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Reporting incentives, Internal Control Weaknesses Disclosure and Remediation
Ⅰ. INTRODUCTION
Leuz (2003), Bradshaw, Bushee, and Miller (2004), and Ball and Shivakumar (2005) argue that financial reporting quality is influenced mainly by firms’ reporting incentives, rather than due to differences in accounting standards. Burgstahler, Hail, and Leuz (2006) claim that “the differences of firms’ reporting incentives play an important role for financial reporting quality.” Daske, Hail, Leuz, and Verdi (2013) further integrate six economic attributes, including firm size, financial leverage, profitability, growth opportunity, dispersed ownership, and internationalization, into a comprehensive indicator to measure reporting incentives. Using accelerated filers with a public float of at least $75 million as our research samples, we extend the claim of Burgstahler et al. (2006), investigating whether higher firms’
reporting incentives calculated from a comprehensive economic indicator actually are associated with higher earnings quality during 2004－2011. We also examine whether reporting incentives can restrain internal control material weaknesses, and attempt to verify that firms with high reporting incentives have fewer company-level material weaknesses.
The Sarbanes-Oxley Act of 2002 (hereafter, SOX) was enacted over a decade ago. One of the main purposes of SOX is to increase the accuracy and reliability of firms’ financial disclosure and to recover investors’ confidence. In July 2012, on the 10th anniversary of SOX, the Chairman of Consumer Federation of America, Barbara Roper, suggested that SOX obviously improves the completeness and quality of financial market and financial reporting.
Recently, the number of academic studies on the subject has grown substantially. The most controversial issue is Section 404—Management assessment and audit of internal control
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(hereafter, SOX 404). Under SOX 404 requirements, executive officers are entrusted with the responsibilities of establishing and maintaining internal control, assessing quarterly the design and implementation of internal controls, evaluating the effectiveness of internal controls over financial reporting (hereafter ICFR), and expressing at the end of a year whether ICFR are effective or with significant/ material weaknesses in the evaluation report.
It further requires firms to have auditor attestation on internal control effectiveness.1 Since SOX 404 has definite requirements on reporting internal control weaknesses, the external auditor is required to express his attestation opinions on ICFR. Studies have expressed concerns regarding companies’ high compliance costs from internal control audits.2 Based on the above reasons, we focus our investigation on the SOX 404 period.
Reporting incentives can be quoted from Ball, Robin, and Wu (2003), who use four countries, Hong Kong, Malaysia, Singapore, and Thailand, to verify that the demand for financial reporting and reporting incentives was derived from political factors. Leuz (2003), Bradshaw et al. (2004), and Ball and Shivakumar (2005) claim that financial reporting quality is influenced mainly by firms’ reporting incentives. Burgstahler et al. (2006) utilize European countries during 1996–2003 as research samples. They found evidence that influenced by capital market pressures and institutional factors, firms with higher reporting incentives had less earnings management. Following Burgstahler et al. (2006), we first examine the relationship between reporting incentives and earnings quality. Two differences in our study include sampled research period and the use of a comprehensive index to measure reporting incentives. Prior literature indicates that SOX 404 can increase accrual and overall financial reporting quality (Ashbaugh-Skaife, Collins, Kinney, and LaFond 2008). Our first purpose is
1 The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed on July 21, 2010, exempts non-accelerated filers from auditor attestation. The Jumpstart Our Business Startups Acts of 2012 also exempts firms with $1 billion or less revenue in the first five IPO years from auditor attestation on internal controls.
2 Highlights of the arguments include whether the costs of internal audit compliance are too high (Raghunandan and Rama 2006; Ogneva, Subramanyam, and Raghunandan 2007; Krishnan, Rama, and Zhang 2008; Kinney and Shepardson 2011), and whether the attestation of internal control over financial reporting may enhance a company’s financial reporting quality (SEC 2009; Iliev 2010; Krishnan and Yu 2012).
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to examine whether reporting incentives correlate with U.S. listing firms’ earnings quality after SOX.
