Internal Control Over Financial Reporting Research Articles

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.

Do Adverse Opinions on Internal Control over Financial Reporting Lead to Changes in Reporting Format?

SYNOPSIS This study examines whether the format of audit reports on financial statements and internal control over financial reporting (ICFR) changes in response to the disclosure of one or more material weaknesses in ICFR. The results indicate that (1) reporting format changes are more likely when adverse opinions are issued on ICFR and (2) formats are more likely to change from a combined report to separate reports than vice versa. Supplemental analysis reveals that format changes to separate reports do not result in more favorable market perceptions but do result in marginally lower levels of auditor dismissal/change. These findings indicate that auditors have incentives to acquiesce to client requests to change reporting formats, even though such changes do not result in more favorable market perceptions. Data Availability: Data are available from public resources noted in the text. JEL Classifications: M41; M42.

Do Audit Data Analytics Influence Juror Perceptions of Audit Quality and Auditor Negligence?

SUMMARY We summarize a recent study that examines whether and how the signals provided by the internal control over financial reporting (ICFR) opinion and auditor use of advanced data analytic tools (ADAs) influence juror negligence perceptions. When auditors issue an unqualified ICFR opinion and rely on traditional statistical sampling, jurors assess the auditors as more negligent than when the auditors use ADAs. Conversely, when auditors issue an adverse ICFR opinion, jurors ascribe less blame to auditors and more to investor plaintiffs, regardless of whether the auditors use ADAs. Further, jurors perceive auditors as less negligent when they use ADAs for full population testing because they perceive ADAs to be an indicator of higher audit quality. Interestingly, jurors perceive no difference in the level of assurance provided by the audit opinion alone when auditors use ADAs relative to traditional sampling testing methods.

The ICFR process: Perspectives of accounting executives at large public companies

AbstractThe Sarbanes‐Oxley Act charges management with the primary responsibility for internal control over financial reporting (ICFR). However, prior research tells us little about the ICFR process from management's perspective. We develop a theoretical model of the ICFR process from management's perspective and examine that model by surveying 145 and interviewing 35 accounting executives at large US public companies. Our primary finding is that executives feel constrained in their ability to direct ICFR and hold perspectives that reflect these constraints. Specifically, most executives feel compelled by auditors to follow the PCAOB's preferences even though executives believe these preferences often tend to distract management and auditors from riskier areas. Executives also believe that audit committees' involvement in ICFR is too passive and that auditors' assessments are sometimes too severe, prompting executives to push back on auditors. Overall, executives strive to make decisions that are optimal for their ICFR, but limited resources and other business conditions, such as restructuring events and lack of qualified personnel, limit the effectiveness of their ICFR efforts. We discuss the implications of our results for practitioners, regulators, and researchers.

Generalist CEOs, management risk and internal control weaknesses

AbstractThis study examines the relationship between CEOs’ general ability and the quality of internal control over financial reporting (ICFR). Using a sample of S&P 1500 firms in the United States from 2004 to 2015, I find that firms with generalist (specialist) CEOs are more (less) likely to report internal control weaknesses under Section 404 of Sarbanes‐Oxley Act of 2002 (ICW404). The positive relationship between generalist CEOs and ICW404 is weaker when the management risk is lower (longer CEO tenure). These results are robust to alternative models and approaches to address potential endogeneity issues. Additional analyses suggest that this positive relationship is attributed to generalist CEOs’ excessive risk taking. Furthermore, CEO type is related to company‐wide ICW404, ICW404 due to staffing, complexity and general issues, rather than account‐specific ICW404 or ICW404 due to revenue recognition issues. Drawing from the Upper Echelons Theory, this study contributes to the research on ICFR quality by documenting CEO type as an additional determinant of ICW404. It highlights the importance of investors, auditors and regulators considering the CEO's career experience and operating style when assessing a firm's internal control environment. It also adds to the literature on general managerial ability by documenting the cost of hiring generalist CEOs regarding ICFR quality.

Does the Presence of an Internal Control Audit Affect Firm Operational Efficiency?*

ABSTRACTThis study examines whether auditors' evaluation and reporting of firms' internal control over financial reporting (ICFR) affects firm operational efficiency. Prior research indicates that the strength of internal controls is positively associated with economic benefits. However, notwithstanding the underlying strength of controls, whether the mere presence of an ICFR audit provides similar economic benefits is unclear. We predict and find that small firms with ICFR audits have significantly higher overall operational efficiency than small firms with only management ICFR reports, even after controlling for underlying internal control strength. We find this effect manifests through improvements in inventory turnover and innovation, and through increased relative product market share. Separately, we find ICFR audits are associated with lower efficiency in SG&A expenses. Cross‐sectional analyses indicate that the mechanism by which ICFR audits affect overall operational efficiency is through auditor detection of internal control problems and through knowledge spillover from auditing other highly efficient firms in the audit office's metropolitan statistical area. These results provide additional evidence on the ongoing cost and benefit debate of ICFR audits for small firms.

