Material Weakness Disclosures Research Articles

Do Shareholders Care about “Surprise” Internal Control Weakness Disclosures?

SUMMARY Prior research shows that many of the companies that disclose material weaknesses in internal control (MWs) do not disclose such weaknesses in earlier quarterly 10-Q filings for the same year—i.e., the year-end MW disclosures are “surprise” disclosures. We find that shareholders at accelerated filers with surprise MW disclosures are more likely to vote against auditor ratification (by a factor of about 1.4 times) than at companies with “no-surprise” MW disclosures. These findings suggest that shareholders may at least partly blame auditors and hold them responsible for the surprise MW disclosures. Internal control disclosures necessarily involve professional judgment, but the results indicate that for shareholders, earlier disclosure of such problems is preferable to waiting until the year-end (and perhaps hoping that the problems will be resolved).

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.

Internal Control and the Insider versus Outsider CEO Choice

ABSTRACT We examine whether the quality of a firm’s internal controls affects a board’s decision to hire an insider as CEO. We find that the board is less likely to select an insider as CEO following an internal control material weakness (ICMW) disclosure. In cross-sectional analyses, we find that the adverse effect of weak internal controls on the likelihood of hiring an insider CEO is attenuated for firms that restate past misstatements and is pronounced when boards are more independent. We also find that audit fees are lower for ICMW firms when an outsider CEO is appointed, indicating that external auditors perceive lower audit risk. Taken together, our findings suggest that in the presence of a weak internal control environment, the board prefers an outsider CEO over an insider who may have been a part of the internal control issues, notwithstanding the fact that evaluating the outsider CEO can be challenging.

Financial statement fraud litigation, material weaknesses, and board characteristics

PurposeThe purpose of this study is to investigate whether the likelihood that a firm will face financial statement fraud litigation is affected by the disclosure of internal control material weaknesses (MW) and the “busyness” of a firm’s board of directors.Design/methodology/approachThe results are derived from logistic regression models and data are collected from the Audit Analytics database augmented by data from CompuStat, the Stanford Law School website and the SEC Accounting and Auditing Enforcement Releases. The authors also test for endogeneity with a propensity score matching procedure.FindingsThe authors find that an MW report is strongly associated with the likelihood of subsequent financial statement fraud litigation, and that the influence of entity-level MW on litigation likelihood is stronger than that of account-level MW. Moreover, the number of outside board directorships significantly increases the influence of entity-level MW on the likelihood of litigation, indicating that board of directors’ busyness significantly increases the risk of litigation.Originality/valuePrevious research notes that board members holding multiple directorships cannot effectively oversee the financial reporting process and, thus, are associated with poorer governance. The authors extend this implication of board busyness to the association between disclosure of MW type and the filing of subsequent litigation alleging financial statement fraud. To the best of the authors’ knowledge, no other research has done so.

The Association between PCAOB Inspection Reports and Seasoned Equity Offering Discounting

SUMMARY We examine the association between Public Company Accounting Oversight Board (PCAOB) inspection reports and a firm’s cost of equity capital, measured using seasoned equity offering (SEO) discounting. SEO discounting occurs when the offer price is lower than the prior day’s market price of the firm’s shares and represents “money left on the table” for issuing firms. We document an economically significant, positive association between SEO discounting and the use of an auditor found to be deficient by the PCAOB for clients of triennially inspected auditors. Cross-sectional evidence suggests that this relation is stronger for clients with lower analyst following and disclosed material weaknesses in financial reporting controls, and weaker if the auditor issues a going concern modification. Our evidence is consistent with PCAOB inspections providing meaningful information about audit quality to market participants, particularly for clients of smaller, triennially inspected auditors. Data Availability: All data are from publicly available sources. JEL Classifications: M42.

Internal control material weakness disclosure and misstatement duration

AbstractOnly a small proportion of companies that announce restatements disclose existing internal control material weaknesses (ICMWs) over financial reporting during misstatement periods. Using a sample of 1939 restatements related to misstatements between 2003 and 2015, we find that misstatement duration decreases with the disclosure of ICMWs during misstatement periods. Our results are robust to different samples and different measures of the dependent and test variables. We also find that the number of ICMWs disclosed is negatively related to misstatement duration. The disclosure of both entity‐level and process‐level ICMWs is associated with misstatements of shorter duration. Moreover, we find that the negative association between ICMW disclosure frequency and misstatement duration is more salient when restatements are intentional. Despite the negative consequences of reporting existing ICMWs found in prior studies, our results suggest that the disclosure of ICMWs can shorten the duration of misstatement periods, leading to more timely improvement in financial reporting. Hence, our evidence provides context and complements prior research suggesting that companies are penalized for disclosing ICMWs.