Prior research discusses the possibility of internal control weaknesses caused by organizational features (Ashbaugh-Skaife, Collins, and Kinney 2007; Doyle, Ge, and McVay 2007a). Ashbaugh-Skaife et al. (2008) and Doyle, Ge, and McVay (2007b) find that companies with internal control weaknesses have less reliable accruals quality. Chan, Farrell, and Lee (2008) show that disclosure of material weaknesses, especially company-level weaknesses, is positively associated with declined earnings quality. Based on economic theory,3 Daske et al. (2013) use factor analysis to integrate six economic attributes into a comprehensive indicator to measure firms’ reporting incentives under International Financial Reporting Standard (hereafter, IFRS) conversion period.4 They find that when firms are larger, in more financing need, more profitable, facing growth opportunities, ownership decentralized, and experience more extensive international operations, would tend to generate stronger incentives to increase reporting transparency to investors. When there is essential transfer on firms’ economic operations, that transfer will provide management with incentives to enhance firms’ reporting strategies and maintain reporting transparency. However, no empirical evidence has been gathered to support the correlation between the comprehensive index of reporting incentives and the disclosure of internal control weaknesses. Our second purpose is to investigate firms’ reporting incentives and the disclosure of internal control weaknesses. We attempt to provide evidence that firms with higher reporting incentives as measured by the above-mentioned indicator would maintain better financial reporting quality and restrain internal control weaknesses.
3 For instance, Leuz and Wysocki (2008) summarize the effects of financial reporting and regulations on the economic consequences. Lang, Lins, and Miller (2003) and Doidge, Karolyi, and Stulz (2004) discuss other cross-listing company’s issues.
4 Daske et al. (2013) focus on the IFRS issues. They consider that a “label”-IFRS adopter may merely follow the conversion of accounting systems instead of implementing significant changes in company reporting system.
Management would have incentives to improve a company’s reporting strategies and maintain transparency to reduce the economic consequences of a “serious” change in a company’s economic environment.
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Internal control weaknesses can be classified into two categories:
account-specific/transaction-level weaknesses and company-level/entity-level weaknesses.
Because company-level weaknesses are related to a firm’s overall control environment, it is more serious than other types of weaknesses (Hammersley, Myers, and Zhou 2012). Doyle et al. (2007b) find that company-level internal control weaknesses are negatively associated with accrual quality. That is, where there exist company-level internal control weaknesses, a firms’ accrual quality is lower. Conceptually, high reporting incentives are the driving force for a company to establish and maintain a good and effective internal control system. Under this premise, we predict that firms with higher reporting incentives are less likely to experience serious company-level internal control weaknesses.
Burgstahler et al. (2006) discuss the effect of country-level reporting incentives on earnings quality. On the other hand, Daske et al. (2013) utilize cross-country firm-level reporting incentives to distinguish who are “serious” vs. “label”-adopters of IFRS, and further trace their economic consequences. We follow Daske et al. (2013) approach and apply factor analysis to integrate six economic attributes, firm size, financial leverage, profitability, growth opportunity, dispersed ownership, and internationalization, into a comprehensive indicator of firm-level reporting incentives. Since in the United States, there are inter-company differences in quality of corporate disclosure, reporting timeliness, accounting recognition methods, and audit quality (Bushman, Piotroski, and Smith 2004), we decide to use U.S. listing firms to test our model.
In cross-section tests, empirical results support our hypothesis. We find that firms with higher reporting incentives had higher earnings quality during the period of 2004-2011. This implies that the strength of firms’ reporting incentives appears to be an important factor in firms’ reporting quality. On the other hand, higher reporting incentives are associated with a lower chance of company-level material internal control weaknesses. Collectively, the
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reporting incentives may restrain the occurrence of internal control weaknesses.
Goh (2009) suggests that researchers could use weaknesses firms as research samples to avoid research bias toward better internal controls in larger firms. Therefore, we further use weaknesses firms as research subjects to verify whether firms with high reporting incentives have fewer material company-level weaknesses. We investigate whether weaknesses firms with higher reporting incentives are more likely to remediate weaknesses in the subsequent year. In the additional test results, we did not find significant differences between firms with various reporting incentives in remediating their internal control weaknesses. Even if the coefficient is positive, the results cannot support the proposition that weaknesses firms with higher reporting incentives are more likely to remediate weaknesses.
Our study makes several contributions. First, we add to the literature about ICFR and firms’ reporting incentives. Based on Burgstahler et al. (2006), Bushman and Piotroski (2006), and Daske et al. (2013), this study links firms’ reporting incentives to internal controls over financial reporting. Second, several studies employ different country features to discuss the reporting incentive issues. Following the approach of Daske et al. (2013), we find evidence in U.S. firms that higher reporting incentives may restrain internal control weaknesses after SOX 404. Third, our study also contributes to weakness-type literatures. Our results show that the possibility of company-level weaknesses are negatively associated with firms’
reporting incentives. We also use the weaknesses firms to discuss remediation in the following year.