The impact of tone management on investor judgments: evidence from ICFR reports

PurposeIn preparing company financial statements, management is required to evaluate internal controls and disclose any material weaknesses in the internal control over financial reporting (ICFR) report. This study aims to examine how the tone of the details management provides to describe a material weakness in its ICFR report impacts investors’ perceptions of the severity of the material weakness and the desirability of the company as a potential investment.Design/methodology/approachThis study uses an experimental design that manipulates whether the company’s ICFR report includes a negatively-toned detail to describe a material weakness disclosed in the report. Participants read the report and answer questions concerning their perceptions of the desirability of the company as an investment and the severity of the material weakness.FindingsThis study finds that using negatively-toned details to describe a material weakness, as opposed to an absence of those details, decreases investment desirability due to an increase in the perceived severity and number of distinct problems in ICFR.Originality/valueThis study extends prior research by showing that the tone of details used to describe a material weakness, not just the quantity of details, impacts investors’ decision-making. This study shows that management can carefully construct their ICFR report to avoid tone and potentially mitigate the negative effect of disclosing ineffective ICFR.

Is It Better to Kill Two Birds with One Stone? Internal Control Audit Quality and Audit Costs for Integrated versus Nonintegrated Audits

ABSTRACTAudits of internal control over financial reporting (ICFR) are typically “integrated” with the audit of the financial statements (FSs)—both audits are conducted by the same audit firm, which designs procedures to satisfy the objectives of both audits simultaneously. A common assumption is that integrating the two audits is more effective and efficient than performing them separately. However, this assumption has not been tested empirically. Using a sample of Chinese companies that employ different audit firms for their FS and ICFR audits (i.e., nonintegrated auditors), we find evidence that challenges this assumption. Specifically, we find ICFR audit quality is higher for nonintegrated audits compared to integrated audits. Moreover, total audit fees are lower for nonintegrated audits, despite higher ICFR audit fees.

Is integrated auditing superior to separate auditing? Evidence from China

ABSTRACT The purpose of this study is to compare audit effectiveness and audit efficiency between companies that have integrated auditing of internal control over financial reporting (ICFR) and financial statements and companies that have separate auditing. We analyse a sample of Chinese public companies that disclosed their ICFR audit reports from 2011 to 2015. Using the full sample, sub-samples, and a propensity score matching (PSM) sample, we consistently find that companies having integrated auditing exhibit higher financial reporting quality measured by excess non-operating income. The findings regarding audit efficiency are mixed, with limited evidence indicating that an integrated auditor is potentially able to complete two audits without further delay. Overall, our results seem to suggest that integrated auditing is superior to separate auditing in that it enhances audit effectiveness and might improve audit efficiency. Such superiority might be due to knowledge spillover when two related audit services are jointly provided.

The effectiveness of the auditor’s opinion on the internal controls over financial reporting

PurposeRecent studies have concluded that auditors underreport existing internal control over financial reporting (ICFR) weaknesses. This study aims to assess how effective external auditors are, as independent third parties, at disclosing reliable opinions to the public on the ICFR.Design/methodology/approachUsing a logistic regression, the authors analyzed a sample of 106 US companies classified as large accelerated filers or accelerated filers consisting in 53 companies which restated their financial statements and a control group of 53 companies having “clean financial statements” at any given moment during the research period, between 2005 and 2018.FindingsThe results indicate that only 34% of companies with financial statements deemed unreliable have received an adverse ICFR opinion issued by the external auditor during the misrepresentation period or its prior year. The authors also notice that external auditors are somewhat effective in identifying and disclosing red flags to the public that certain companies have internal control (IC) material weaknesses. The results also indicate that the average presence of an adverse IC opinion issued by the external auditor during the misrepresentation period or its prior year for companies with unreliable financial statements is higher than for companies with financial statements deemed reliable.Practical implicationsThis study tests if an increase in efforts and disbursements with audit fees are justifiable by external auditors’ issuing effective, reliable opinions and reinforcing a more transparent and ethical capital markets environment, that is, an environment where accurate information is available for stakeholders. If external auditors are negligent in providing a qualitative and independent opinion to stakeholders, the increase of disbursements made with audit fees is less justifiable. Thus, the research has practical implication for auditors as well as standard setters.Originality/valueThis study extends the literature on ICFR by empirically testing whether the public can rely on external auditors’ opinions expressed on Sarbanes–Oxley Section 404 reports.

