowledges financial assistance from the David Eccles School of Business at the University of Utah. All errors are our own.
Determinants of weakness in internal control over financial reporting
哥伦比亚人
Abstract
We examine determinants of weakness in internal control for 779 firms disclosing material weakness from August 2002 to August 2005. We find that the firms tend to be smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. Firms with more rious entity-wide control problems are smaller, younger and weaker financially, while firms with less vere, account-specific problems are healthy financially but have complex, diversified, and rapidly changing operations. Finally, we find that the determinants also vary bad on the specific reason for the material weakness, consistent with each firm facing their own unique t of internal control challenges.
JEL Classification: M41
Keywords: Internal Control; Material Weakness; Sarbanes-Oxley
anderson cooper1. Introduction
In this paper we examine the determinants of material weakness in internal control over financial reporting. A material weakness in internal control is defined as “a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected” (PCAOB, 2004).1 We u a sample of companies that disclod material weakness in internal control over financial reporting under Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 from August 2002 to August 2005.2Under Section 302, SEC registrants’ executives are required to certify that they have evaluated the effectiveness of their internal controls over financial reporting. If management identifies a material weakness in their controls, they are precluded from reporting that the controls are effective and must disclo the identified material weakness (SEC, 2002 and SEC, 2004). Section 404 requires that each annual report include an asssment by management of the effectiveness of the internal control structure and procedures of the issuer for financial reporting that is attested to by the firm’s public accountants.
Although firms were required to maintain an adequate system of internal control before the enactment of Sarbanes-Oxley, they were only required to publicly disclo deficiencies if
1A significant deficiency is defined as “a control deficiency, or combination of control deficiencies, that adverly affects the company’s ability to initiate, authorize, record, process, or report external financial data reliably in
accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company’s annual or interim financial statements that is more than inconquential will not be prevented or detected” (PCAOB, 2004, Auditing Standard 2, Paragraph 9). A “significant deficiency” and a “material weakness” are both deficiencies in the design or operation of internal controls, but significant deficiencies are less vere and are not required to be publicly disclod under Sections 302 or 404 (SEC, 2004).
2Section 404 became effective for fiscal years ending after November 15, 2004 for accelerated filers, which generally includes public firms with a market capitalization of at least $75 million (the due date was extended an additional 45 days for accelerated filers with a market capitalization of less than $700 million in November 2004). For non-accelerated filers, Section 404 will be effective fo
r years ending after July 15, 2007. Non-accelerated filers, however, must still evaluate their controls and disclo any material weakness under Section 302. To the extent that our inclusion of Section 404 disclosures bias our sample toward larger firms, the inclusion of market value of equity in our multivariate analys should act as a control. In untabulated results we also replicate our results using only the Section 302 disclosures and find qualitatively similar results.
there was a change in auditor (SEC, 1988). While prior rearch studies this limited t of disclosures (Krishnan, 2005), there is little evidence regarding internal control quality for firms in general under the new Sarbanes-Oxley regime.
price tag歌词We investigate whether material weakness in internal control are associated with 1) firm size, measured by market value of equity; 2) firm age, measured by the number of years the firm has CRSP data; 3) financial health, measured by an aggregate loss indicator variable and a proxy for the likelihood of bankruptcy bad on the hazard model developed by Shumway (2001); 4) financial reporting complexity, measured by the number of special purpo entities reported, the number of gments reported, and the existence of a foreign currency translation; 5) rapid growth, measured by merger and acquisition expenditures and extreme sales growth; 6) restructuring charges; and 7) corporate governance, measured using the governance score developed by Brown and Caylor (200
4).
Our sample is comprid of 970 unique firms that reported at least one material weakness from August 2002 to August 2005, of which 779 have Compustat data. We identify the firms through a combination of a arch of Compliance Week, a website which tracks internal control disclosures after Sarbanes-Oxley, and a arch of 10-K filings in the EDGAR databa.
For the full sample, we find that material weakness in internal control are more likely for firms that are smaller, younger, financially weaker, more complex, growing rapidly, and/or undergoing restructuring. The firm-specific characteristics em to create challenges for companies in maintaining a strong system of internal controls. Our findings also appear to be economically significant in identifying firms with material weakness. For example, the joint marginal effect of our main model (i.e., the change in the predicted probability of a material weakness when altering the independent variables in the predicted direction between the 1st and
3rd quartiles or between zero and one for indicator variables) greatly increas the predicted probability of a material weakness—from 3.75 percent to 26.41 percent.
In this paper, we focus solely on material weakness for two reasons. First, it is the most vere typ
e of internal control deficiency, and thus offers the greatest power for our determinants tests. Second, the disclosure of material weakness is effectively mandatory, while the disclosure of “significant deficiencies” is unambiguously voluntary.3Focusing on the more mandatory disclosures helps avoid lf-lection issues associated with voluntary disclosures. Although disclosures of material weakness are effectively mandatory, it is possible that individual firms or auditors apply different materiality standards in deciding what to disclo. While we do not have a model of the materiality threshold of material weakness (Mayper, 1982; Mayper et al., 1989; Messier et al., 2005), our determinants results are similar to tho documented by Ashbaugh-Skaife et al. (2006) who examine all types of significant deficiencies (i.e., not just tho internal control weakness that meet the threshold to be classified as “material weakness”) and find that firms disclosing significant deficiencies typically have more complex operations, recent changes in organization structure, more accounting risk exposure, and fewer resources to invest in internal control. Therefore, it appears that our results extend to a broader sample that does not rely on a potentially subjective judgment of what constitutes a “material weakness,” although it is still possible that the broader sample in
wall street
3Although disclosure of material weakness is definitely mandatory under Section 404 (SEC, 2003),
there is some ambiguity regarding whether Section 302 certifications require public disclosure of material weakness. For
example, Question 9 of the SEC’s Frequently Asked Questions (SEC, 2004) ems to imply that firms should only “carefully consider” whether to publicly disclo material weakness. However in Question 11 they state without rerve that “A registrant is obligated to identify and publicly disclo all material weakness.” Confusion aris due to the existence of two largely overlapping definitions of controls (“disclosure controls and procedures” and “internal controls over financial reporting”), two reporting regimes (Sections 302 and 404), and two tiers of reporting requirements (accelerated vs. non-accelerated filers). Although it is possible that some firms might interpret the material weakness disclosure requirement under Section 302 as voluntary, our reading of the bulk of SEC guidance and many firms’ begrudging material weakness disclosures ems to indicate that most firms are treating the disclosure as mandatory.