The remainder of the study is organized as follows. The next section discusses literature review and hypotheses. Section Ⅲ develops research design and details of our sample selection. Section Ⅳ presents our empirical results and additional tests. Section Ⅴ summarizes our conclusions.
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Ⅱ. LITERATURE REVIEW AND HYPOTHESIS
Earnings quality and reporting incentive
The mission for SOX is to enhance the quality of financial reporting and to recover investors' confidence in capital market. A 2008-2009 SEC-sponsored Web survey interview with publicly traded companies’ CFOs on the issue of SOX revealed that half of the interviewees still had several doubts: whether internal controls could enhance financial reporting quality; whether good internal controls could avoid or detect fraud in time; and if good internal controls could enhance investor confidence and the company's operational efficiency (SEC 2009). Good internal control systems can provide high quality financial reporting (PCAOB 2004；Donaldson 2005) and improve the accuracy of financial reports (Ashbaugh-Skaife et al. 2008; Beneish, Billings, and Hodder 2008). On the contrary, low quality internal control systems can negatively affect the quality of financial reporting for management and investment decisions (Feng, Li, and McVay 2009), and can lead to financial restatements (Krishnan and Yu 2012).
Prior studies argue that financial reporting quality is mainly influenced by firms’
reporting incentives, instead of the difference in accounting standards (Leuz 2003; Bradshaw, Bushee, and Miller 2004; Ball and Shivakumar 2005). Burgstahler et al. (2006) use two major types of reporting incentives at the national level, capital market pressures and institutional factors, to examine the effect of reporting incentives on firm’s earnings quality.5 Their study concludes that firms with higher reporting incentives tend to show less earnings management through the deployment of judgments and measurement in the application of principles. This study continues the proposition of Burgstahler et al. (2006), and further
5 Burgstahler et al. (2006) argue that if the harmonization efforts brought by European countries adopting IFRS could reduce the differences in the compliance of accounting standards, these European countries’ reported earnings quality should be indistinguishable. Since this is not the case, it is worthwhile to further explore the differences in company reporting incentives.
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makes use the sample of companies that mandatorily adopted SOX 404 between 2004-2011 to examine the relationship between earnings quality and reporting incentives. We propose that even for companies under SOX 404 regimes, reporting incentives still have an impact on firms’ earnings quality. Therefore we infer that during the SOX 404 period firms with high reporting incentives still produce higher financial reporting quality than firms with lower incentives. The above discussions lead to the following Hypothesis 1:
Hypothesis 1: Ceteris paribus, firms with higher reporting incentives report higher earnings quality than firms with lower reporting incentives.
Internal controls weaknesses, weaknesses type, and reporting incentives
Krishnan (2005) finds that the internal control weaknesses were related to firm sizes, financial risk, quality of corporate governance, and auditor resignation. Recent studies also indicate that when companies are complying with SOX 302 and SOX 404, the disclosure of their internal control weaknesses are mainly attributed to organizational complexity, risks, firm sizes, and resource constraints. For example, Ashbaugh-Skaife et al. (2007) conclude that it may not be possible for younger companies of smaller sizes, companies less financially-sound and with limited resources to maintain effective ICFR. For companies that are more complex organizationally, with more diverse operations, or growing companies, a higher possibility of internal control weaknesses is observed (Doyle et al. 2007a).
On the other hand, the quality of corporate governance also affects companies’
disclosure of weaknesses (Zhang, Zhou, and Zhou 2007; Hoitash, Hoitash, and Bedard 2009).
Zhang et al. (2007) examine the professional expertise of audit committee members and its impact on internal controls weaknesses. They find that when there are no financial or accounting experts on the committee, companies tend to have internal control weaknesses.
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For those companies where auditors are more independent, or if an auditor has been recently replaced, internal control weaknesses are more likely to be discovered and disclosed. Li, Sun, and Ettredge (2010) explore the relationship between the CFO professional qualifications and internal control weaknesses. They point out that companies receiving adverse SOX 404 opinions employ less competent CFOs; when they hire better qualified CFOs, quality of internal controls can be greatly improved.
Daske et al. (2013) find that if companies undergo serious changes in their economic operations when substantially adopting IFRS, they would be able to provide incentives for their management to improve transparency and reporting strategy, thereby reducing economic consequences. We argue that firms with higher reporting incentives can generate sufficient motivation for management to maintain good ICFR which are able to detect or prevent material impacts of financial misstatements. This paper infers that the reporting incentive is an important factor in driving companies to actively maintain the quality of internal control over financial reporting, and firms with higher reporting incentives are less likely to disclose internal control weaknesses than firms with lower incentives. Hypothesis 2a is as follows: