LIKELINESS OF PENALTIES IN CASE OF FAILURE TO REPORT EXISTING INTERNAL CONTROL WEAKNESSES

Abstract

Sarbanes-Oxley Act (SOX) was passed in 2002 to increase corporate responsibility and to help restore investors trust in capital markets after several large accounting scandals related to lack of effective internal controls. Section 404 of SOX became effective in 2004. It has since then been a controversial aspect of the Act because of its requirement for both management and external auditor to formally give their opinion in annual report on the effectiveness of a company's internal controls over financial reporting. Despite the requirements of the Act it has been found that many material internal control weaknesses are not disclosed until after the restatements. Consequently concerns have begun to emerge considering effectiveness and trustworthiness of SOX 404, as previous research has suggested that the relatively small amount of timely reported internal con-trol weaknesses may be due to material weaknesses not being noticed or reported. Pur-pose of this research is to investigate whether penalties are more likely for companies that fail to report their internal control weaknesses in a timely manner. The study com-pliments prior research of Rice, Weber and Wu (2015). Research method used for em-pirical testing is multiple linear regression analysis. Empirical data used for testing are collected from fiscal years 2006 to 2015.

Final results of this study support finding of Rice, Weber and Wu (2015): no evidence is found that penalties would be more probable for companies that fail to report existing internal control weaknesses in a timely manner. This is concerning, as it suggests that enforcement mechanisms of SOX 404 are not likely to provide strong incentives to detect and disclose internal control weaknesses. In the long run this may cause for SOX 404 not to be able to fulfill its quest of enhancing the reliability of financial reporting.