The effect of SOX 404 material weaknesses and their remediation on accrual quality

Abstract

The objective of internal control over financial reporting (ICFR) is to provide reasonable assurance regarding the reliability of financial reporting and produce financial statements for external purposes. Weaknesses in internal controls have often been associated with fraud and business failure. Accruals are a fundamental component of reliable financial information and internal control weaknesses can affect accrual quality in two principal ways: through unintentional misstatements and intentional misrepresentations.

This study examines the effect of internal control weaknesses on financial reporting quality, more specifically on accrual quality. The purpose of this study is to examine whether 1) the firms disclosing SOX 404 material weaknesses have lower quality accruals compared to firms not disclosing control weaknesses, 2) a remediation of internal control weaknesses affects accrual quality and 3) whether changes in accrual quality are consistent with changes in internal control efficiency. The research data consists of companies listed in U.S. stock markets and it is collected from Audit Analytics and Orbis databases. The examined period is the fiscal years 2012–2013. This study uses two measures of accrual quality: accrual noise and abnormal accruals. The tests with the abnormal accrual quality measure are performed separately with using unsigned, signed, positive and negative values. In addition, abnormal accrual values are performance-adjusted to control the effect of performance on accruals. The relation between internal control weaknesses and accrual quality is tested with cross-sectional and within-firm tests.

The empirical findings do not suggest that material weaknesses in internal controls have an effect on accrual quality. In addition, there was no significant evidence suggesting that the remediation of internal control weaknesses affect accrual quality or that changes in accrual quality are consistent with changes in effectiveness of internal controls.