SOX 4O4 Assessments and Financial Reporting Errors

Abstract

This paper investigates the usefulness of auditor's adverse SOX Section 404 internal control over financial reporting (ICOFR) opinions as leading indicators of financial reporting errors, which are proxied by subsequent financial report restatements. Consistent with our expectations, we find that companies that receive adverse ICOFR opinions are more likely to report restatements in the future than companies receiving clean ICOFR opinions. This result indicates that adverse ICOFR opinions are representationally faithful since they actually are associated with poorer financial controls. We also find subsequent restatements from companies receiving adverse ICOFR opinions have larger net income impacts and involve more account groups. Further analyses of types of internal control material weaknesses suggest both general and specific material weaknesses are positively associated with subsequent restatements. We also investigate whether internal control weaknesses falling into specific COSO categorizations are associated with subsequent restatements.