The economic effects of mandated ICFR disclosure in China: an insider perspective

ABSTRACT Using a survey of corporate insiders from 1,148 Chinese listed firms, this paper examines the direct effects of compliance with mandated Internal Control over Financial Reporting (ICFR) disclosure. In contrast with their U.S. counterparts, vast majorities of respondents recognize compliance benefits and perceive these benefits to outweigh the costs. However, the degree to which the firm is susceptible to market forces is a major determinant of the effects of compliance. The paper shows the evidence which supports the idea that the effectiveness of mandated ICFR disclosure depends crucially on the broader market and institutional environment in which firms operate.

Perceptions of Tone at the Top from the Inside: Insights into Audit Pricing

SUMMARYTone at the top plays an important role in entities' internal control over financial reporting (ICFR) and in auditors' planning and risk assessment decisions. Using a novel measure based on employee perceptions, we find that strong tone at the top is associated with reduced audit pricing and that this relation holds even for firms that report effective ICFR. This relation is stronger when employees' tone perceptions are more consistent throughout the organization, when accounting is more complex, and when earnings manipulation risk is higher. We also find that strong tone is negatively associated with the incidence of reported material weaknesses and positively associated with positive abnormal accruals, and that the management integrity component of tone is more strongly associated with audit pricing than is the quality of management communication. Finally, we find evidence that auditors become familiar with employees' tone perceptions in the normal course of an audit.

BLOCKCHAIN AND INTERNAL CONTROL: THE COSO PERSPECTIVE: AN INTRODUCTION AND BRIEF REVIEW

As the title says this is an introduction and brief review of a long and rather complex study of issues related to internal controls over financial reporting (ICFR) and auditing the new distributed ledger technology known as Blockchain Ledgers. The report points out many of the control issues related to Blockchain Ledgers (BC), including potentially advantageous characteristics such as immutability and shared ledgers. It also addresses the new risks and needs for additional controls for which the search for solutions continues. Audit procedures have always followed technology advances, but they will never impede the innovation and related creative destruction that come with advancing business models. Much more work lies ahead, nevertheless, this COSO report is an excellent summary that will inform discussions about new control methods and methodologies. The COSO report has value for all readers including GRC professionals as well as C-suite and board members. However, the primary beneficiaries will be in tech support to the CFO and Chief Audit Executives, BC developers in company operations, and BC specialists in public accounting firms. This summary should inform all readers.

Auditor Evaluation of Manager's Competence After a Failure in Internal Control

SUMMARY Audit guidance requires auditors to assess management's competence with respect to internal controls over financial reporting (ICFR) based on the recommendations of COSO's integrated framework. The omission bias theory suggests that after internal control failures, auditors may assess managers' competence in a manner inconsistent with these requirements. Results from four experiments using 313 experienced audit and accounting professionals support this concern and a means of mitigating it. I find that auditors view the manager to be most competent when prior to the failure in the key control the manager did nothing to prevent the failure versus reinforced the key control. I do not find this effect when auditors had shared their concerns about the key control with the manager prior to the control's failure. My results also show that auditors incorporate their competence judgments about management into evaluations of the ICFR, as required by the audit guidance.

How U.S. audit committees oversee internal control over financial reporting

On the basis of a survey of U.S. public company audit committee members, we provide detailed insights into the process underlying audit committee oversight of internal control over financial reporting (ICFR), and we explore cross‐sectional variations in audit committee ICFR oversight. We find that audit committees spend the most time in the monitoring activities and control environment areas and the least time in the information and communication and control activities (related to revenue) areas. Further, our exploratory regression analysis reveals that audit committee member age and internal audit experience, company size and regulated industry are positively associated with the extent of overall audit committee ICFR oversight, whereas audit committee member certified public accountant (CPA) certification is negatively related to ICFR oversight. Finally, we provide many specific examples of ICFR oversight process elements that appear to be more substantive, extensive and proactive versus more ceremonial, limited and reactive.

