Internal Control Deficiencies Research Articles

The impact of local incentive-based legislation on the financing constraints of private firms–Evidence from China

This study selects A-share private firms in Zhejiang Province and its neighboring provinces in 2018–2021 and finds that private firms’ incentive-based legislation significantly alleviates private firms' financing constraints through a double difference model. The legislation alleviates the financing constraints of private firms by reducing the burden of financial liabilities, broadening financing channels such as operating liabilities, and enhancing debt servicing capacity. The effect of the private firm's incentive-based legislation on alleviating financing constraints is more pronounced in firms that are consistently private, have higher tax burdens, have lower competition in the industry, and do not have internal control deficiencies.

Peripheral Benefit of Single Audit Monitoring in Attracting Charitable Donations

SYNOPSIS Our study examines whether the presence of a Single Audit is positively associated with charitable donations. A Single Audit offers incremental monitoring benefits beyond a basic financial audit. Specifically, it includes additional audit procedures and publicly disclosed reporting on internal controls over financial reporting and on compliance over major programs. In an entropy-balanced sample of 44,364 observations over the period 2010 to 2016, we find that charities subject to a Single Audit receive higher donations, regardless of whether the audit reveals internal control deficiencies. We find similar results when donors are more sophisticated, but not when they are less sophisticated. Finally, our results show donors differentiate between clean and unclean audit findings when deficiencies are defined more strictly as material weaknesses only. Policymakers, charities, and other stakeholders should be interested in the finding that Single Audits, often viewed for their costs, also yield a peripheral monitoring benefit by attracting donations. Data Availability: All data are from publicly available sources quoted in the text. JEL Classifications: M41; M42; M48.

Reporting Control Deficiencies in Repeat Internal Audit Engagements*

ABSTRACTThis study examines the reporting of control deficiencies in repeat internal audit engagements. Experienced internal auditors were presented with a hypothetical case in which they were asked about the likelihood of reporting an internal control deficiency discovered last year but which was, “through an oversight,” not reported to company management. The study varies whether the deficiency is an operational control or an internal control over financial reporting and who identified but failed to report the deficiency last year (either the participant, the participant's colleague whom they like and admire, or a colleague whom they neither like nor dislike). The results show that internal auditors are less likely to report an operational deficiency (versus a financial reporting deficiency) in the current year that was not reported last year. Further, internal auditors are less likely to report a control deficiency in the current year when they themselves or a colleague they like and admire (versus a colleague they feel neutral about) failed to report it last year.

Can government supervision alleviate the deviation of enterprises from the real economy to the financial sector: Evidence from China

AbstractIn China, the deviation of enterprises from the real economy to the financial sector has raised concerns. Using a sample of listed companies held by central state‐owned enterprises from 2009 to 2018, we investigate the influence of government supervision on this deviation. We find that government supervision effectively reduces investments in financial assets by central state‐owned enterprises. The impact is more significant in enterprises with internal control deficiencies, especially in those related to finance. Further study finds that the effect of government supervision conducted for the first time, second time, and third time shows a decreasing trend.

Risiko Kecurangan (Fraud) pada Pemerintah Daerah di Indonesia: Analisis Terhadap Temuan Audit

The risk of fraud in local governments in districts and cities resulting from internal control deficiencies was reported in a series of audits carried out by the Audit Board. This research analyzes 23 Audit Reports on the Financial Report of Regency and City Regional Governments in Aceh for the 2022 Fiscal Year issued by the Aceh Province Representative of Audit Board. The Audit Result Reports on the Financial Reports of the Regional Government of Regency Municipalities in Aceh for the 2022 Fiscal Year observed in this research each contained between 10 and 21 findings with an average of 16 findings related to weaknesses in the internal control system and non-compliance with legislative regulations. Some of these entities, city districts, are indeed small. The 23 district and city government control audits, 18 (78%) which is considered to have a good internal control system and operates effectively, resulting in an audit opinion of "Unqualified ". The remaining 5 district and city government control audits (22%) identified internal control deficiencies and contains recommendations for improvement with a number ranging from 10 to 21 with an average of 16 recommendations per audit. Not all recommendations involve a lack of control, but most do (due in part to budgeting issues).

