Audit Committees, Boards of Directors, and Remediation of Material Weaknesses in Internal Control*

Abstract

The Sarbanes-Oxley Act (SOX) was passed in 2002 in response to a series of accounting improprieties at well-known companies sucb as Enron and WorldCom. One important aspect of SOX is the internal control requirements. SOX section 302 requires that management evaluate the effectiveness of disclosure and control procedures, report results of the evaluation, and indicate any significant changes in internal controls since the last 10-K or 10-Q report (Securities and Exchange Commission [SEC] 2002). In addition, SOX section 404 requires that management's assessment of the effectiveness of internal control over financial reporting and auditors' attestation on management's assessment be included in firms' 10-K reports (SEC 2003a). The heightened attention to internal control can enhance the reliability of financial statements by helping companies to identify internal control deficiencies and remediate these deficiencies in a timely manner (Charles River Associates 2005). Prior to SOX, little was understood about the remediation of internal control deficiencies due to the lack of publicly available data on internal controls. The remediation of internal control deficiencies is important because these deficiencies can undermine the quality of a firm's financial reporting, as proxied by accruals quality (Ashbaugh-Skaife, Collins, Kinney, and LaFond 2008; Doyle, Ge, and McVay 2007a), and the remediation of these deficiencies can improve the quality of financial reporting (Ashbaugh-Skaife et al. 2008).' Furthermore, Moody's has indicated that the existence of ongoing internal control problems can trigger negative rating action against the firm (Moody's 2006), highlighting the need for remediation of internal control deficiencies to restore confidence in financial reporting. The prompt remediation of these deficiencies also sends a strong signal to the market that the firm is committed to and competent in ensuring credible financial reporting. Following prior evidence that the quality of the audit committee is associated with the quality of financial reporting and internal controls (Carcello and Neal 2000; Krishnan 2005), this study examines whether corporate governance mechanisms, specifically the audit committee and the board of directors, play an important role in monitoring the remediation of internal control deficiencies.