Material Weaknesses Research Articles

Predicting Material Weaknesses In Internal Control Systems After The Sarbanes-Oxley Act Using Multiple Criteria Linear Programming And Other Data Mining Approaches

<h1 style="TEXT-JUSTIFY: inter-ideograph; TEXT-ALIGN: justify; MARGIN: 0in 0.5in 0pt"><span style="font-family: Times New Roman;"><span style="COLOR: black; FONT-SIZE: 10pt">Our study proposes a multiple criteria linear programming (MCLP) </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other data mining </span><span style="COLOR: black; FONT-SIZE: 10pt">method</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">s</span><span style="COLOR: black; FONT-SIZE: 10pt"> to predict </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">material weaknesses in a firm’s internal control system after the Sarbanes-Oxley Act</span><span style="COLOR: black; FONT-SIZE: 10pt"> (SOX) using </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">2003-2004</span><span style="COLOR: black; FONT-SIZE: 10pt"> </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">U.S. </span><span style="COLOR: black; FONT-SIZE: 10pt">data.<span style="mso-spacerun: yes">  </span>The results of the MCLP </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other data mining </span><span style="COLOR: black; FONT-SIZE: 10pt">approaches in </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">our</span><span style="COLOR: black; FONT-SIZE: 10pt"> </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">prediction </span><span style="COLOR: black; FONT-SIZE: 10pt">study show that the </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">MCLP</span><span style="COLOR: black; FONT-SIZE: 10pt"> method performs</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO"> </span><span style="COLOR: black; FONT-SIZE: 10pt">better overall than the </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">other data mining approaches </span><span style="COLOR: black; FONT-SIZE: 10pt">using financial </span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO">and other </span><span style="COLOR: black; FONT-SIZE: 10pt">data from the Form 10-K report.</span><span style="COLOR: black; FONT-SIZE: 10pt; mso-fareast-language: KO"><span style="mso-spacerun: yes">  </span>Consistent with prior research, firms that disclosed material weaknesses in their SOX Section 302 disclosures were more complex (based on the existence of foreign currency translations), more often used Big 4 auditors, and had lower operating cash flows-to-total assets ratios than the non-material weakness control firms.<span style="mso-spacerun: yes">  </span>Because of mixed results on several profitability measures and marginal predictive ability for the MCLP and other methods used, more research is needed to identify firm characteristics that help investors, auditors, and others predict material weaknesses.</span></span></h1>

When Is a Liability Not a Liability? Textual Analysis, Dictionaries, and 10‐Ks

ABSTRACTPrevious research uses negative word counts to measure the tone of a text. We show that word lists developed for other disciplines misclassify common words in financial text. In a large sample of 10‐Ks during 1994 to 2008, almost three‐fourths of the words identified as negative by the widely used Harvard Dictionary are words typically not considered negative in financial contexts. We develop an alternative negative word list, along with five other word lists, that better reflect tone in financial text. We link the word lists to 10‐K filing returns, trading volume, return volatility, fraud, material weakness, and unexpected earnings.

How Much Can We Learn from Regressing Corporate Characteristics Against the State of Incorporation?

Several well-known papers attempted to measure the causal impact of state corporate laws on the economy by regressing a single financial or accounting variable against the state of incorporation and controls for other firm characteristics. In this paper, I provide evidence that this approach is misguided because it does not address endogeneity of firms’ incorporation choices. First, I show that all well-known results attributed to incorporation in Delaware or Nevada disappear when we control for the fact of out-of-state incorporation; this plausibly proxies for unobserved firm characteristics that drive both the choice of the state of incorporation and some of the financial and accounting values. In particular, if we do not control for the firm’s decision to incorporate outside its home state (as prior literature did), incorporation in DE predicts multiple measures of corporate quality: higher Tobin’s Q, lower R-squared, lower abnormal accruals, lower real earnings management, and lower rates of “material weakness” and “significant deficiency” reports. However, with proper controls for the out-of-state incorporation, none of these results survive, including the often-cited Tobin’s Q result. Furthermore, on most of these measures, firms incorporated in Nevada perform as well or better than Delaware firms, when we control for the out-of-state incorporation choice. Finally, I show that firms that choose to incorporate outside their home states are systematically different from firms that do not: they are more likely to have proxies for better firm-level governance.