내부통제와 미래이익에 대한 주가 정보성

Purpose - This study examines whether internal control has an effect on stock price informativeness about future earnings. High quality internal control provides continuous assurance for the quality of financial reports, and these future earnings-related information is accurately reflected in the current stock price.
 Design/methodology/approach - This study collected 12,862 data from 2006 to 2021 in China to make an empirical analysis using the future earnings response coefficient (FERC) and the multiple regression analysis were hired in order to analyze the data.
 Findings - We find that internal control strengthens the association between current returns and future earnings, indicating that more information about future earnings is reflected in current stock prices. This positive effect exists in both the main board market and the growth enterprise market of China's stock market, especially in the main board market after the implementation of the internal control policy. In addition, we find that the positive effect is weaker for firms that report internal control deficiencies or receives non unqualified internal control audit opinions. The results using earnings persistence yield similar findings, further supporting the results based on the FERC model.
 Research Implications or Originality - Our tests provide strong evidence that the quality of internal control affects FERC in China stock market.

Classifying Internal Control Deficiencies: The Case of Magnum Hunter Resources Corporation

ABSTRACT Magnum Hunter Resources Corporation (MHRC) was an oil and gas company headquartered near Dallas, TX. Although the company grew rapidly through acquisitions, the accounting department did not keep pace with the company’s growing size and sophistication. Management identified this as an internal control deficiency (ICD) prior to issuing the 2011 financial statements but did not disclose it because management underestimated its severity. The company later disclosed multiple material weaknesses when it restated its financial statements. This case study is designed for use in the undergraduate or graduate audit classroom to examine the classification and disclosure requirements for ICDs. After completing this case study, students will be able to apply professional standards to classify ICDs; critique the decision-making process of management, consultants, and auditors tasked with evaluating ICDs; and consider the impact of material weakness disclosure on investors. JEL Classifications: M41; M42.

Evaluasi Pengendalian Internal atas Aset Tetap pada PT WAN

This research aims to evaluate the implementation of the concept of internal control within the COSO framework for the procurement and management of fixed assets in an effort to increase the reliability of financial reports. PT WAN is a logistics service provider company by providing land transportation services. Dump trucks and heavy equipment are important components in business activities. Several incidents of errors in fixed assets such as discrepancies in recording and asset ownership status, also inadequate documentation. In addition, other fixed assets also have problems such as unrecorded and depreciated assets and ignorance of the acquisition value of assets. This made PT WAN have to initiate the right steps to suppress the problem. This study uses a case study method with a qualitative approach. The processed data is obtained from interviews, conducts observations, analysis internal documents and then evaluated based on COSO 2013 principles. The results showed that there are still deficiencies in internal control over the procurement and management of the company's fixed assets. These weaknesses are the unorganized flow of procurement, recording and sale of assets, not recording of all fixed assets, and lack of knowledge about the process of procuring and recording fixed assets. PT WAN must establish formal documents related to SOPs of fixed assets, labeling the company's equipment and tools, carrying out stock taking of fixed assets every month, re-managing data on all of the company's fixed assets, adding accounting personnel and providing training.

The Auditor’s Responsibility for Noncompliance with Laws and Regulations: A Case of Unauthorized Account Activity at Wells Fargo

ABSTRACT In September 2016, the Consumer Financial Protection Bureau (CFPB) announced an enforcement action against Wells Fargo related to improper sales practices. Following investigations revealing widespread abuse by thousands of employees (e.g., opening deposit and credit accounts without customer consent), Wells Fargo paid civil monetary penalties of $185 million and other substantial punitive fees and fines. This case study uses this real-world example to explore the influence of materiality on the scope of an audit, the auditor’s responsibility for detection and communication of noncompliance with laws and regulations (NOCLAR), and the auditor’s consideration of the control environment in the evaluation of internal controls over financial reporting (ICFR). After completing the case, learners are able to discuss relevant professional standards and recognize the impact of materiality considerations on decisions about financial statement misstatements, NOCLAR, and internal control deficiencies. JEL Classifications: M41; M42.

