On Controlling for Misstatement Risk

Ex ante misstatement risk confounds nearly all settings relying on restatements as a measure of audit quality, but researchers continue to debate how to effectively control for this construct. In this study, we consider a recent approach that involves controlling for prior period restatements (“Lagged Restatements”). Using a controlled simulation as well as a basic archival analysis, we show that a lagged restatement control can significantly bias coefficient estimates. We demonstrate this bias using audit fees as a variable of interest but also show the same issue persists for other constructs that respond to the identification of a restatement (i.e., internal control material weaknesses and auditor changes). We conclude by discussing alternative approaches for controlling for ex ante misstatement risk and providing guidance for future research. Taken together, this study provides an important methodological contribution to the broad literature using restatements as a measure of audit quality.

The debate concerning the recent regulation in the USA mandating accounting firms to disclose engagement partners' identity is ongoing. We examine the impact of the Public Company Accounting Oversight Board's (PCAOB's) requirement of disclosing engagement partners' names on Form AP on the quality of audit engagements. Using two measures of audit quality (abnormal accruals and the probability of detecting material weaknesses in internal control), we find that disclosing engagement partners' names is associated with a lower level of abnormal accruals and a higher probability of accounting firms detecting material weaknesses in internal control. Our study extends the contemporary research on the disclosure of engagement partners' identification by providing additional evidence to the literature on this issue in the U.S. setting. Our study also provides evidence supporting the PCAOB's perception that this disclosure leads to higher audit quality.

This study examines the factors influencing material weaknesses in internal control over financial reporting among the companies in the property industry in Malaysia. Specifically, this study examines six factors namely firm age, firm size, financial health, financial reporting complexity, rapid growth and corporate governance. Using content analysis on the annual reports of 80 property companies, this study shows that only firm size has a significant influence on the material weaknesses in internal control over financial reporting. Other factors however, show no significant influence on the material weaknesses in internal control over financial reporting. The result in this study indicates that small companies tend to have material weaknesses in internal control due to them having limited resources in building effective internal control. These companies generally could not afford to spend on expertise such as internal auditor or consultant to assist in improving and strengthening internal control. The findings of this study shed some lights to the regulators and practitioners on the factors influencing material weaknesses in the internal control over financial reporting. Of consequence, this would reduce information asymmetry between the insiders and outsiders of a company and thus, increasing the quality of financial reporting.

Purpose Prior research finds that auditors often fail to disclose existing material weaknesses in internal controls before they lead to material misstatements. This study aims to investigate whether auditors are aware of such control issues and how they respond by examining subsequent audit-related outcomes of firms with undisclosed control problems (UCPs). Design/methodology/approach Using a prediction model developed by prior research, the study first identifies firms likely to have UCPs. The study then empirically analyzes how these identified UCPs influence changes in audit fees, audit reporting lags and the likelihood of auditor changes in the subsequent year. The study analysis is based on a large sample of accelerated filers from 2007 to 2019. Findings The study finds that firms with UCPs are likely to experience higher audit fees and longer reporting lags in the following year, indicating auditors’ awareness of these problems and their proactive responses. However, these increases are smaller than those for firms with formally disclosed material weaknesses, suggesting that auditors perceive UCPs as less severe. In addition, firms with UCPs exhibit a higher likelihood of subsequent auditor dismissal and replacement with higher-quality auditors, which implies that audit committees may be dissatisfied with auditors’ decisions not to publicly report these control deficiencies. Originality/value This study contributes new empirical evidence regarding auditor and audit committee reactions to internal control deficiencies that remain undisclosed, addressing a critical yet largely overlooked issue in the auditing literature. This study offers unique insights into auditors’ internal risk assessments, materiality judgments and audit committees’ oversight roles, providing practical implications for regulators, auditors and audit committees in enhancing financial reporting transparency and audit quality.

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.

We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes-Oxley Act have 13% lower valuation than non-ICW firms based on Tobin’s q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. Those ICW firms that remedy the internal control weakness in the year after disclosure have much better stock performance compared to those ICW firms who fail to remedy ICW during the same period. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has reflected the negative information associated with SOX 404 ICW reports before the actual disclosures are made. Additional analysis suggests that the market cannot independently reflect the ICW information. More likely, the activities related to the preparation of ICW disclosure generate new information that is reflected in the stock prices.

