Internal Control Reports Research Articles

Changes in Internal Control Disclosure and Analyst Forecasts Around Mandatory Disclosure Required by the China SOX

SYNOPSIS Beginning January 1, 2012, all publicly listed firms in China are required, under the Basic Standard of Enterprise Internal Control (China SOX), to provide an internal control report (ICR). Prior to that, many firms had elected to voluntarily comply with this regulation. We examine the change in internal control disclosure regimes and its impact on the properties of analyst earnings forecasts. We compare the quantity and severity of ICWs disclosed under voluntary versus mandatory regimes, and find evidence suggesting that the disclosure of more serious ICWs increases when ICW disclosures become mandatory. We then investigate the effect of ICW disclosures on analyst forecast error and dispersion. We find that measures of ICWs are negatively associated with desirable properties of analyst earnings forecasts. We also find a less positive association between ICW disclosures and forecast error and dispersion in the mandatory regime. JEL Classifications: G34; G38; M41.

Factors that influence the perceived use of the internal audit function's work by executive management and audit committee

The internal audit function (IAF) is an important component of high-quality corporate governance. We study how the head of internal audit perceives the executive management team and the audit committee to rely on the IAF's work. It is not obvious from prior work or professional anecdotes whether the IAF satisfies the needs of both groups. If multiple factors influence the IAF's work, chief audit executives (CAEs) may find themselves in a situation with competing demands, which could then compromise quality for all stakeholders. Based on a unique dataset from CAEs, two logistic regression models identify factors that influence the degree to which IAF's results are perceived as being used by both executive management and the audit committee. The results show the existence of various factors that are relevant either to both groups (e.g., strategic project reports and IAF quality) or to only one (e.g., only audit committees are interested in risk management reports while only executive management teams are interested in internal control reports), depending on whether the IAF focuses on assurance or consulting work.

Performance of Budgeting, Accountability System for Government Institutions, Performance Internal Control and Accountability Performance Report of Government Agencies in East Kalimantan.

The form of the accountability report for regional financial management for one budget year for central government agencies for one fiscal year is in the form of Government Institutional Performance Accountability Reports (LAKIP), in which this financial report contains annual performance reports and accountability for the performance of a regional government or central government agency. To ensure that the budget that has been set is carried out properly and in accordance with the goals of the organization, it is necessary to apply controls. the purpose of this research is to explain the causal relationship between research variables by testing the hypotheses that have been formulated. In this study will explain the causal relationship between internal or exogenous variables in the form of Performance Budgeting, Government Agency Performance Accountability System (SAKIP), and Government Institution Performance Accountability (AKIP) in the form of external variables or endogenous Internal Control 1 and external or endogenous variables 2 Performance Accountability Report Government Agencies (LAKIP). From the results of the study showed that the effect of Performance Budgeting had no significant effect on internal control, while the results of other variables have a significant effect on the Government Institutional Performance Accountability System (SAKIP), and Government Institutional Performance Accountability (AKIP), Internal Control and Government Institution Performance Accountability Reports (LAKIP)

Linguistic Tone and Internal Control Reporting: Evidence from Municipal Management Discussion and Analysis Disclosures

ABSTRACT We study the textual content of MD&A disclosures. Specifically, we model the determinants of linguistic tone (based on the fraction of positive or negative words) in municipal MD&A sections and test for associations with the reporting of future internal control weaknesses. Our evidence suggests that factors such as high unemployment, general fund deficits, and less funding from higher levels of government are associated with negative tone, based on a sample of 362 MD&A disclosures in fiscal year 2011. Our internal control analysis is consistent with positive (negative) tone in municipal MD&A disclosures being associated with fewer (more) subsequent-year internal control weaknesses after controlling for other governance, demographic, and performance factors. Our analysis also suggests that positive tone is associated with a lower probability of future general fund deficits. Our findings suggest that municipal MD&A content contains important information regarding the quality of future municipal financial reporting through internal control quality. JEL Classifications: H83.