Management equity incentives and corporate tax avoidance: Moderating role of the internal control.

Under the modern enterprise system, the principal-agent relationship can cause a conflict of interest between the two power counterparts, thus affecting the degree of corporate tax avoidance. As a tool to align the interests of management and owners, management equity incentives can alleviate the conflict of interests brought about by the separation of powers and, therefore, may influence corporate tax avoidance. We examine the relationship between management equity incentives and corporate tax avoidance from both theoretical and empirical perspectives by using data from Chinese A-share listed companies from 2016 to 2020. Firstly, the effect of management equity incentives on tax avoidance is theoretically and normatively analyzed. Secondly, examine the effectiveness of moderating the effect of internal control and distinguishing the ownership of enterprises' nature through regression analysis. (1) There is a positive relationship between management equity incentives and corporate tax avoidance which means, more the stock incentive offered to executives, the more likely corporations are to pursue tax avoidance strategies aggressively. (2) Internal control deficiencies enhance the positive relationship between equity incentives and enterprise tax avoidance behavior. Therefore, in Chinese enterprises, the lack of an internal control system and the failure of internal control measures are prevalent, and such loopholes can intensify the tax avoidance behavior that arises when executives are subject to equity incentives. (3) The influence of management equity incentives on enterprise tax avoidance behavior is greater in state-owned (SOE) than private enterprises. State-owned enterprises are more likely to increase enterprise tax avoidance behavior when management is subject to equity incentives for reasons such as strict performance requirements, lower regulatory oversight, and less interference from negative information. Finally, our findings have significant implications for policymakers/regulators, public companies, investors, standard setters, managerial labor markets, and the welfare of the overall economy.

Quando os controles importam: evidências da associação não linear entre as Deficiências de Controles Internos e a Qualidade de Auditoria

ABSTRACT This study aimed to analyze the association between Internal Control Weaknesses (or Internal Control Deficiencies - ICDs) and Audit Quality (AQ). The article fills a gap in the national literature, as it provides evidence of an association between reported ICDs and the main AQ proxies. The study is relevant because it evinces the lack of contemporary association between reported ICDs and the AQ of listed Brazilian companies, but found a lagged association between these variables. Unlike prior studies, it was observed that the ICDs reported in the previous year can function as an Audit Red Flag in the current year, thus contributing to risk assessment by accountants, auditors, members of governance and audit committees, and regulators. The study, documentary and descriptive, with a quantitative approach, analyzed data from a sample of 257 companies listed on the Brazil Stock Exchange and Over-the-Counter Market (Brasil, Bolsa, Balcão [B3]) in the period 2010-2018. Data were assessed using regression models with panel data, logistic and negative binomial. The results showed that, although there are significant differences between the AQ proxies for companies that reported ICD and those that did not, there is no contemporary and statistically significant association between ICD disclosure and AQ proxies. However, it was observed that audit delay and the probability of being involved in an Administrative Sanctioning Procedure (ASP) are associated with the number of ICDs reported in the previous year.

Psychological Distance and Auditor Assessment of the Severity of an Internal Control Deficiency

Psychological Distance and Auditor Assessment of the Severity of an Internal Control Deficiency

Research on the Impact of New Securities Law on Earnings Management of Listed Companies

Based on a sample of A-share non-financial listed companies under the approval system from 2017 to 2020, this paper examines the impact of new Securities Law on corporate earnings management behavior. The study found that compared with companies without material internal control deficiencies, the earnings management level of companies with major internal control defects decreases more after the implementation of the New Securities Law. This phenomenon is more pronounced when the company has academic independent directors and analyst coverage is higher. Further analysis shows that the new Securities Law affects the earnings management by improving the quality of internal control and strengthening external supervision. This paper not only enriches the research on law and earnings management, but also provides evidence for the implementation effect of the new Securities Law.

