Internal Control Over Financial Reporting Research Articles

Reducing Management’s Influence on Auditors’ Judgments: An Experimental Investigation of SOX 404 Assessments

ABSTRACT: Auditors often receive summary information or conclusions from management about account balances or internal controls. They must then gather evidence to assess whether this information is fairly stated. In such situations, management can be considered the “first mover” and the auditor the “second mover.” When auditors are the second mover, they are vulnerable to the curse of knowledge bias—the inability to ignore previously processed information (Fischhoff 1977). Specifically, because information from management could be incorrect or biased, auditors must arrive at an independent evaluation of the item in question (e.g., year-end book values, accounting estimates, or internal controls). This study examines the general issue of auditors being “second movers” by investigating how their awareness of management’s severity classifications of internal control problems influences auditors’ initial assessments of internal control over financial reporting (ICFR) under Auditing Standard No. 2. Our experimental design allows us to determine that management’s “first mover” influence on auditors’ judgments is an unintentional cognitive effect, rather than an intentional use of management’s classifications. We further examine whether cognitively restructuring the ICFR assessment task reduces management’s influence on auditors’ judgments by asking auditors to evaluate and explicitly document the likelihood and magnitude of the effect of an ICFR problem on the financial statements. We find that cognitively restructuring the task mitigates management’s “first mover” influence on auditors’ judgments.

The Impact of SOX Section 404 Internal Control Quality Assessment on Audit Delay in the SOX Era

This study analyzes the impact of internal control quality on audit delay following the implementation of the Sarbanes-Oxley Act (2002) (SOX). Unlike prior studies of audit delay that obtain information about internal control strength via surveys, or use fairly crude proxies for internal control quality, our study employs external auditor assessments of internal control over financial reporting (ICOFR) that are publicly disclosed in SEC 10-K filings under SOX Section 404. Thus, the empirical evidence provided in this study is both timely and reliable (i.e., not subject to small sample bias or weak proxies). Consistent with our expectation, we find that the presence of material weakness in ICOFR is associated with longer delays. The types of material weakness also matter. Compared to specific material weakness, general material weakness is associated with longer delays. Additional analyses indicate that companies with control problems in personnel, process and procedure, segregation of duties, and closing process experience longer delays. After controlling for other impact factors, this study also documents a significant increase in audit delay associated with the fulfillment of the SOX Section 404 ICOFR assessment requirement. This suggests that Section 404 assessments have made it more difficult for firms to comply with the SEC's desire to shorten 10-K filing deadlines. Our finding thus supports and helps explain the SEC's decisions in 2004 and 2005 to defer scheduled reductions in 10-K filing deadlines (from 75 days to 60 days) for large, accelerated filers.

SOX 4O4 Assessments and Financial Reporting Errors

This paper investigates the usefulness of auditor's adverse SOX Section 404 internal control over financial reporting (ICOFR) opinions as leading indicators of financial reporting errors, which are proxied by subsequent financial report restatements. Consistent with our expectations, we find that companies that receive adverse ICOFR opinions are more likely to report restatements in the future than companies receiving clean ICOFR opinions. This result indicates that adverse ICOFR opinions are representationally faithful since they actually are associated with poorer financial controls. We also find subsequent restatements from companies receiving adverse ICOFR opinions have larger net income impacts and involve more account groups. Further analyses of types of internal control material weaknesses suggest both general and specific material weaknesses are positively associated with subsequent restatements. We also investigate whether internal control weaknesses falling into specific COSO categorizations are associated with subsequent restatements.

Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements

ABSTRACT: We examine the impact of adverse auditors’ opinions on clients’ internal control over financial reporting (ICFR), issued under SOX Section 404, on auditor dismissals. Companies receiving adverse ICFR opinions are more likely to subsequently dismiss their auditors. This association between adverse reports and dismissals persists over a four-year period beginning with the initial year of SOX 404 reporting. Our evidence also suggests that these dismissals tend to be part of clients’ efforts to improve their overall financial reporting. Clients receiving adverse reports are more likely to switch to higher-quality auditors, as proxied by Big 4 membership and two measures of industry specialization, than are clients receiving favorable reports. Further, adverse opinion clients that dismiss auditors and then hire new auditors that specialize in the client’s industry are more likely to receive an improved ICFR report in the next year.

The Impact of Internal Control Quality on Audit Delay in the Sox Era

This study analyzes the impact of internal control quality on audit delay following the implementation of the Sarbanes-Oxley Act (2002) (SOX). Unlike prior studies of audit delay that obtain information about internal control strength via surveys, or use fairly crude proxies for internal control quality, our study employs external auditor assessments of internal control over financial reporting (ICOFR) that are publicly disclosed in SEC 10-K filings under SOX Section 404. Thus, the empirical evidence provided in this study is both timely and reliable (i.e. not subject to small sample bias or weak proxies). Consistent with our expectation, we find that the presence of material weakness in ICOFR is associated with longer delays. The types of material weakness also matter. Compared to specific material weakness, general material weakness is associated with longer delays. Additional analyses indicate that companies with control problems in personnel, process and procedure, segregation of duties, and closing process experience longer delays. After controlling for other impact factors, this study also documents a significant increase in audit delay associated with the fulfillment of the SOX Section 404 ICOFR assessment requirement. This suggests that Section 404 assessments have made it more difficult for firms to comply with the SEC's desire to shorten 10-K filing deadlines. Our finding thus supports and helps explain the SEC's decisions in 2004 and 2005 to defer scheduled reductions in 10-K filing deadlines (from 75 days to 60 days) for large, accelerated filers.