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Ⅱ The Impact of Internal Control Reports on Information Precision
1. Introduction
Section 404 of the Sarbanes-Oxley (SOX) Act (U.S. House of Representatives 2002) requires management to report the effectiveness of the internal controls over financial reporting and auditors to attest the validity of these reports. SEC registrants argue that high implementation costs are not commensurate with its perceived benefits, and hence, call for modification or repeal of this section (e.g., Ongeva et al., 2007;
Powell, 2005). Although regulators and auditors argue that Section 404 requirements should lead to higher financial reporting quality, and in turn lower cost of capital, several studies regarding the success in achieving these goals are mixed, regardless of the effect of SOX on accruals quality6 or on cost of capital.7 However, all these studies do not explore whether internal control weaknesses under Section 404 convey a bad signal to the market participants and impact ICW firms’ information environment. This essay addresses these questions.
The essay investigates the association between internal control weaknesses and information precision contained in analysts’ earnings forecasts. This essay presents an examination of whether analysts’ public and private information precisions are related to a firm’s weak information system, i.e. internal control system. The public information precision component arises from public information disclosed by a firm and observed by most analysts and the private information precision component arises from idiosyncratic information gathered by individual analyst (Barron et al., 1998, 2002). Specifically, I first explore the association between the presence of ICW and
6For example, Doyle et al. (2007a) document no significant difference in accrual quality between ICW firms and non-ICW firms under Section 404, while Ashbaugh-Skaife et al. (2008) find that ICW firms have lower accrual quality than non-ICW firms. However, Doyle et al. (2007a) further demonstrate that when material weakness disclosures are broken down by account-specific versus firm-level weaknesses, firm-level Section 404 weaknesses are related to poorer accrual quality.
7Ogneva et al. (2007) document no significant difference in their implied cost of equity estimates between ICW firms and non-ICW firms. In contrast, Ashbaugh-Skaife et al. (2009) find that ICW firms exhibit a significantly higher cost of equity capital, relative to non-ICW firms.
information environment including precisions of public and private information. I employ Barron et al. (1998) empirical proxies for the average precisions of analysts’
public and private information sets to capture the underlying quality of investors’
information sets. Second, prior studies show that there are differential effects on earnings quality among firms with firm-level weaknesses and firms with account-specific weaknesses (e.g., Doyle et al. 2007b). This essay further explores the relative effects of degree of the ICW severity on the precisions of public and private information contained in analysts’ forecasts. Finally, I examine whether firms’ initial disclosures of ICW and remediation of previously reported ICW are related to the precisions of public and private information contained in analysts’ forecasts.
My first question to be addressed is whether the precisions of public and private information contained in analysts’ earnings forecasts vary with the degree of internal control weakness. I explore whether the effect of public and private information precisions varies with quality of accounting information system, per se, i.e., the quality of internal control system. Prior empirical research suggests that ineffective internal control reduce the quality of analysts’ earnings forecasts and analysts’ belief (Ghosh and Lubbernik, 2006; Kim et al., 2008; Xu and Tang 2009; Ogneva et al, 2007). Since weak internal control is an determinant characteristic of analysts’
forecasts (Kim et al., 2008; Xu and Tang 2009), I predict that poor quality of analysts’
earnings forecasts for ICW firms might be mainly driven by less precise public information observed by most analysts. I assume that analysts’ information environment are similar to those of investors. Barron et al. (2005) support this assumption by revealing that investors’ trade consistent with analysts’ information sets.
Thus, I first hypothesize that ICW has a direct and adverse effect on the precision of public information in the capital market.
However, it is unclear that ICW would have a positive or negative effect on
private information precision. There are two opposite perspectives about the association between public and private information precisions. Theoretical models traditionally argue that public and private information are substitute, and thus public information reduces analysts’ incentives to develop private information (Verrecchia 1982; Diamond 1985). In contrast, another perspective posits that a public release of information triggers analysts with diverse information-processing skills to generate more accurate private information from the public announcement (e.g., Kim and Verrecchia, 1994, 1997). Recent empirical research provides supporting evidence of the latter (Barron et al. 2002). In the ICW context, the substitute perspective argues that ICW firms are associated with lower precision of private information, but the complimentary perspective posits that ICW firms are associated with higher precision of private information. Therefore, I do not predict the sign of the effect of ICW firms on precision of private information contained in analysts’ forecasts.