Research on the Effect of Executives as Audit Committee Members on Internal Control Weakness

The Audit Committee is a specialized agency under the Board of Directors, and supervising the company's internal control is one of its duties. This article takes the 2012-2017 Shanghai-Shenzhen A-share non-financial listed company as a research sample, focusing on the chairmen, CEOs, CFOs, board secretaries and executive directors other than the CEO, discussing the impact of their concurrent appointment as audit committee members on the arising, correction and repair of internal control weakness in listed companies. The study found that different types of executives who are concurrently members of the audit committee would lead the internal control weakness to different directions. In general, excluding some less significant results, executives concurrently serve as members of the audit committee could stimulate the arising of internal control weakness and promote the correction and repair of the existing internal control weakness of the listed company. This indicates that when a listed company does not have internal control weakness, its executive layer intervention will weaken the effectiveness of the audit committee's governance and induce the arising of internal control weakness. Conversely, when the company inherently has internal control weakness, the intervention will strengthen the effectiveness of the audit committee's governance, making the audit committee more effective in monitoring internal control weakness. In addition, an important finding is that the existence of the Secretary of the board among the members of the audit committee will limit the chairs’ role in promoting internal control deficiencies.

Does the disclosure of internal control deficiency matter for accrual quality? Evidence from China

Using a sample of Chinese listed firms that are required to audit and disclose any internal control deficiency (ICD), this paper examines the effect of mandatory ICD disclosure on accrual quality (AQ) in China. We find that relative to voluntary ICD disclosure, mandatory ICD disclosure is associated with poorer AQ, as proxied by abnormal accruals, suggesting that the mandated disclosure of ICD effectively identifies financial reporting quality in Chinese firms. This relationship is enhanced by government control of firms (especially the central government) and by the intensity of government inspections and is stronger in undeveloped regional markets. The results are robust to the application of the PSM-DID method and use of different measures and samples. Our findings demonstrate the critical role of the mandated disclosure of ICD and improve our understanding of internal control mechanisms in emerging markets.

The influence of qualified foreign institutional investors on internal control quality: Evidence from China

This study aims to investigate whether qualified foreign institutional investors (QFIIs) improve companies' internal control quality to mitigate information asymmetry. By analysing a sample of 22,310 firm-year observations from Chinese listed companies between 2005 and 2017, we found that companies with QFIIs exhibit higher internal control quality and fewer internal control deficiencies. In particular, higher QFII ownership is associated with higher quality of internal control. Interestingly, QFIIs from high-governance-quality countries are more likely to improve the internal control system of their investee companies. Finally, the improvement in internal control quality attributed to QFIIs leads to better operating performance. Our results are robust to alternative measures of QFIIs, alternative proxies for internal control quality, and various controls for endogeneity issues.

Are federal single audit reports of internal control weaknesses a useful tool for evaluating management? The case of charter schools