Shades of Gray: Internal Control Reporting by Chinese U.S.-Listed Firms

SYNOPSISChinese firms listing in the U.S. via reverse mergers (CRMs) have dominated prior media, regulator, and research attention. Yet CRMs have effectively ceased, leaving Chinese firms listing via initial public offerings (CIPOs) as the relevant remaining class of Chinese firms listing on U.S. exchanges. This study documents salient differences between CIPOs, CRMs, and U.S.-domiciled U.S.-listed firms by examining Sarbanes-Oxley Act Section 302 and 404(b) ineffective internal control (IIC) and related disclosures that underlie financial reporting quality, with three main sets of findings. First, both CIPOs and CRMs are more likely to report IICs than U.S.-domiciled counterparts. Second, both CIPOs and CRMs are more likely to under-report IICs than U.S.-domiciled counterparts (CIPO for only 302 disclosures). Third, CIPOs are both less likely to report and less likely to under-report IICs than CRMs. These findings clarify and recast prior characterizations of the internal controls underlying the reporting quality of Chinese U.S.-listed firms.JEL Classifications: G18; G34; G38; M41; M42; M48.Data Availability: All data are available from public sources.

Investor reactions to restatements conditional on disclosure of internal control weaknesses

Purpose The purpose of this paper is to investigate investor reactions to financial restatements conditional on disclosures of internal control weaknesses under Section 404 of the Sarbanes-Oxley Act. Design/methodology/approach The research uses cumulative abnormal stock returns (CARs) as a proxy for investor reactions. Restatements and internal control reports are available on audit analytics. Multivariate regression analyses were used for testing. Findings Using a sample of restating firms whose original misstatements are linked to underlying internal control weaknesses, the research finds that cumulative abnormal returns for firms disclosing internal control weaknesses in a timely manner is negative in a three-day window around the restatement announcements. The finding indicates that restatements with early disclosure of internal control weaknesses provide more persuasive evidence of the ineffectiveness of a firm’s internal control over financial reporting, rather than early disclosure lowering the information asymmetry between a firm and investors. Research limitations/implications This study employs CARs to examine the market reaction to restatements conditional on disclosure of internal control weaknesses. Practical implications Further study on reactions by creditors who have access to private information on firms could extend the implications of the finding. Originality/value The study contributes to the existing research by documenting that early disclosure of material weaknesses in internal control affects investors’ reactions to financial restatements.

Internal control risk and audit fees: Evidence from China

This study examines the association between internal control risk and audit fees under the voluntary adopting regime of the Basic Standard of Enterprise Internal Control in China. We find that audit fees are positively related to disclosed internal control weaknesses (ICWs). In particular, they are significantly associated with non-financial reporting-related, but not with financial reporting-related, ICWs.Our results also indicate that voluntary assurance in internal control reports can mitigate higher audit fees associated with ICWs. Our study provides timely evidence relating to the debate on whether the scope of internal control should be expanded to non-financial reporting-related areas.

Material Weaknesses in Internal Control in Relation to Derivatives and Hedge Accounting

We examined 173 internal control reports containing material weaknesses (MW) in internal control over financial reporting related to derivatives and hedge accounting issues (FASB codification ASC 815). We found that a majority of the companies (122) did not properly implement the ASC 815 accounting rules, followed by inadequate monitoring and review (72), insufficient resources (61), incomplete documentation for hedge effectiveness (49), and inaccurate valuation (32). We also found that companies with MW mostly fixed their problems by process and procedure improvement (205), training expansion (60), engaging external specialists (53), and increasing staffing (52). Our review and discussion of the MW in internal control related to ASC 815 should benefit external auditors, management, and regulators. © 2018 Wiley Periodicals, Inc.

Factors That Influence the Use of the Internal Audit Function by Executive Management and Audit Committee

The internal audit function (IAF) is an important component of high quality corporate governance. We study how two important groups in the corporate governance mosaic—the executive management team and the audit committee—rely on IAF's work. It is not obvious if the IAF satisfies the needs of both groups. Especially if multiple factors influence IAF's work, Chief Audit Executives (CAEs) may find themselves in a Serving Two Masters-situation which could compromise quality for all stakeholders. Based on a unique dataset from CAEs, two logistic regression models identify factors that influence the degree IAF's results are used by both the executive management and the audit committee. The results show the existence of various factors, which are relevant for either both (e.g. strategic project reports and IAF quality), or only one of the respective players (e.g., audit committees are interested in risk management reports while executive management teams are interested in internal control reports), depending on whether the IAF focuses on assurance or consulting.