Impact of Firm and Corporate Governance Characteristics on Auditor Dismissal: Evidence from Material Weakness Firms

Impact of Firm and Corporate Governance Characteristics on Auditor Dismissal: Evidence from Material Weakness Firms

Disclosures of Material Weaknesses by Japanese Firms after the Passage of the 2006 Financial Instruments and Exchange Law

Disclosures of Material Weaknesses by Japanese Firms after the Passage of the 2006 Financial Instruments and Exchange Law

Disclosures of Material Weakness by Japanese Firms after the Passage of the 2006 Financial Instruments and Exchange Law

Disclosures of Material Weakness by Japanese Firms after the Passage of the 2006 Financial Instruments and Exchange Law

Chief Financial Officers on Their Company’s Board of Directors: An Examination of Financial Reporting Quality and Entrenchment

Considerable prior research investigates whether the extent of insider presence on corporate boards is detrimental. However, the majority of past research treats all inside directors as a homogenous group. This study considers that issue in the context of chief financial officers (CFO) serving on their own company's board. Our research is important because individuals in different executive roles bring different skills and knowledge to board interactions, highlighting the potential for differential contributions. As prior research does not specifically distinguish CFOs from other board insiders, the potential benefits of knowledge sharing due to increased communication with other board members may have been masked. Specifically, the CFO is directly responsible for the quality of the financial reporting process and can therefore be associated with specific outcome measures. Our results show that the percentage of CFOs serving on their own boards is not large, likely due to the perspective (consistent with agency theory and reflected in independence guidelines) that company insiders on boards could promote their own best interest at the expense of shareholders. Contrary to this perception, we find that companies whose CFO has a seat on the board are associated with higher financial reporting quality (i.e., a lower likelihood of reporting a material weaknesses in internal controls or having a financial restatement, and better accruals quality). Yet, we also find potential drawbacks in that CFOs with a board seat tend to have higher excess compensation and lower likelihood of termination following poor performance, signaling greater entrenchment. While our results provide information to companies considering appointing the CFO to the board, both costs and benefits are demonstrated, and thus we conclude that each board should consider this decision based on its own circumstances and composition.

Audit Partner Evaluation of Compensating Controls: A Focus on Design Effectiveness and Extent of Auditor Testing

SUMMARY: Prior research has shown that when auditors are aware of overall risk information from procedures performed earlier in the audit, halo effects in subsequent judgments result (e.g., O’Donnell and Schultz 2005). The purpose of this study is to examine whether such effects occur in the context of evaluating the effectiveness of a client’s internal control over financial reporting. We experimentally examine whether information about overall risks (i.e., existence of a material weakness unrelated to a compensating control being evaluated and level of overall inherent risk) influences audit partners’ judgments related to a compensating control that has been implemented within a specific client process. The judgments we examine include the (1) level of precision needed in a compensating control for it to be assessed as effectively designed, and (2) extent of evidence needed for auditor testing of the operating effectiveness of the control.Our results are based on responses from 90 audit partners. We find that the existence of a material weakness unrelated to a compensating control being evaluated results in partners preferring a more precise compensating control and requiring more auditor testing. Further, while prior research has demonstrated that knowledge of overall inherent risk factors results in halo effects, our results indicate that this knowledge does not influence partners’ judgments about a compensating control.

Should Independent Board Members with Social Ties to Management Disqualify Themselves from Serving on the Board?

This paper examines whether independent directors who have social ties to management (inside directors) can effectively perform their fiduciary duty to monitor management on behalf of shareholders. Ex ante, it is not clear whether social ties will enhance or obstruct the quality of board performance. Theory suggests that directors who are socially tied to management are ineffective and would make decisions favoring management. However, social ties can increase trust and information sharing between management and independent directors, improving directors’ ability and effectiveness in governing the company (Westphal, J.D.: 1999, The Academy of Management Journal 42(1), 7–24). To examine these contradicting predictions I use social network analysis and construct proxies for social ties between management and independent board members. Using these proxies, I first demonstrate that social ties are associated with higher managerial compensation. Further analyses reveal that these results are driven by social ties that include members of the compensation committee. Conversely, I demonstrate that financial reporting quality is improved when social ties exist. Specifically, I find that the likelihood of material weaknesses in internal controls and the likelihood of financial restatements are lower in companies with social ties. I further observe that this improved quality of financial reporting holds only when social ties include members of the audit committee. I conclude that ethically, socially tied independent directors should disqualify themselves from serving on compensation committees where social independence is essential. However, in tasks where collaboration with management is essential, directors with social links to each other can be of added value to shareholders.

Audit Fees after Remediation of Internal Control Weaknesses

SYNOPSIS: In this study, we examine audit fees for SEC registrants that remediate previously disclosed material weaknesses in internal control. We find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years. Firms that had an adverse Section 404 report only in the first year, but remediated the problems in year two and had clean Section 404 reports in years three and four, pay an audit fee premium of 32 (21) percent in the third (fourth) year when compared to firms that had clean Section 404 reports in each of the first four years. The results, thus, suggest that audit fees are “sticky” for firms that have material weaknesses in internal controls over financial reporting, and suggest some interesting questions for future research.