Early Warnings of SOX 404 Material Weaknesses in Internal Control

SUMMARYSOX Section 404(b) continues to be of interest to legislators and regulators. Prior studies show that in the initial implementation years of SOX 404, the majority of material weakness (MW) disclosures were “surprise” MWs—i.e., disclosed at year-end, but not in prior quarterly filings (Hermanson and Ye 2009; Munsif, Raghunandan, and Rama 2013). We show that during the years 2010–2019, 74 (72) percent of MW disclosures by accelerated (non-accelerated) filers were surprise disclosures. Additionally, surprise MWs are more likely to be associated with internal control issues that involve year-end adjustments and/or documentation, procedure, or policy issues. “Early-warning” MWs are more likely due to systemic internal control problems, like segregation of duties. Our findings suggest a role for auditors and substantive audit tests in the disclosure of certain types of MWs. Increased auditor emphasis on interim substantive tests may reduce the likelihood of surprise MWs.

“Surprise” material weakness disclosures: Effects on audit fees and audit report lags

Prior research shows that many of the companies that disclose material weaknesses in internal control (MWs) do not disclose such weaknesses in earlier quarterly 10-Q filings for the same year—i.e., the year-end MW disclosures are “surprise” disclosures. I first show, using data from 2009 to 2019, that such surprise MWs continue to be the majority of MW disclosures as late as 2019. I find that accelerated filer companies with surprise MWs pay lower fees compared to companies with no-surprise MWs; however, this finding does not hold for non-accelerated filers. I also find that there are no significant differences in the audit report lag of surprise and no-surprise MW disclosers. Thus, the lower audit fee paid by surprise MW disclosure companies may offer a possible explanation for the widespread prevalence of surprise MW disclosures. The results also highlight the importance of the external auditor in public disclosures of MWs. The findings have public policy relevance given the ongoing efforts to expand the set of companies that would be exempt from the auditor attestation of internal controls.

Disclosure of internal control material weaknesses and optimism in analyst earnings forecasts

This paper investigates how analyst forecast optimism is associated with disclosures of internal control material weaknesses (ICMWs) and their remediation under Section 404 of the Sarbanes–Oxley Act (SOX). Drawing on agency theory, I hypothesize that analysts are likely to issue earnings forecasts that are more optimistic for firms with ICMW disclosures than for those without ICMW disclosures. Using a sample of 20,875 firm-year observations with 10-K (10-Q) reports from 2004 to 2018, I find a positive association between ICMW disclosures and analyst forecast optimism. This positive association is partially driven by investors’ inability to unravel analyst forecast bias and analysts’ intentions to curry favor with management for private information. In addition, analysts are found to issue less optimistic forecasts for firms with ICMW remediation disclosures compared with those without ICMW remediation disclosures. A series of propensity score matching and regression analyses are conducted to test the robustness of my inferences. Overall, the paper suggests that analysts have incentives to take the opportunity of firms disclosing ICMWs to bias their forecasts upward for self-interest. The findings have the potential to assist regulators in guiding analyst behavior and educating investors to unravel positive bias in analyst forecasts.

Determinant Factors of Bank Financial Reporting Quality; Study at Regional Development Banks in Sumatra

This study examined the simultaneous influence of performance credibility, go-public companies, company director with adequate auditing experience, age of CEO, material weakness disclosure, changes in public accountant, connection between CEO with the government, and Good Corporate Governance on the quality of financial reporting of Regional Development Banks in Sumatera. This study also analyzed the partial influences of Independent variables on the quality of financial statements of Regional Development Banks in Sumatera, and determined the variable with the strongest influence on the quality of financial statements of regional banks in Sumatera. Secondary data were analyzed using logistic regression tests. Sample in this study is all of Regional Development Banks in Sumatera. The hypotheses of this study consist of three types of tests; Simultaneous Significance Test (F test), Individual Parameter Significance Test (T-test), and Coefficient Determination Test (R2). The results of the data analysis showed that : the first, performance credibility, go-public companies, company director with adequate auditing experience, age of CEO, changes in public accountant, connection between CEO with the government, ,material weakness disclosures, and Good Corporate Governance simultaneously affected the quality of financial statements reporting at regional banks in Sumatera. Secondly, material weakness disclosures and Good Corporate Governance had partial influence on the quality of the financial reporting, Meanwhile, performance credibility, go-public companies, directors with auditing experience, age of CEO, changes in public accountant, and the connection between CEO with the government had not partial influence on the quality of the financial reporting. Third, All variable was found influence significance (65%) on the quality of financial reporting of regional banks in Sumatera. Keywords: Good corporate governance, public accountant and quality of financial statements DOI: 10.7176/RJFA/11-17-19 Publication date: October 31 st 2020

