The effect of reporting internal control weakness on predicting future performance using discretionary accruals

Abstract

We investigate whether firms reporting internal control weaknesses (ICW) over financial reporting under Section 404 of Sarbanes-Oxley Act, on average, have accruals that exhibit lower future performance (earnings and cash flow) predictive properties compared to firms without ICWs. We also investigate whether firms that remediate ICWs have accruals with greater ability to predict future performance compared to firms with no ICW remediation. We find that firms with weak internal control result in accruals with lower performance predictability. We also find that firms that remedy ICW generate accruals with higher performance predictability compared to firms that do not remedy ICW. Our findings emphasise that the internal control environment is an important factor in providing higher quality accruals, which in turn has substantial implications on firm valuation. Our findings also emphasise the benefit of a highly contentious portion of SOX, namely Section 404.