PurposeThe authors examine whether reports of internal control weaknesses (ICWs) under federal single audit (FSA) guidelines are a useful tool for evaluating non-profit (NP) management, using a unique nationwide sample of NP charter schools. While prior research focuses on external stakeholder reactions to reported ICWs, little if any research addresses the utility of these reports for internal users. The authors fill this gap in the literature, finding evidence suggesting that NP charter school decision-makers use internal control (IC) reports when setting executive compensation – awarding lower pay increases when deficiencies are reported.Design/methodology/approachThe authors regress executive compensation changes on reported ICWs and likely determinants of NP compensation, including organization size, growth, liquidity and management performance, using a sample of 173 school/year observations representing 113 unique schools for the years 2012–2015.FindingsThe authors find a negative relationship with executive pay increases subsequent to reports of initial and repeated IC deficiencies, indicating that lower than average pay increases are awarded subsequent to reports of ICWs.Research limitations/implicationsInterpretation of the authors' results is subject to several limitations, including the possibility of omitted variable bias and the authors' sample, though it comprises all available data for the sample period, and is relatively small and may be considered exploratory in nature. Further, charter schools represent a unique public/private partnership in the educational sector, and the results may not be generalizable to other NPs. Future research could explore the relationship between reported IC deficiencies and governance in other, broader NP sectors.Practical implicationsThe authors' findings are useful to NP organization boards of directors as they consider what factors to evaluate in their chief executive officer (CEO) compensation decisions. In addition to other criteria, inclusion of IC effectiveness in the CEO reward system is prudent, especially in today's environment of increasingly important information security and IC matters. The results suggest such information is being included. This previously undocumented use is also of particular value to regulators when weighing the costs and benefits of mandating single audits for smaller NPs, who are otherwise unlikely to obtain information on the organization's IC environment.Social implicationsThese findings may help inform the debate regarding NP charter schools, a fast-growing, economically significant and highly controversial sector in public education. Charters are predominantly funded by state and local taxes. As such, the quality of governance in NP charter schools is of interest to a wide range of stakeholders including parents, regulators and the public at large.Originality/valueWhile prior research on ICWs and NPs focuses on external stakeholder reactions to reported ICWs, little if any research addresses the utility of these reports for internal users, especially in relatively smaller organizations. The research leverages the existence of charter schools, which are independent but present nationwide, providing a suitable sample of like organizations. Further, no extant research to the authors' knowledge examines the relationship of NP executive compensation and reported ICWs – a topic previously addressed in the for-profit (FP) literature.

Internal Controls and Operational Performance of Nonprofit Organizations

ABSTRACT This study examines the impact of auditor-reported internal control deficiencies (ICDs) on operational performance within nonprofit organizations. Contemporary studies in the for-profit environment document evidence that poor internal controls over financial reporting (ICFR) cause suboptimal operational performance. While these analyses are restricted to ICFR, the nonprofit environment allows external stakeholders to observe the effectiveness of both ICFR and internal controls over compliance. We find robust evidence of negative associations between both ICD types and two key measures of nonprofit operational performance: surplus and the charitable expense ratio. Our findings are relevant to multiple nonprofit stakeholders, demonstrating that the control environment has a pervasive impact on a nonprofit's ability to effectively execute its charitable mission. JEL Classifications: M41; M42.

Archival Evidence on the Audit Process: Determinants and Consequences of Interim Effort*

ABSTRACTUsing proprietary data from a global accounting firm, we investigate the determinants of auditors' interim effort as well as the impact of interim effort on audit quality, client disclosure timeliness, audit hours, and audit fees. Public statements from accounting firms and regulators suggest various benefits from accelerating auditor effort, but these claims remain largely untested. We find that interim effort is higher for large, complex clients that require integrated audits of both financial statements and internal control over financial reporting. With respect to consequences, we find that allocating relatively more work to the interim period is associated with a reduced likelihood of late 10‐K filings, decreased total audit hours, and higher fees. Although increasing interim period effort is not, on average, associated with a reduced likelihood of misstatement, we do find that current period material weaknesses are less likely with greater interim work. Thus, greater interim effort appears to facilitate the remediation of internal control deficiencies before year‐end. We also show that the benefits of increased interim period effort allocation are much stronger—including improved audit quality—when manager and partner interim involvement is high. Overall, our study provides important new insights on audit production and highlights benefits of reduced hours for auditors, earlier identification of control deficiencies for clients, and more timely financial reports for investors.

Whistleblowing Allegations, Audit Fees, and Internal Control Deficiencies*

ABSTRACTWe investigate whether audit fees and auditors' opinions on internal controls are associated with whistleblowing allegations externally filed to regulatory agencies. We find that firms subject to whistleblowing allegations have significantly higher audit fees, regardless of the substance of these allegations, whereas an auditor is more likely to issue an adverse opinion on internal controls when the allegation is substantiated, rather than frivolous. Further, our findings suggest that auditors are involved in the auditing of whistleblowing when the allegation is still in an internal stage. We also show that firms subject to external whistleblowing allegations have a lower likelihood of restating financial statements prepared in the allegation year when greater audit effort is made in that year. Our study is among the first to demonstrate the role of auditors in the context of whistleblowing.