To Outsource or Not? Evidence from Changes in Component Auditor Use after the Disclosure of An Internal Control Material Weaknesses

This paper investigates how increases in client audit risk influence the use of component auditors. Auditors respond to increases in audit risk by making adjustments to the audit engagement such as increasing fees and/or increasing effort. As more audit resources are demanded by clients with increased audit risk, one way for the lead auditor to free up resources is to allocate more work to component auditors. Using a difference-in-difference research design, with the revelation of an internal control material weakness (ICMW) as an event for increased audit risk, we find that component auditor use increases after the revelation of an ICMW, and increases even more when the ICMW is severe. We also find that the increase in component auditor use after an ICMW is positively associated with the likelihood of ICMW remediation. Thus, we identify a situation where component auditor use enhances audit quality and provides a benefit to the company (i.e., increased likelihood of ICMW remediation). Our study should be of interest to regulators, given the criticism by the PCAOB regarding firms’ use of component auditors and the evidence in prior literature on how component auditor use influences audit quality.

Internal Control Quality and Investment Efficiency

SYNOPSISWe investigate whether the quality of internal control over financial reporting (ICOFR) has implications for the quality of internal control over fixed assets by examining the relation between material weaknesses (MWs) and investment efficiency. After excluding restating firms and controlling for externally reported earnings quality and the potential endogeneity of material weakness disclosure, we find that managers in firms with weak ICOFR are more likely to make inefficient investments. This relation is stronger when investment-specific MWs are related to capital expenditure and property, plant, and equipment. We further show a significantly negative relation between future cash flows and investments made by firms with weak ICOFR. Overall, our findings are distinct from prior studies in that they are independent of financial reporting quality and suggest that weak ICOFR implies that internal controls over fixed assets failed as well.Data Availability: Data are available from public sources identified in the paper.

Earnings management and instances of material weaknesses reported under Sections 302 and 404

ABSTRACT Sections 302 and 404 of the 2002 Sarbanes-Oxley Act require firms to disclose material weaknesses (MWs) in internal controls. We investigate the association of single and multiple instances of MWs with earnings management. Multiple instances are positively associated with earnings management for Section 302 and 404 firms, whereas single instances have no such association for either firm type. Thus, MWs that are not remediated within one quarter or year tend to be positively associated with earnings management and, in particular, with income-decreasing earnings management. Multiple instances of MWs for such firms can therefore provide critical information for auditors and investors.

Material weakness disclosures and restatements: value of external auditor attestation

PurposeThe purpose of this study is to examine the value of auditor attestation in internal control over financial reporting (ICFR) disclosures. The authors argue that internal control material weakness (ICMW) disclosures issued without auditor attestation by non-accelerated filers provide weaker signal to the impaired financial reporting quality compared to those issued with auditor attestation by accelerated filers.Design/methodology/approachThis study investigates the differences in the association between ICMW disclosures and impaired financial reporting quality, as proxied by financial statement restatements, for accelerated and non-accelerated filers. The authors use propensity score matching to find control groups for both accelerated and non-accelerated filers.FindingsThe authors find that ICMW disclosures signal impaired financial reporting quality for both accelerated and non-accelerated filers, but such signaling is weaker for non-accelerated filers compared to accelerated filers.Research limitations/implicationsAlthough propensity score matching was used to match firms with and without ICMW disclosures, any unobservable fundamental differences between these groups may affect the results of this study.Originality/valueThis study shows that auditors’ involvement in the assessment of internal control effectiveness improves the signaling effect of ICMW disclosures on impaired financial reporting quality. As approved by the House Financial Services (HFS) Committee on November 4, 2009, non-accelerated filers are permanently exempt from auditor attestation requirement. This study provides some evidence that the exemption of non-accelerated filers from auditor attestation may have unintended consequences, and these results should be of interest to regulators and investors.