Studies on the impact of accounting information and assurance on commercial lending judgments

This paper reviews studies that have examined how accounting information impacts commercial lending judgments. Issues discussed involve the usefulness of accounting data in lending decisions, effects of different accounting methods on lenders’ judgments, bankruptcy and default judgments, and decision processes pertaining to the use of accounting information in lending decisions. Additionally, the paper reviews the research on how audits and other forms of assurance influence commercial loan officers’ judgments. Topics include the way perceived auditor independence influences loan officers’ judgments, the impact of financial statement audits and audit opinions on lending decisions, how internal control reports and other CPA firm reports influence loan decisions, ways in which audit report disclosures and wording impact lending decisions, how perceived auditor quality affects lending decisions, and the effects of limited assurance engagements on loan officers’ judgments.

Management's Responsibility Acceptance, Locus of Breach, and Investors' Reactions to Internal Control Reports

ABSTRACTThe triangle model of responsibility (Schlenker, Britt, Pennington, Murphy, and Doherty 1994) predicts that the extent that investors hold management responsible for an adverse event is jointly determined by the links among three elements—management, the adverse event, and the relevant accounting regulations/standards or public norms. Applying this theory, we conduct experiments to examine how the locus of breach (external versus internal) moderates the efficacy of management's responsibility acceptance (higher versus lower). Our results show that management's higher (versus lower) responsibility acceptance is a more effective strategy in the presence of an external breach, but not in the presence of an internal breach (Experiment 1). Follow-up experiments suggest that this result is driven by the relative strength of the triangle links underlying the external versus internal breaches, rather than the locus per se.JEL Classifications: G40; M41.Data Availability: Contact the authors.

Audit Partner Tenure and Internal Control Reporting Quality: U.S. Evidence from the Not‐For‐Profit Sector

AbstractThis study examines the effects of audit partner tenure and audit partner changes on internal control reporting quality for large U.S. not‐for‐profit (NFP) organizations. Regulators contend that audit partners lose their objectivity over successive audits, reducing audit quality. A large body of research has examined this issue, primarily in non‐U.S. jurisdictions, with mixed results. We examine the associations between audit partner tenure and audit partner changes and the incidence of reported internal control deficiencies (ICDs), the quality of internal control reports (following PCAOB audit quality indicators), and the severity of reported ICDs. We find negative associations between audit partner tenure and the incidence of reported ICDs, the quality of internal control reports, and the severity of reported ICDs. Together, these findings indicate that internal control reporting quality deteriorates with audit partner tenure. However, we find no association between audit partner changes and internal control reporting, which is consistent with partners lacking client specific knowledge in their first year with a client. Finally, we find no association between either audit partner tenure or changes and the likelihood of remediation. Our findings contribute large‐sample U.S. evidence on the association between audit partner tenure and internal control reporting quality and provide useful information to government regulators, NFP boards charged with the oversight of the external auditor and internal controls, and NFP stakeholders.

Audit fees and pricing strategy: Do restatements of internal control reports and earnings matter?

Under Sarbanes-Oxley (SOX) Act Section 302, management should, from one hand, certify and disclose in reports the effectiveness of internal controls applied to processes and procedures followed by a listed entity and, on the other, highlight potential deficiencies and provide information on potential frauds or sources of risk that could negatively impact on the effectiveness of the internal controls in place. Building on the above, SOX Act Section 404 requires that management should report information in its annual reports regarding the adequacy and effectiveness of the system of internal controls, which affects the procedures of financial reporting. These internal control reports, as part of the internal audit system within an organization, they undergo a review initially by the internal audit department and then by external auditors. The external auditors’ comments may dictate certain changes to be made, which could inevitably lead to refinements, which are then depicted to the adjusted internal control reports. The need for restatements of internal control reports is definitely associated with additional work from the side of the external auditor and may initiate more extensive audit work. Hence, the aim of the particular study is to investigate to what extent the audit fees paid to external auditors (i.e. the audit firm) are affected by such restatements to the internal control reports and whether the entity’s earnings and book value of equity have a mediating role to the above relationship. The innovativeness of the current research lies at the fact that it is the first time that a research focuses on “Restatements of Internal Control Reports” (RICR) and “Firm’s Earnings” (FE) as significant determinants of “Audit Fees” (AF) paid to external auditors, providing materially useful evidence about the behavioral profile of audit firms concerning their pricing strategy. Employing a dataset that captures the period before and during the global financial crisis of 2007-2008, we use RICR as control variable to assess not only the effectiveness of internal controls, but also the performance of the selected financial institutions and to what extent do the above influence the pricing strategy adopted by audit firms. In methodological terms, we apply Multiple Regression Analysis to a data set that consists of 2.878 observations, which stem from 300 US financial institutions and are recorded for a period of seven years that range from 2004 to 2010. The selection of the specific period facilitates comparisons between the period before and during global financial crisis. These findings are then contrasted with the results that cover the whole 2004-2010 period.