This paper investigates how increases in client audit risk influence the use of component auditors. Auditors respond to increases in audit risk by making adjustments to the audit engagement such as increasing fees and/or increasing effort. As more audit resources are demanded by clients with increased audit risk, one way for the lead auditor to free up resources is to allocate more work to component auditors. Using a difference-in-difference research design, with the revelation of an internal control material weakness (ICMW) as an event for increased audit risk, we find that component auditor use increases after the revelation of an ICMW, and increases even more when the ICMW is severe. We also find that the increase in component auditor use after an ICMW is positively associated with the likelihood of ICMW remediation. Thus, we identify a situation where component auditor use enhances audit quality and provides a benefit to the company (i.e., increased likelihood of ICMW remediation). Our study should be of interest to regulators, given the criticism by the PCAOB regarding firms’ use of component auditors and the evidence in prior literature on how component auditor use influences audit quality.

PurposeThe purpose of this paper is to examine the association between pervasiveness, severity, and remediation of internal control material weakness (ICMW) reported by the SEC registrants pursuant to SOX Section 404 and audit fees.Design/methodology/approachThe paper employs multivariate regression models for a sample of 854 firms that disclosed ICMW for the first time in 2004, 2005, or 2006, to investigate the empirical relationship of pervasiveness and severity of ICMW and its subsequent remediation with audit fees.FindingsThe analyses demonstrate that audit fees are significantly positively related to the severity (and pervasiveness) of ICMW in the years of ICMW disclosures and are significantly negatively related to the remediation of internal control weaknesses in the years when ICMW remediation took place. The test results further demonstrate that the remediation of systematic control weaknesses has a greater effect on reduction of audit fees compared to the remediation of nonsystematic (transaction/account related) control weaknesses, though the remediation of both systematic and nonsystematic control weaknesses is accompanied by audit fee declines.Research limitations/implicationsThe study produces evidence on pricing audit services by incumbent auditors in response to the severity of internal material control weaknesses and their remediation in subsequent fiscal periods. Its results shed light on certain new aspects of audit fee determinants in the post‐SOX period by virtue of their implications that the pervasiveness and severity of internal control problems induce auditors to make an upward fee adjustment while their remediation has a moderating effect on pricing audit services.Originality/valueThe study's finding is a useful addition to the existing fee literature and is relevant for the post‐SOX world which experienced a structural change in financial accounting and auditing environment.

We examine whether short sellers are interested in, and capable of, identifying firms with an upcoming revelation of internal control material weaknesses (ICMW). We show that short sellers accumulate positions in firms that are about to disclose ICMW under Section 404 of the Sarbanes–Oxley Act for the first time when internal control problems are severe. We find that the short-interest buildup is mainly due to the use of private rather than public information, which suggests that their trades contain incremental prediction power of the upcoming internal control failure. Furthermore, the ability of short sellers to predict ICMW is more pronounced in firms operating in poor information environment. Finally, we find no evidence that trades by short sellers prior to the ICMW disclosure create a cascade of selling that leads to an overreaction of ICMW. Overall, we present evidence that corporate governance information in the form of ICMW is part of the short sellers’ information set, and we establish a path through which ICMW impacts equity investors.

Prior research finds that internal control material weakness (ICMW) reduces the reliability of financial reporting numbers, imposes costs on firms and affects firm performance. Given these effects, we examine two research questions: Does the disclosure of ICMW hamper a firm's ability to hire high‐ability CEOs? Consequentially, does it also impact CEO contracting in terms of the compensation offered to newly hired CEOs? We provide three key findings. First, we find firms that disclose ICMW are more likely to appoint CEOs with lower managerial ability relative to firms that do not disclose ICMW. Second, we find ICMW firms offer lower compensation to new CEOs, suggesting that the pay offered is commensurate with the ability of the CEO recruited. However, the negative relation between ICMW and compensation is attenuated for individual CEOs with relatively higher abilities. Further analyses reveal that some high‐ability CEOs do take positions at ICMW firms, but these ICMW firms pay a premium to hire them, which contributes to greater dispersion and disparity in pay among the top‐five executives. Overall, our results point to ICMW imposing labor market consequences in terms of firm recruitment of high‐ability CEOs.