From Phishing To Advanced Persistent Threats: The Application Of Cybercrime Risk To The Enterprise Risk Management Model

This paper examines the issues of cybercrime in the context of risk to organizations. In particular, it considers the control frameworks most commonly used by U.S. public companies to benchmark their internal controls over financial reporting. It discusses the market for stolen identities, looking at the sources from which many of those identities are stolen. It reviews the available internal control frameworks and explains how a firm’s risk of cybercrime might be classified as a material weakness under Sarbanes-Oxley Section 404. It models how the use of COSO’s Enterprise Risk Management model could improve an organization’s chances of avoiding a serious incident.

Perceptions of Investment Risk Associated with Material Control Weakness Pervasiveness and Disclosure Detail

ABSTRACT: This research examines whether investors adjust their assessments of investment risk in response to material control weakness disclosures, the pervasiveness of material control weaknesses, and the detail of explanation provided regarding the pervasiveness of material control weaknesses. Findings from a laboratory experiment with 97 nonprofessional investors, a second experiment with 53 nonprofessional investors, and surveys of 47 investors and 28 Fortune 500 directors confirm prior archival findings that investors adjust their investment risk assessments in response to material weakness disclosures. More importantly, we find evidence of an interactive effect of material control weakness pervasiveness and disclosure detail that is counter to the expected benefits of expanded disclosure desired by corporate directors. When material weakness disclosures include specific and detailed discussion of the pervasiveness of control weaknesses, investors increase assessments of investment risk for less pervasive weaknesses and decrease assessments of risk for more pervasive weaknesses. Results indicate that these findings are driven by different levels of investor trust in management.

Determinants of Internal Control Weaknesses

The major purpose of this paper is to find the financial and nonfinancial variables which would be useful in identifying companies with Sarbanes-Oxley Act internal control material weaknesses (MW). Recently, three research papers have been published on this topic based on different variables. Using the decision tree model of data mining, this paper examines the predictive power of the variables used in each paper in identifying MW companies and compares the predictive rates of the three sets of the variables used in these studies. In addition, an attempt is made to find the optimal set of the variables which gives the highest predictive rate. Our results have shown that each set of the variables is complementary to each other and strengthens the prediction accuracy. The findings from this study can provide valuable insights to external auditors in designing a cost-effective and high-quality audit decision support system to comply with the Sarbanes-Oxley Act. Keywords: Sarbanes-Oxley Act, Internal Control Material Weakness, Data Mining

The Consequences of Information Technology Control Weaknesses on Management Information Systems: The Case of Sarbanes-oxley Internal Control Reports

In this article, the association between the strength of information technology controls over management information systems and the subsequent forecasting ability of the information produced by those systems is investigated. The Sarbanes-Oxley Act of 2002 highlights the importance of information system controls by requiring management and auditors to report on the effectiveness of internal controls over the financial reporting component of the firm's management information systems. We hypothesize and find evidence that management forecasts are less accurate for firms with information technology material weaknesses in their financial reporting system than the forecasts for firms that do not have information technology material weaknesses. In addition, we examine three dimensions of information technology material weaknesses: data processing integrity, system access and security, and system structure and usage. We find that the association with forecast accuracy appears to be strongest for IT control weaknesses most directly related to data processing integrity. Our results support the contention that information technology controls, as a part of the management information system, affect the quality of the information produced by the system. We discuss the complementary nature of our findings to the information and systems quality literature.

Why Don't Japanese Companies Disclose Internal Control Weakness?: Evidence from J-SOX Mandated Audits

This study uses data on Japanese listed companies for the period 2009 to 2012 to examine the incentive factors for the (non-)disclosure of material weakness (MW) in internal control over financial reporting. The propensity score-matching results of matched and potential MW companies from the research sample reveal that companies that do not disclose MW have longer management tenure, Big 3 auditors, lower audit fees, larger boards of directors, fewer outside directors, and greater main bank involvement than those companies that disclose MW. In addition, the non-disclosure of MW at the company level is associated with longer management tenure, larger management shareholdings, and greater main bank involvement, whereas the non-disclosure of MW at the account-specific level is associated with longer management tenure, Big 3 auditors, lower audit fees, significant non-audit services, and greater main bank involvement. These results suggest that the assessment and audit process of internal control systems in Japan is sensitive to management- and audit-related (non-)disclosure incentives. The findings could provide useful academic insights as well as practical guidance for companies in Japan, the United States, and other countries.

