Financial Misstatements Research Articles

The Influence of Auditor and Client Section 404 Processes on Remediation of Internal Control Deficiencies at All Levels of Severity

SUMMARY This paper examines remediation of Sarbanes-Oxley Section 404 internal control deficiencies (ICDs) at all levels of severity, before the balance sheet date. While a number of studies investigate remediation of publicly disclosed material weaknesses (MWs), the activity we study takes place out of public view and occurs among companies with both clean and adverse Section 404 opinions. Using data provided by multiple auditing firms, we find that about one-fourth of detected ICDs are remediated before year-end, leaving many uncorrected. We model remediation activity with direct measures of company and auditor Section 404 processes not available to prior research. Model results show that companies' effective information technology integration and early start to control testing are positively associated with remediation. In contrast, remediation is negatively associated with discovery by auditors, discovery by substantive tests, and related financial misstatements. Following prior research on MWs, we also observe that ICD remediation is less likely for smaller companies with greater financial risk, and for certain entity-level control problems.

Clawback Provisions among Canadian Issuers after Sarbanes-Oxley Type Reforms

At least since the 2007 proxy, Canadian issuers clearly have not embraced the use of clawback provisions with the same fervour as US issuers. This paper examines the potential reasons why. It does so through attempting to model the incidence of clawback provisions among Canada’s largest issuers as of the 2011 proxy. The data for the analysis come from reviewing the 2011 proxy statements of the 245 firms comprising the Canadian S&P/TSX as of December 2010. Conceptually, certain structural differences between the US and Canada’s capital markets, as well as their different philosophies towards implementing corporate governance should largely explain the incidence of clawback provisions adopted by Canadian issuers. However, this paper is unaware of any study that has tried to bring these reasons together for empirical examination. The results suggest that the Canadian firms’ access to US capital markets as well as their market capitalization are the most significant factors behind the adoption of clawback provisions. Their location in the financial industry, and whether they have had previous experience with a financial misstatement would also seem to play an important role.

Fee Assessment: The Audit Price Tag of Innovative IT Solutions

ABSTRACTNow in its sixth decade, the field of business information systems continues to advance at an astonishing pace. As information technology (IT) based solutions continue to evolve, they get ever more sophisticated and integral to the operational processes of a company. Investment in information systems (IS) has benefitted companies by facilitating cost savings through implementation of operational efficiencies and adding value through differentiation of offerings and advanced data analysis. IT capabilities have also been credited with the creation of competitive advantage. While business success thrives on innovation and out-of-the-box thinking, financial audit relies on systematic, controlled and measurable processes and reporting. In this paper we explore the intersection of innovative information systems and the financial audit process. As information systems innovate the business strategy, we seek to understand the impact on the audit process. In this study, we capture auditors' perceptions through an analysis of the relationship between innovative IT solutions and audit fees. Findings indicate that sophisticated information systems contribute significantly to increases in audit fees. Seemingly, innovation in IS has induced auditors to expend more effort in minimizing the risk of financial misstatement rather than increasing their confidence in the controls that the systems provide.

Some Observations about SOX 404(b) Control Process Audits

In the decade since the July, 2002 passage of the quickly-legislated Sarbanes-Oxley Act, audit production in the U.S. has been substantially augmented by implementation of mandated internal control process audits. Audit production changes are important as the control audit mandate is unique and imposes substantial costs on U.S.-traded firms, yet little is known about the conduct of control process audits or the efficacy of substantially lower cost alternative mechanisms to provide auditor scrutiny and reporting on internal control quality. This paper reflects our collective experiences and observation of a consistent message across the decade from analyses of extensive public and limited non-public archival data, analytical studies, and numerous personal experiences of audit practitioners. Our primary observation is that, absent knowledge of any financial misstatements, auditors find it difficult to identify material weaknesses in internal control over financial reporting. Conversely, with knowledge of misstatements, auditors can and do identify, at low incremental cost, most entities that have ineffective internal controls as identified by control audits. Financial misstatement detection is, of course, the primary tangible output of a financial statement audit. Thus, it appears possible to exploit this observation to obtain for investors information about companies with weak controls without incurring the cost of a full internal control process audit. We believe that U.S. markets could benefit from more transparency about the current U.S. audit production process and from informed debate about the best mechanism design for balancing the needs of all parties interested in internal control quality disclosure.