Internal control quality and relationship‐specific investments by suppliers and customers

AbstractThis paper investigates the association between the quality of internal control over financial reporting (ICOFR) and relationship‐specific investments by suppliers/customers. I find a significant negative association between the disclosure of a material weakness (MW) in ICOFR and changes in the relationship‐specific investments of suppliers/customers. Relationship‐specific investments of suppliers/customers have a stronger negative association with inventory‐related MW. The negative association between MW disclosures and the relationship‐specific investments of suppliers/customers is stronger when economic dependence between the firms and the suppliers/customers is more important and when the suppliers/customers have greater bargaining power. Also, suppliers/customers significantly increase their relationship‐specific investments following the remediation of ineffective ICOFR. Overall, my findings show that a firm's quality of ICOFR affects the relationship‐specific investment decisions of suppliers/customers.

Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections

ABSTRACTWe find that firms are less likely to report an internal control material weakness (as mandated by the Sarbanes‐Oxley Act) in a given year if one of their audit committee members is concurrently on the board of a firm that disclosed a material weakness within the prior three years. We find a similar spillover effect for financial restatement disclosures. The spillover from material weakness disclosures is evident only if a shared director has more experience with the disclosing firm or can channel more information about the disclosed material weakness. Our findings suggest that prior director experiences outside the firm influence the work of audit committees inside the firm. One rationale is that a director's prior experience with an adverse disclosure helps diffuse important insights and serves as a catalyst for improvements in a firm's internal control and financial reporting practices. An alternative explanation, which we cannot dismiss, holds that a director's prior experience helps a firm to underreport material weaknesses and financial restatements without any attendant improvements in the underlying practices.

Earnings Management and Instances of Material Weaknesses Reported Under Sections 302 and 404

Sections 302 and 404 of the 2002 Sarbanes-Oxley Act require firms to disclose material weaknesses (MWs) in internal controls. We investigate the association of single and multiple instances of MWs with earnings management. Multiple instances are positively associated with earnings management for Section 302 and 404 firms, whereas single instances have no such association for either firm type. Thus, MWs that are not remediated within one quarter or year tend to be positively associated with earnings management and, in particular, with income- decreasing earnings management. Multiple instances of MWs for such firms can therefore provide critical information for auditors and investors.

Material weakness disclosures and restatement announcements: The joint and order effects

AbstractWe examine differences in stock price, option volatility, and litigation reactions to restatement announcements that are associated with a material weakness (MW) disclosure. Contrasted with restatements that are not associated with any MW disclosure, our analyses reveal that firms that announce both a restatement and an associated MW experience significantly more negative market returns, greater implied volatility, and higher likelihood of class action lawsuits. Separating the restatements into timely reporters, where the MW precedes the restatement, and non‐timely reporters, where the MW is concurrent with or follows the restatement, we find that timely reporters experience more negative returns at the time of the restatement, relative to non‐timely reporters, suggesting that investors perceive the early MW disclosure to signal more pervasive control‐related problems. Interestingly, we find that timely and non‐timely reporters are equally likely to be sued, consistent with the argument that wrongdoing (through either a timely or non‐timely MW disclosure) provides stronger grounds for establishing scienter. However, timely reporters appear to secure more favorable litigation outcomes: they face higher likelihood of lawsuit dismissals and pay much lower settlements, compared to non‐timely reporters. Overall, our evidence provides new insights into how market participants incorporate information about internal control weaknesses into their perceptions regarding the economic implications of financial restatements, and financial reporting quality.

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.

Employee Perceptions of Control Environment Quality and Audit Pricing

According to the internal control and auditing literatures, “tone at the top” plays an important role in entities’ internal control over financial reporting (ICFR) and in auditors’ planning and risk assessment decisions. We offer new insights on the relation between tone at the top and audit production costs by measuring tone at the top based on employees’ perceptions of management as independently solicited and gathered by Great Place to Work Institute (GPTW). Consistent with prior research findings that use material weakness disclosures as a proxy for internal control quality, we find that tone at the top is associated with reduced audit production costs. However, we find that the effect of tone at the top continues to be associated with audit production costs even for firms that have no material weakness disclosures, suggesting that auditors observe and rely on tone at the top even where ICFR is deemed to be effective overall. Our new proxy allows us to offer additional new insights. For example, we find that the relation between tone at the top and audit production costs is especially strong when employee perceptions relating to tone are more consistently held throughout the organization. We also find that a positive tone at the top is more positively associated with audit production costs in the presence of indicators of heightened client risk (i.e., higher earnings manipulation risk and complex accounting). Additionally, when we disaggregate our tone at the top measure into two components (employee perceptions of integrity and communication practices), we find that in higher risk settings, integrity is particularly strongly associated with audit production costs.