The Role of the Internal Audit Function in the Disclosure of Material Weaknesses

ABSTRACT: This study investigates the role that a firm’s internal audit function (IAF) plays in the disclosure of material weaknesses reported under Section 404 of the Sarbanes-Oxley Act of 2002 (U.S. Congress 2002). Using data from 214 firms, we examine the relation between material weakness (MW) disclosures and various IAF attributes and activities. Our results indicate that MW disclosures are negatively associated with the education level of the IAF and the extent to which the IAF incorporates quality assurance techniques into fieldwork, audits activities related to financial reporting, and monitors the remediation of previously identified control problems. The timing of Section 404 work and the nature of follow-up monitoring suggests that these aspects of IAF quality help prevent MWs from occurring. We find that MW disclosures are positively associated with the IAF practice of grading audit engagements and external-internal auditor coordination, suggesting that these activities increase the effectiveness of Section 404 compliance processes.

Investor reactions to disclosures of material internal control weaknesses

PurposeThe purpose of this paper is to examine investor reactions to material internal control weakness disclosures. In particular, the abnormal returns, the change in volatility, and the change in systematic risk are analyzed around auditors' material weakness reports.Design/methodology/approachThe sample consists of 342 firms with initial Sarbanes‐Oxley Act, Section 404 weakness disclosures issued between 2005 and 2007. The paper uses three measures for investor reactions: abnormal returns and the change in volatility and systematic risk. The hypotheses of the paper are investigated using univariate analysis.FindingsThe initial results imply surprisingly that the material weakness disclosure is good news to investors. However, after controlling for the preceding management's internal control disclosure, the results show that the abnormal reaction is positive only when the audit report is consistent with the preceding management report. In addition, the results show a significant change in volatility after the auditor's weakness disclosure.Research limitations/implicationsThese results imply that the investor reactions to auditors' material weakness disclosures depend on the content of the preceding report issued by management: there is a positive reaction if management has identified and reported the existing material weaknesses before the auditor, and a negative reaction when management has failed to identify or report the material weaknesses before the auditor.Originality/valueThe findings of this paper emphasize that the value of the information contained in the auditors' material internal control weakness disclosures vary significantly depending on management disclosures.

A Risk Model to Opine on Internal Control

SYNOPSIS: In recent years, auditors have reported on the effectiveness of internal control, usually as part of integrated audits. The audit risk model currently in auditing standards was designed for financial statement audits, not internal control audits—a key part of integrated audits. Because the audit of processes (internal control) is conceptually different from the audit of outputs (financial statements), the auditor needs a different risk model to provide a conceptual framework for internal control audits. The model I propose1 provides the auditor a method to determine the appropriate nature, timing, and extent of testing in an integrated audit. My model is focused on the risk of material weakness, rather than the risk of material misstatement. I also show how the auditor would use two different models in an integrated audit.

Auditor’s Industry Specialization and Earnings Management of Firms Reporting Internal Control Weaknesses Under SOX Section 404

Prior studies document that firms having material weaknesses in internal control over financial reporting adjust more discretionary accruals in financial reporting process than other firms. This study examines the influence of industry-specialist audits on accrual management behavior of firms whose internal control is reported as ineffective by their external auditors pursuant to SOX Section 404. Previous research further shows that specialist auditors have greater industry-specific knowledge and expertise, and are more familiar with clients’ business. They constrain management’s propensity to misreport earnings and other financial information. In this study, we include auditor industry specialization as a proxy for the mitigating force on earnings management in an economic setting where incentive to manage earnings is deemed to be at an elevated level. The test results suggest that though firms with ineffective internal control (ICW) manage discretionary accruals at a greater level than firms with effective internal control (non-ICW), specialist auditors influence accrual management decision of the ICW firms and reduce the level of discretionary accrual adjustments. As a result, industry-specialist audits also substantially attenuate the difference in accrual management between ICW and non-ICW firms. We find consistent results for both the absolute and signed discretionary accruals for the sample ICW and non-ICW firms. Moreover, the supplemental tests for a sample of constant ICW and non-ICW firms produce similar results. Finally, our main results also hold for a reduced sample of the Big 4 client companies. **Please do not quote without permission.

Analysis of The Relation Between The Material Weakness of Internal Accounting Control System and Firm's Characteristics Variables, Validation Comparison of Testing Models

Analysis of The Relation Between The Material Weakness of Internal Accounting Control System and Firm's Characteristics Variables, Validation Comparison of Testing Models