The Effects of Clients' Controversial Activities on Audit Pricing

SUMMARY:We examine the effects of clients' involvement in controversial corporate activities on audit pricing. Clients' involvement in controversial activities raises concerns about management integrity and ethics. Moreover, clients involved in such activities are perceived to have higher risk of adverse financial performance. As a result, there is greater potential for financial misstatement, which increases the auditor's perceived business risk. We hypothesize that, given the higher perceived business risk, auditors charge higher fees to clients engaged in controversial activities. Using a unique dataset from Kinder, Lydenberg, and Domini, we identify clients that engage in controversial activities related to consumers, employees, the community, and the environment. Consistent with our hypothesis, we find that clients involved in controversial corporate activities pay higher audit fees compared to clients not involved in such activities.

Trust and Financial Reporting Quality

Using unique survey data from Great Place to Work® Institute, we investigate the association of intra-organizational trust (i.e., employees’ trust in management) with three aspects of financial reporting: accruals quality, misstatements, and internal control quality. We find that trust is associated with better accrual quality, lower likelihood of financial statement misstatements, and lower likelihood of internal control material weakness disclosures. However, these effects are not uniform across all companies. Consistent with trust improving financial reporting quality through improved information production and information sharing, we find that trust is significantly associated with financial reporting quality in relatively decentralized firms, but not in firms that are relatively centralized. Our results are robust to several analyses that attempt to control for potential alternative explanations.

The Association between Audit Committee Multiple-Directorships, Tenure, and Financial Misstatements

SUMMARY This study examines the association between multiple-directorships and tenure of independent audit committee members and financial misstatements in the pre- and post-Sarbanes-Oxley (SOX) reform environment. Regulatory reforms following the accounting scandals at Enron and WorldCom substantially expanded the responsibilities and scrutiny of the audit committee and, consequently, amplify the reputational and litigation risks facing the directors serving on the committee. Our results show a significant positive association between financial misstatements and multiple-directorships in the post-SOX environment. This finding suggests that independent audit committee members serving on multiple boards may be stretched too thinly to effectively perform their monitoring responsibilities. We also find a significant positive association between the tenure of independent audit committee members and financial misstatements in the post-SOX environment, suggesting that directors with longer tenure may not exercise independent judgment. These observations support calls for limits on multiple-directorships and director tenure, and add to our understanding of how independent directors' characteristics affect the effectiveness of the audit committee.

Mandatory clawback provisions, information disclosure, and the regulation of securities markets

Chan et al. (2012) find that voluntary adoption of compensation clawback provisions is followed by fewer financial restatements and fewer auditor reports of material internal control weaknesses, higher earnings response coefficients, and reduced auditing fees and lags. They conclude that voluntary adoption of clawback provisions leads to increased financial integrity. Based on these findings they suggest that U.S. government mandated clawback provisions will be effective in reducing material financial misstatements. I offer possible alternative interpretations of CCCY’s results and discuss issues surrounding government regulation of clawback provisions in particular and corporate behavior more generally.

Exploring Top Management Language for Signals of Possible Deception: The Words of Satyam’s Chair Ramalinga Raju

This paper explores the potential for systematic scrutiny of the language of top management to reveal signals of possible deceptive conduct. The language used in letters signed by Ramalinga Raju, Chair of the Indian multi-national company Satyam, are analysed using a multi-method quantitative approach. We explore the language in Raju’s annual report letters from 2002–2003 to 2007–2008; and in his letter of January 7, 2009 in which he confessed to deceptive conduct. We analyse the frequency of personal pronouns, the tone of positivity or negativity, the frequency of words of extreme emotion and aspects of the characteristics of language use indicated by the DICTION 5.0 text analysis master variable, CERTAINTY. The text of Raju’s letters appears to have been influenced by his self-confessed deceptive behaviour. Raju’s word choice changed noticeably in his five annual report letters prior to the collapse of Satyam as the scale and impact of his financial misstatements increased. The methods presented should be considered for adoption by auditors and regulators—as a way of assessing whether signals emerging from language use warrant closer (including audit) scrutiny of a firm’s financial reporting and governance. They should also be considered for use by monitors of entity risk, such as credit rating agencies and financial analysts.

Dodd‐Frank clawbacks: hot issue for 2012

PurposeThe purpose of this paper is to explore the requirements of Section 954 of the Dodd‐Frank Act, “Recovery of erroneously awarded compensation”, and what companies should currently be doing in anticipation of these requirements.Design/methodology/approachThe paper explains what clawbacks are, what purposes they serve, the key requirements under Section 954, challenges with Section 954, including key terms that require greater definition and unresolved enforceability issues, and recommends what companies can do now to prepare for the likely enactment of the rules implementing Section 954 in 2012.FindingsThe Dodd‐Frank Act's clawback requirements under Section 954 relate to the recovery of “windfall” compensation without regard to misconduct if there is a financial misstatement or other change in financial results, and as a result more compensation was paid than otherwise would have been paid had the correct financial results originally been reported.Practical implicationsGiven the number of key open issues with Section 954 and the potential sensitivities around a policy that could require companies to recover previously earned and paid compensation without fault of the executive, companies will want to closely monitor the rulemaking process in 2012.Originality/valueThe paper provides practical guidance from experienced financial services lawyers.

