The Impact of Internal Control Weaknesses on Pension Assumptions Manipulation

Abstract

This study examines the effect of internal control weaknesses (ICWs) on managers’ choice of pension assumptions, using data disclosed under Sarbanes-Oxley Section 404 from 2004 to 2012. We hypothesize that firms with ICWs are better able to opportunistically set pension assumptions, such as the expected rate of return (ERR) and the discount rate (DR), which in turn help to report higher earnings or healthier balance sheets. First, we find that firms tend to report higher ERR and DR when they receive an adverse audit opinion on internal control. In addition, we find that the firms facing more incentives to manage the funding status of pension plan are likely to choose higher DR in response to the incentives. Next, we find that firms with ICWs are more likely to adjust their biased ERR when they receive an unqualified audit opinion on internal control. Finally, we find that market returns are significantly negative for the firms assuming higher ERR in the 3-day window around the disclosure of material weaknesses if the firms’ earnings are sensitive to the changed ERR.