The Incentive Factors for the (Non‐)Disclosure of Material Weakness in Internal Control over Financial Reporting: Evidence from J‐SOX Mandated Audits

Abstract

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.