Do Financial Statement Misstatements Facilitate Corporate Acquisitions?

We provide evidence suggesting that managers use financial statement misstatements which improve reported results to facilitate acquisitions. Specifically, we find that firms misstating their financial statements are more likely to make stock-based acquisitions, but not cash-based acquisitions, after the start of the misstatement. In addition, misstatements classified as errors are not associated with stock-based acquisitions. We also find that managerial overconfidence and entrenchment are associated with managers making acquisitions after misstatements. Stock price reactions to restatement announcements are more negative, by 770 basis points on average, when stock-based acquisitions were made during the misstatement period, and these acquisitions are significantly more likely to result in goodwill impairments than are stock-based acquisitions made during non-misstatement periods. Collectively, these results suggest that managers exploit earnings overstatements to facilitate acquisitions and these acquisitions are largely value destroying.

On IT Control Weaknesses in Financial Reporting Systems

By analysing auditors’ SOX 404 reports from 2004 to 2011 we find that after 2006 Big 4 reporting of both information technology control weaknesses (ITWs) and non-ITWs in reports with ITWs decreased significantly. This change appears to reflect Big 4 reporting practices in response to a change in auditing standards rather than the nature of Big 4 clients’ internal control systems, suggesting that SOX 404 auditors’ reports have become less informative. We find that associations between ITWs, non-ITWs and financial misstatements are moderated by auditor type and time period (2004-2006 vs. 2007-2011). We identify a small number of ITWs and non-ITWs in SOX 404 reporting that may hold practical implications for an auditor’s consideration of IT control testing, management’s remediation of ITWs, and an educator’s teaching of IT and non-IT controls.

Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures

SYNOPSIS Although a substantial body of academic research is devoted to developing and testing risk proxies that detect accounting irregularities, the academic literature has paid little attention to commercially developed risk measures. This is surprising given the general consensus that academic risk measures have relatively poor construct validity. We compare the commercially developed Accounting and Governance Risk (AGR) and Accounting Risk (AR) measures with academic risk measures to determine which best detects financial misstatements that result in Securities and Exchange Commission enforcement actions, egregious accounting restatements, and shareholder lawsuits related to accounting improprieties. We find that the commercially developed risk measures outperform the academic risk measures in all head-to-head tests for detecting misstatements. The commercial measures also perform as well as or better than the academic measures in new tests that predict future accounting irregularities using numbers reported one year before the misreporting even begins. Our results suggest commercially developed risk proxies can be useful to practitioners and academics when trying to detect or predict accounting irregularities. JEL Classifications: M41; G30; K22. Data Availability: Contact the authors.

Creative Accounting, Corporate Governance Watch Dogs Institutions and Systems- the Case of Cadbury (Nig) Plc

This is a case study of the financial misstatements in Cadbury (Nig) Plc running to about # 13 billion over a three year period with particular reference to how corporate watch dog institutions and systems in the company were affected. This study relied on the published findings of SEC (Nig) Board of enquiry on the matter. Financial statements of the company were also analyzed where relevant. Empirical works on various aspects of the scandal were also consulted. This study found out that virtually all the watch dog institutions and systems were compromised. This has implications for effectiveness considerations in corporate governance arrangements. The study also lent credence to the fact that the benefits of IFRS as a global standard may be lost if jurisdictional weaknesses in accounting infrastuctures and regulations are not properly addressed.

Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures

Although a substantial body of academic research is devoted to developing and testing risk proxies that detect accounting irregularities, the academic literature has paid little attention to commercially developed risk measures. This is surprising given the general consensus that academic risk measures have relatively poor construct validity. We compare the commercially developed Accounting and Governance Risk (AGR) and Accounting Risk (AR) measures with academic risk measures to determine which best detects financial misstatements that result in Securities and Exchange Commission enforcement actions, egregious accounting restatements, and shareholder lawsuits related to accounting improprieties. We find that the commercially developed risk measures outperform the academic risk measures in all head-to-head tests for detecting misstatements. The commercial measures also perform as well as or better than the academic measures in new tests that predict future accounting irregularities using numbers reported one year before the misreporting even begins. Our results suggest commercially developed risk proxies may be useful to practitioners and academics trying to detect or predict accounting irregularities.