Effects of SOX 404(b) implementation on audit fees by SEC filer size category

This study provides novel information about the consequences of the Sarbanes-Oxley Act (SOX) by documenting differential audit fee shocks accompanying implementation of SOX 404(b) internal control tests and reports for clients in three size categories: large accelerated filers (LAFs), small accelerated filers (SAFs), and non-accelerated filers (NAFs). First, we find that although both LAFs and SAFs experience audit fee shocks attributable to 404(b), SAFs on average experience relatively greater fee shocks than LAFs (107.8% versus 84.6%; Table 6). Second, even though NAFs are not subject to 404(b) procedures, we document a 42.7% fee shock for NAFs. Our interpretation is that 404(b) generated an immediate increase in demand for audit services with no corresponding sudden increase in supply of experienced audit personnel, enabling audit firms to charge higher prices for all filers including NAFs. We find that audit fee shocks attributable to 404(b) are positively associated with audit offices’ bargaining power relative to clients, and that the effect of offices’ bargaining power is strongest for SAFs and weakest for NAFs. Although higher audit fees (with client characteristics held constant) are often considered an indicator of better audit quality, we find virtually no evidence that the massive fee increases in 2004 are accompanied by improvements in same-year or next-year audit quality, measured as decreases in discretionary accruals and a lower likelihood of subsequent restatements of audited financial reports.

Effects of SOX 404(b) Implementation on Audit Fees by SEC Filer Size Category

This study provides novel information about the consequences of the Sarbanes-Oxley Act (SOX) by documenting differential audit fee shocks accompanying implementation of SOX 404(b) internal control tests and reports for clients in three size categories: large accelerated filers (LAFs), small accelerated filers (SAFs), and non-accelerated filers (NAFs). First, we find that although both LAFs and SAFs experience audit fee shocks attributable to 404(b), SAFs on average experience relatively greater fee shocks than LAFs (107.8% percent versus 84.6% percent; Table 6). Second, even though NAFs are not subject to 404(b) procedures, we document a 42.7% percent fee shock for NAFs. Our interpretation is that 404(b) generated an immediate increase in demand for audit services with no corresponding sudden increase in supply of experienced audit personnel, enabling audit firms to charge higher prices for all filers including NAFs. We find that audit fee shocks attributable to 404(b) are positively associated with audit offices’ bargaining power relative to clients, and that the effect of offices’ bargaining power is strongest for SAFs and weakest for NAFs. Although higher audit fees (with client characteristics held constant) are often considered an indicator of better audit quality, we find virtually no evidence that the massive fee increases in 2004 are accompanied by improvements in same-year or next-year audit quality, measured as decreases in discretionary accruals and a lower likelihood of subsequent restatements of audited financial reports.

Management's Responsibility Acceptance, Locus of Breach, and Investorss Reactions to Internal Control Reports

The triangle model of responsibility (Schlenker, Britt, Pennington, Murphy, and Doherty 1994) predicts that the extent that investors hold management responsible for an adverse event is jointly determined by the links among three elements—management, the adverse event, and the relevant accounting regulations/standards or public norms. Applying this theory, we conduct experiments to examine how the locus of breach (external versus internal) moderates the efficacy of management’s responsibility acceptance (higher versus lower). Our results show that management’s higher (versus lower) responsibility acceptance is a more effective strategy in the presence of an external breach, but not in the presence of an internal breach (Experiment 1). Follow-up experiments suggest that this result is driven by the relative strength of the triangle links underlying the external versus internal breaches, rather than the locus per se.

