Internal Control Weaknesses and Evidence of Real Activities Manipulation

Abstract

Abstract We examine whether US public firms that file internal control weakness (ICW) disclosure reports with the Securities and Exchange Commission, as part of the reporting requirements under Section 404 of the Sarbanes–Oxley (SOX) Act, exhibit higher levels of real activities manipulation (RM), compared to firms that do not file such reports. Using firm-level data for the post-SOX period, 2004–2010, we find a positive relationship between firms reporting internal control weaknesses and real activities manipulation. Further, those ICW-firms that use RM to beat earnings benchmarks have lower performance in the subsequent year. Our results also show that firms do not use discretionary accruals as a substitute for RM when they report internal control weaknesses. Overall, our findings suggest that ICW-firms are prone to using real activities manipulation as a form of earnings management. Our findings also have implications for audit quality as auditors need to gain a better understanding of how real activities manipulation influences the operations of the firm.