Determinants of Weaknesses in Internal Control over Financial Reporting and the Implications for Earnings Quality

Abstract

We examine determinants of internal control deficiencies and their effect on earnings quality using a sample of 261 firms that disclosed material weaknesses from August 2002 to November 2004. We find that material weaknesses in internal control are more likely for firms that are smaller, less profitable, more complex, growing rapidly, or undergoing restructuring. These findings are consistent with firms struggling with their financial reporting controls in the face of a lack of resources, complex accounting issues, or a rapidly changing business environment. Next, we show that firms with material weaknesses in internal control have lower earnings quality, as measured by the extent to which accruals map into cash flows. This relation is robust to the inclusion of discretionary accruals as a proxy for managerial opportunism, as well as proxies for inherent difficulty in accrual estimation (Dechow and Dichev, 2002). Thus, internal control appears to be one of the fundamental drivers of earnings quality. Furthermore, we find that earnings quality is especially poor for those material weaknesses that relate to overall company-level controls, which may be more difficult to audit around.