Voluntary Disclosure of Internal Control Weakness and Earnings Quality: Evidence From China

Using a sample of 1059 listed firms that voluntarily provide internal control reports in the period 2010–2011, this paper investigates the relationship between voluntary disclosure of internal control weaknesses (ICWs) and earnings quality in China. Our results show that earnings quality, measured by absolute discretionary accruals, is significantly associated with voluntary disclosure of ICWs. Furthermore, our results demonstrate that both accounting-related and non-accounting-related ICWs affect earnings quality. This study contributes to the internal control literature by extending the evidence for ICW disclosure to an emerging economy and examining the impact of disclosure of different types of ICWs on earnings quality. This study demonstrates that the control of non-accounting-related ICWs is critical for enterprise risk management.

Correlation between luminescence intensity and cytotoxicity in cell-based cytotoxicity assay using luciferase

The luciferase reporter assay has become one of the conventional methods for cytotoxicity evaluation. Typically, the decrease of luminescence expressed by a constitutive promoter is used as an index of cytotoxicity. However, to our knowledge, there have been no reports of the correlation between cytotoxicity and luminescence intensity. In this study, to accurately verify the correlation between them, beetle luciferase was stably expressed in human hepatoma HepG2 cells harboring the multi-integrase mouse artificial chromosome vector. We showed that the cytotoxicity assay using luciferase does not depend on the stability of luciferase protein and the kind of constitutive promoter. Next, HepG2 cells in which green-emitting beetle luciferase was expressed under the control of CAG promoter were exposed to 58 compounds. The luminescence intensity and cytotoxicity curves of cells exposed to 48 compounds showed similar tendencies, whereas those of cells exposed to 10 compounds did not do so, although the curves gradually approached each other with increasing exposure time. Finally, we demonstrated that luciferase expressed under the control of a constitutive promoter can be utilized both as an internal control reporter for normalizing a test reporter and for monitoring cytotoxicity when two kinds of luciferases are simultaneously used in the cytotoxicity assay.

The Effects of Internal Control Reporting Regulation on Control Quality, Compensation and Audit Effort

The new internal control reporting (ICR) requirements under the Sarbanes-Oxley Act of 2002 (SOX) imposed affirmative duties on managers and auditors to evaluate and attest to the effectiveness of internal controls and disclose any control weaknesses. This paper studies the role of ICR regulation in enhancing incentives for internal control quality and audit effort which jointly alleviate accounting manipulation. I formulate a model that emphasizes the strategic interaction between internal control and external audit in detecting accounting manipulation as well as the stewardship and valuation roles of accounting information in financial reporting. I show how and why the ICR regulation enhances incentives for internal control quality and audit effort, and make predictions regarding the regulatory effects on the audit failure rate, manager's expected compensation, audit fee and current owner's expected payoff.

Internal control weakness and accounting conservatism in China

Purpose The purpose of this study is to investigate the impact of internal control weaknesses on accounting conservatism in Chinese listed firms. It also investigates the relationship between the demand for external audit and accounting conservatism, and whether additional assurance of internal control reports (ICRs) can mitigate the negative impact of ICWs on accounting conservatism. Design/methodology/approach An empirical research approach is taken through the use of ordinary least squares (OLS) models and hand-collected internal control weakness data from ICRs released by Chinese listed firms. Findings The results of this paper show that the existence of ICWs has a negative effect on accounting conservatism in China. Further, the results demonstrate that both accounting-related and non-accounting-related ICWs affect accounting conservatism. The authors also find that there is a complementary relationship between accounting conservatism and the demand for additional assurance of ICRs, and additional assurance of ICRs can mitigate the negative impact of ICWs on accounting conservatism. Practical Implications This study provides timely evidence to Chinese regulators of the possible economic consequences of the official implementation of internal control standard in China from 2012. The findings of this paper can also benefit regulators around the world and, in particular, the regulators in emerging markets that are considering implement regulations similar to the US SOX. Originality/value The paper demonstrates that a wider scope of ICWs, including non-accounting-related ICWs, also has a significant impact on accounting conservatism. Therefore, this research provides a more general evidence on the relationship between internal control quality and accounting conservatism.