Internal Control Material Weakness and Real Earnings Management

Abstract

Abstract This study examines the relation between internal control material weakness (ICMW) under Section 404 of the Sarbanes-Oxley Act (SOX) and real earnings management. Our measures of real earnings management are abnormal cash flow from operations (ABCFOs), abnormal discretionary expenses (ABDISEXP), and abnormal production cost (ABPROD). We use a sample of 1,824 manufacturing firms over the period 2004–2011 to run regressions of ABCFO, ABDISEXP, and ABPROD on ICMW and other independent variables. We find that ICMW is negatively associated with ABCFOs. Another result that emerges from this study is a positive relation between ICMW and ABPROD. Our results imply that manufacturing firms with materially weak internal controls predominantly use overproduction and excessive price discounts to manage operational activities to achieve earnings targets. As SOX Section 404 is designed to reduce the instances of firms having ICMW, our finding that ICMW firms engage in real earnings management suggests that the use of real earnings management could be reduced as SOX Section 404 succeeds in reducing ICMW.