The second question I address is whether there is differential relation between information precision and different types of internal control weaknesses. As indicated by Moody’s Investors Service (2006, 2007), the severity of weakness varies significantly within material internal control weaknesses. Account-level weaknesses are auditable and thus do not represent as serious a concern regarding the reliability of the financial statements. In contrast, firm-level material weaknesses are less
"auditable" and thus more likely to result in less accurate financial information.8 Much of information which investors use in their evaluation is provided directly from the firm (Lang and Lundholm, 1996). Accordingly, I predict that firm-level weaknesses have a stronger negative effect on the quality of analysts’ forecasts than account-specific weakness, and in turn a relatively stronger impact on information
8 Doyle et al. (2007a, 2007b) provide supporting evidence that firm-level material weaknesses will have a stronger association with accruals quality than account-specific material weaknesses.
precision including in public information precision and private information precisions (Verrecchia 1982; Diamond 1985).
The final question I address is whether firms whose auditors confirm remediation of previously reported ICW have more precise public and private information relative to firms that do not remediate their internal control problems.
These tests are motivated by prior evidence that earnings quality will be improved for ICW firms which remediate their internal control problems. For example, Ashbaugh–Skaife, et al. (2008) document that firms whose auditors confirm remediation of preciously reported internal control weaknesses exhibit an increase in earnings quality relative to firms failing to remediate their control problems.
However, they does not examine whether the remediation of their internal control weaknesses positively affects analysts’ information quality.
To conduct my tests, I identify a sample of firms that has at least one SOX 404 audited opinion on internal control system. Following prior studies (Barron et al., 2002; Byard and Shaw, 2002; Venkataraman, 2000; Botoson et al., 2004; ), I employ Barron et al (1998) empirical proxies for the precisions of analysts’ public and private information sets to be mirror of investors’ information sets. I find that ICW firms have both lower precisions of public and private information contained in analysts’ earnings forecasts, which in turn worsen the overall information environment. I further find that there are differential effects on public and private information precisions among ICW firms, and the negative association between the presence of ICW and precision of information is stronger for firms with firm-level weaknesses than for those with account-specific weaknesses. Third, empirical analyses show that private and public information precisions are significantly higher for firms remedying previously weakness relative to firms who fail to remedy their weaknesses.
As a robustness check, I conduct several further analyses. First, an important concern regarding my specifications is the endogeneity issue. After controlling the selection bias, my primary findings are robust and remain qualitatively unchanged.
Second, following Ashbaugh-Skaife et al. (2008), and Kim et al. (2008), I conduct intertemporal analysis of SOX 404 opinions across successive years. The analysis of successive year SOX 404 opinions indicates that firms whose internal controls improve exhibit an increase in public and private information precisions. The results are also robust after controlling fixed or random effect.
This essay contributes to the literature in several important aspects. First, it contributes to the literature on internal control and information precision by empirically linking the strength of firm’s internal control over financial reporting to analysts’ information quality through SOX 404 reporting. While prior studies show that public information disclosure leads to the change in public and private information precisions (e.g., Barron et al., 2002), I further provide evidence that quality of accounting information systems (i.e., internal control), per se, that produce that information is also a critical determinant of analysts’ information precision.
Second, this essay also contributes to the literature designed to assess economic consequences of Section 404. In response to the concerns of public that Section 404 provides little benefits to investors (e.g., Burn, 2007), regulators and auditors argue that Section 404 requirements should result in higher quality of financial reporting, and in turn lower cost of capital. While prior research focuses primarily on specific economic consequence of Section 404 Act, and empirical results regarding the success in achieving these goals are mixed, my findings provide stronger evidence that internal control weaknesses lead to reduced quality of overall information environment as well as analysts’ public and private information precisions. As a result, this essay also contributes to the intense debate regarding costs and benefits of Section
404 and has policy implications for regulators.
Fourth, this essay has an implication for the debate between regulators and registrants. The public firms argue that they focus on unnecessary controls over routine processes and their high costs of complying with Section 404 are not commensurate with its perceived benefit (American Bankers Association, 2005;
Financial Executives Institute, 2005; Powell, 2005)9. However, I provide evidence that effective internal controls enhance a firm’s information environment by increasing analysts’ public and private information quality and improving information uncertainty. Thus, the implementation of Section 404 Act will help to enhance analysts’ information quality and is more informative to the market participants. Thus, my results have implications for the debate about whether to implement this provision for smaller public companies. These findings support that the disclosures of internal control systems in public companies can provide more information and more benefit to the market participants.
Finally, this essay also contributes to the literature on the association between public and private information precisions. While theoretical model documents that there are two opposite perspectives about the relation between public and private information precisions, I empirically show that these two types of information precision are complementary, at least in the context of internal control weakness.
The remainder of this essay is organized as follows. Related literature and hypothesis development are discussed in Section 2. The sample and the research design are shown in Section 3. The empirical results and the conclusions are presented in Section 4 and in Section 5.
9 Powell (2005) suggests that as a result of Section 404 Act, auditors’ fees have been doubled, with a disproportionately larger burden falling on smaller companies and, hence, calls for modification or repeal of the section.
2. Literature Review and hypothesis development