Intellectual capital, isomorphic forces and internal controls over financial reporting in Ugandan microfinance institutions

The purpose of this study is to examine the role of intellectual capital and isomorphic forces in strengthening internal controls over financial reporting (ICFR) in microfinance institutions (MFIs). This study is cross-sectional and correlational. Data were collected through a questionnaire survey of 66 MFIs that are members of the Association of Microfinance Institutions of Uganda (AMFIU). Both intellectual capital and isomorphic forces positively and significantly contribute to the strength of ICFR. In terms of control variables, ownership structure, capital structure and firm age are not significant predictors of ICFR. Policy-wise, the regulator(s) of MFIs should always issue-specific and time-bound directives to MFIs with ICFR shortfalls to enhance their control environment. Also, the responsibility of maintaining adequate ICFR should be extended to the management of MFIs by tasking them to account for lapses in ICFR. This would reduce incidences of senior management usurping the powers of the board, which would lead to overriding of ICFR. Also, policies should be specific on the composition of the board to improve its intellectual potential. To the authors’ knowledge, this study provides initial empirical evidence of the influence of intellectual capital and isomorphic forces in strengthening ICFR in MFIs using evidence from a developing African country. Overall, this study found that intellectual capital (entity factor) and isomorphic forces (institutional factors) are all predictors of ICFR. This is possible because managers, employees and those charged with governance of the entity can be influenced by institutional forces that affect ICFR positively.

Audit committee interlocking and internal controls over financial reporting: an examination of different audit committee roles

This study investigates the relationship between audit committee (AC) interlocking and the effectiveness of internal controls over financial reporting (ICFR) while differentiating between chair and non-chair connections. Chen et al. (2017) point out that the effect of corporate governance on the system of internal controls has been largely overlooked by extant research. Khemakhem and Fontaine (2019) discuss the fact that the audit committee chair role, while key in corporate governance, is largely ignored by researchers. The results show that the effects of interlocks vary based on the interlocking medium, where companies are more likely to have effective ICFR if they are interlocked through the AC chair with other companies that have effective ICFR. No significant impact is observed for interlocks through the non-chair members. Furthermore, the results do not show a significant relationship for interlocks with companies with ineffective controls.

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.

Does Control Self-Assessment Influence Financial Reporting Quality?

The aim of this study is to examine the effect of control self-assessment (CSA) on financial reporting quality by using CSA as a proxy of monitoring quality. CSA has an important feature that allows the employees themselves to become involved in the assessment of internal controls’ effectiveness. Moreover, CSA has two important monitoring functions. First, it can add value to internal auditing. Second, because all employees of operational units participate in the assessment of internal controls in CSA, that control environment is expected to be mature. The investigation of this study used data from 3,517 Japanese firms listed on the First Section, Second Section, Mothers, and JASDAQ of the Tokyo Stock Exchange. The result of 2SLS regression shows that CSA adoption has a negative relationship with the number of financial restatements and audit fees, and therefore, I conclude that CSA has positive consequences for financial reporting quality. This result indicates that the internal monitoring mechanism that continuously monitors internal control over financial reporting (ICFR) effectiveness and in which all employees participate has some positive effects on financial reporting quality. There are two reasons for this result. First, employees have easier access to negative information concerning ICFR effectiveness than outsiders and can share that information with the internal personnel in charge of monitoring (e.g., internal auditors). Moreover, CSA is expected raise an entity’s awareness of ICFR, that is, the control environment of ICFR components is made into an environment that prevents and detects impropriety in the accounting process.

PENINGKATAN PELUANG BISNIS STRATEGIS PADA PEMASANGAN SPM DAN JALUR PIPA BAWAH LAUT PROYEK SUPPLY AVTUR KE BANDARA SOEKARNO HATTA DARI REFINERY UNIT-VI BALONGAN

Increasing business opportunities from an economic aspect that includes the financial performance of the Refinery Unit VI is very important to manage. Good financial performance will support the company's business continuity, and also have a positive impact on stakeholders. Refinery Unit VI's commitment to improving financial performance is very high, and strives to achieve predetermined key performance indicators (KPI). Refinery Unit VI measures the achievement of KPI regularly every quarter as part of the evaluation.
 Targets related to current economic performance are the achievement of KPIs on Refinery Gross Margin and Net Margin. The person in charge for recording and reporting financial performance is under the Financial Function. Refinery Unit VI uses Internal Control over Financial Reporting (ICoFR) to control financial reports, where each function that has the authorization uploads it on the ICoFR web system. In 2017, Refinery Unit VI succeeded in 100% compliance with the IcoFR.
 The realization of the Refinery Unit VI financial performance from 2015 was always above the target despite fluctuations in product prices. This is a good thing, supported by the achievement of the increasing Gross Refinery Margin and Net Margin from 2015–2017. Refinery Unit VI has continuously succeeded in improving financial performance and achieving the highest Gross Refinery Margin among all Refinery Units owned by PT Pertamina (Persero).
 The installation of SPM and subsea pipelines is the target of increasing the Refinery Unit VI development program.