The effects of disclosure type and audit committee expertise on Chief Audit Executives’ tolerance for financial misstatements

This study involves an experiment where 73 Chief Audit Executives and deputy Chief Audit Executives determine the amount of adjustment required to correct a misstatement. We manipulate the financial reporting location of the misstatement (recognized vs. disclosed) and the level of audit committee expertise (high vs. low). The results indicate that financial reporting location has significant effects on internal auditors’ decisions to correct misstatements. Specifically, internal auditors are more willing to waive disclosed misstatements relative to recognized misstatements. Contrary to expectations, the results do not indicate that increased audit committee expertise and associated increases in audit committee members’ perceived powers cause internal auditors to be less willing to waive misstatements.

Restatements, family ownership and the forced turnover of related parties of financial statements

This paper examined the consequences of mandatory restatements and family ownership to related parties of financial statements (top management, outside directors and firm auditors) in Taiwan. Mandatory restatements are externally prompted, showing the material financial misstatements. Taiwan provides an ideal setting to examine the issues due to low awareness of business ethics and a prevalence of family control. Results showed that top management, chief executive officer (CEO), financial executives and firm auditors are replaced in the context of mandatory restatements. Furthermore, results also showed that family ownership reduces the forced turnover of top management, financial executives, firm auditors and supervisors. Findings raise concerns about the need to popularize the value of business ethics as ethical deterioration is biased to financial reporting failure and ineffective punishment mechanisms. This study also demonstrates the need to highlight the effect of family management on business operations due to the entrenchment effect of family ownership on firms’ replacement decisions. Key words: Restatements, family ownership, turnover, ethics, Taiwan.

Financial restatements and corporate governance among Malaysian listed companies

PurposeThis paper seeks to examine the effects of Malaysian Code on Corporate Governance on the nature of financial restatements in Malaysia and whether corporate governance characteristics are associated with financial restatements.Design/methodology/approachData for this paper are obtained from annual reports that had been restated for the period of 2002‐2005 with firm‐years being the unit of observation. A control group comprising non‐restating firms is formed using match‐pair procedures where restated and non‐restated firms are matched by size, industry, exchange board classification, and financial year end. The data are subsequently analyzed using a t‐test, the Pearson correlation and logistic regression.FindingsThe results show that the primary reason for misstating the accounts is to inflate earnings. The nomination committee of the firms that restated is found to be less independent with higher managerial ownership. The logistic regression analysis indicates that the extent of ownership by outside blockholders deters firms from misstating accounts. Surprisingly, audit committee independence is associated with the likelihood of financial misstatement. Financial restatements, nevertheless, are not found to be associated with board independence, managerial ownership, and CEO duality. Finally, the results show that firms with high level of debts are more likely to commit in financial misstatement.Practical implicationsThe research is significant as it provides evidence on the role of corporate governance, especially the independence of the nomination committee and extent of ownership by outside blockholders in Malaysia. It shows that outside blockholders is effective in disciplining managers so that the accounts so prepared are not misleading. The move in 2007 by the Malaysian Government to require companies audit committee to be composed of only independent and non‐executive directors, as well as requiring audit committee members to be financially literate, should be seen as important in ensuring the effectiveness of the audit committee.Originality/valueThis research is considered as the first study which examines the effects of corporate governance variables on the incidents of financial restatements in a developing country. The findings of this paper would be useful for policy makers in evaluating the importance of corporate governance in emerging countries, specifically on the issue of quality financial reporting.

Effects of Clients’ Controversial Activities on Audit Pricing

We examine the effects of clients’ involvement in controversial corporate activities on audit pricing. Clients’ involvement in controversial activities raises concerns about management integrity and ethics. Moreover, clients involved in such activities are perceived to have higher risk of adverse financial performance. As a result, there is greater potential for financial misstatement, which increases the auditor’s perceived business risk. We hypothesize that, given the higher perceived business risk, auditors charge higher fees to clients engaged in controversial activities. Using a unique dataset from Kinder, Lydenberg, and Domini, we identify clients that engage in controversial activities related to consumers, employees, the community, and the environment. Consistent with our hypothesis, we find that clients involved in controversial corporate activities pay higher audit fees compared to clients not involved in such activities.

Liability for Financial Misstatements and the 'Non-Speaking Actor' Dilemma

Securities issuers are charged with specific duties to disclose and inform investors in securities markets. Those duties can be violated by them through deceptive practices and fraudulent schemes elaborated and/or implemented in cooperation with third parties ( “secondary actors”) like auditors, investment banks, lawyers, commercial partners. This paper reports on the origins of “scheme liability” doctrine in U.S. and on its fall under the Supreme Court decision in Stoneridge case. The article discusses how to assess liability for financial misstatements when a third party cooperates silently (absent any public statement or direct reliance by investors) with the issuer. It focuses on the “non-speaking-actor” dilemma (third party liability for misrepresentation without any reliance‘) that has arisen as a result, and outlines the comparative law perspective and the European regulatory policy.