5.1 Different Way to Identify Companies with Ineffective ICFR
Although prior studies suggest that misstatements are indicative of ineffective internal control systems (Kinney and McDaniel 1989; DeFond and Jiambalvo 1991;
McMullen et al. 1996), it is arguable that there may exist some extenuating or unique situations in which a misstatement does not always parallel to ineffective internal controls (PCAOB 2004). In this case, applying our research method could not exactly measure the likelihood of TypeⅠand TypeⅡerrors.
Ashbaugh-Skaife et al. (2006) and Doyle et al. (2007a) suggest that internal control problems are associated with lower accruals quality because weak internal controls are reasonably possible to fail to detect intentionally biased accruals through earnings management or unintentional accrual estimation errors. As a result, low accruals quality could be viewed as a strong indicator that a material weakness in
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internal controls exists. We measure accrual estimation error based on the method developed by Dechow and Dichev (2002) and modified by McNichols (2002) and Francis et al. (2005). We divide our sample into two categories: (1) low-AQ sample which covers observations whose residual is above the median and (2) high-AQ sample which covers observations whose residual is below the median. Except the different way to identify companies with weak ICFR, we conduct the analyses with the same research method described above. The results are presented in Table 8 and Table 9 and are very similar with our main results. Our results are consistent across the different ways to identify companies with weak internal controls.
[Insert Table 8 here]
[Insert Table 9 here]
5.2 Periods of Financial Restatements
Doyle et al. (2007a) argue that material weaknesses, on average, have existed for several years before being reported. Due to the long duration of material weaknesses, weak internal controls may increase the likelihood of misstatements in not only current but also future financial reports. In this sensitivity test, we regard companies which restate financial statements of the current or next period as those which are more likely to have material weaknesses and should be more likely to receive adverse ICFR opinions in the current period. We replicate the analyses using the alternative definition of restatement companies. The results are presented in Table 10 and Table 11 and are very similar with our main results, indicating that our main results are robust to the different choices regarding the periods of restatements.
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[Insert Table 10 here]
[Insert Table 11 here]
6. CONCLUSION
In this study, we examine both of the impacts of SOX 404 and AS5 on ICFR disclosure errors. We find that the enactment of SOX 404 results in a lower TypeⅡ error rate without the side effect of increasing TypeⅠerrors. Moreover, we document that even though the more flexible and laxer AS5 can enhance the efficiency of ICFR audits manifested by reduced TypeⅠerrors, the leeway provided by AS5 allows auditors to misuse their professional judgment and cut back on necessary testing procedures in the audits of internal controls, which inadvertently results in lower public ICFR disclosure quality measured by increased Type Ⅱ errors. Our results echo the concerns raised by investors and regulators about AS5. A potential limitation of this study is the restricted sample which we can draw because only large companies (i.e. accelerated filers) are confirmed to be subject to SOX 404(b) after the passage of
Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. It is unclear
whether our evidence can be generalized to other small companies. Our paper is among the first studies which provide insights into both of the impacts of SOX 404 and AS5 on ICFR disclosure quality and may help policymakers and standard setters formulate future ICFR audit-related rulings.- 22 -
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