This study uses data on Japanese listed companies for the period from 2009 to 2012 to examine the incentive factors for the (non‐)disclosure of material weakness (MW) in internal control over financial reporting (ICFR). The propensity score matching results of matched and potential MW companies from the research sample reveal that companies that do not disclose MW have longer management tenure, Big 3 auditors, lower audit fees, larger boards of directors, fewer outside directors, and greater main bank involvement than those companies that disclose MW. In addition, the non‐disclosure of MW at the company level is associated with longer management tenure, larger management shareholdings, and greater main bank involvement, whereas the non‐disclosure of MW at the account‐specific level is associated with longer management tenure, Big 3 auditors, lower audit fees, significant non‐audit services, and greater main bank involvement. These results suggest that the assessment and audit process of internal control systems in Japan is sensitive to management‐ and audit‐related (non‐)disclosure incentives. The findings provide useful academic insights as well as practical guidance for companies in Japan, the United States, and other countries.

ABSTRACTIn this study, we examine whether audit committee accounting expertise helps to promote audit quality by motivating auditors to conduct diligent internal control audits and make appropriate internal control assessments because audit committee accounting expertise safeguards auditors from dismissal following adverse internal control opinions. Among clients with existing and likely internal control material weaknesses (as proxied by future restatements of audited financial statements), we find a greater likelihood of adverse internal control audit opinions when the audit committee has greater accounting expertise (measured by the proportion of accounting experts on the audit committee). Among all clients, we find a lower likelihood of subsequent auditor dismissal following an adverse internal control audit opinion when the audit committee has greater accounting expertise. In further analyses, we find that this lower likelihood of subsequent auditor dismissal occurs when at least two audit committee members possess accounting expertise. We also find some evidence that CFO influence (but not CEO influence) over the audit committee negates the increased likelihood of adverse internal control opinions when internal control material weaknesses likely exist, as well as the decreased likelihood of auditor dismissal following adverse internal control opinions. These findings have important implications for regulators and corporate nominating committees interested in promoting audit committee effectiveness.

This study examines how CEO equity incentives affect the remediation of material weaknesses (MWs) in internal control disclosed pursuant to the Sarbanes‐Oxley Act (SOX). We find that the sensitivity of CEO equity portfolios to stock price (CEO price sensitivity, or delta) has a positive impact on firm promptness in remedying MWs, whereas the sensitivity of CEO equity portfolios to stock return volatility (CEO volatility sensitivity, or vega) has a negative impact on firm promptness in remedying MWs. In addition, we provide evidence that effective boards of directors mitigate the undesirable, negative effect of CEO volatility sensitivity on remediation of MWs. Our results shed light on the effects of equity compensation structures on internal control quality in the more transparent, post‐SOX environment.

We examined 173 internal control reports containing material weaknesses (MW) in internal control over financial reporting related to derivatives and hedge accounting issues (FASB codification ASC 815). We found that a majority of the companies (122) did not properly implement the ASC 815 accounting rules, followed by inadequate monitoring and review (72), insufficient resources (61), incomplete documentation for hedge effectiveness (49), and inaccurate valuation (32). We also found that companies with MW mostly fixed their problems by process and procedure improvement (205), training expansion (60), engaging external specialists (53), and increasing staffing (52). Our review and discussion of the MW in internal control related to ASC 815 should benefit external auditors, management, and regulators. © 2018 Wiley Periodicals, Inc.

Adding to prior research on internal control material weaknesses (ICMW), our study investigates whether information technology material weaknesses (ITMWs) are associated with CEO/CFO turnover, and whether their turnover will promote subsequent remediation. We find that disclosures of ITMW are positively associated with CEO/CFO turnover; however, only CEO turnover promotes subsequent remediation. Our findings on ITMW are different from the prior findings on ICMW – aligned with prior research on ICMW, ITMWs are associated with CEO/CFO turnover; however, unlike prior research on ICMW suggests, dismissals of CFOs do not promote subsequent remediation of ITMW. Thus, future research should consider ICMW and ITMW separately in the examination of their consequences and remediation.