翻译13 (2)

Determinants of weaknesses in internal control over financial reporting

☆

Jeffrey Doyle, Weili Ge, Sarah McVay

Abstract

We examine determinants of weaknesses in internal control for 779 firms disclosing material

weaknesses from August 2002 to 2005. We find that these firms tend to be smaller, younger, financially

weaker, more complex, growing rapidly, or undergoing restructuring. Firms with more serious entity-wide

control problems are smaller, younger and weaker financially, while firms with less severe,

account-specific problems are healthy financially but have complex, diversified, and rapidly changing

operations. Finally, we find that the determinants also vary based on the specific reason for the material

weakness, consistent with each firm facing their own unique set of internal control challenges.

Keywords:

Internal control; Material weakness; Sarbanes-Oxley

1. Introduction

In this paper, we examine the determinants of material weaknesses in internal control over financial

reporting. A material weakness in internal control is defined as “a significant deficiency, or combination of

significant deficiencies, that results in more than a remote likelihood that a material misstatement of the

annual or interim financial statements will not be prevented or detected” (

PCAOB, 2004

).

We use a

sample of companies that disclosed material weaknesses in internal control over financial reporting

under Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 from August 2002 to 2005.

Under

Section 302, SEC registrants’ executives are required to certify that they have evaluated the

effectiveness of their internal controls over financial reporting. If management identifies a material

weakness in their controls, they are precluded from reporting that the controls are effective and must

disclose the identified material weakness (

[32]

and

[34]

). Section 404 requires that each annual report

include an assessment by management of the effectiveness of the internal control structure and

procedures of the issuer for financial reporting that is attested to by the firm's public accountants.

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Although firms were required to maintain an adequate system of internal control before the enactment of

Sarbanes-Oxley, they were only required to publicly disclose deficiencies if there was a change in auditor

(

SEC, 1988

). While prior research studies this limited set of disclosures (

Krishnan, 2005

), there is little

evidence regarding internal control quality for firms in general under the new Sarbanes-Oxley regime.

We investigate whether material weaknesses in internal control are associated with (1) firm size,

measured by market value of equity; (2) firm age, measured by the number of years the firm has CRSP

data; (3) financial health, measured by an aggregate loss indicator variable and a proxy for the likelihood

of bankruptcy based on the hazard model developed by

Shumway (2001)

; (4) financial reporting

complexity, measured by the number of special purpose entities reported, the number of segments

reported, and the existence of a foreign currency translation; (5) rapid growth, measured by merger and

acquisition expenditures and extreme sales growth; (6) restructuring charges; and (7) corporate

governance, measured using the governance score developed by

Brown and Caylor (2006)

.

Our sample is comprised of 970 unique firms that reported at least one material weakness from August

2002 to 2005, of which 779 have Compustat data. We identify these firms through a combination of a

search of Compliance Week, a website which tracks internal control disclosures after Sarbanes-Oxley,

and a search of 10-K filings in the EDGAR database.

For the full sample, we find that material weaknesses in internal control are more likely for firms that are

smaller, younger, financially weaker, more complex, growing rapidly, and/or undergoing restructuring.

These firm-specific characteristics seem to create challenges for companies in maintaining a strong

system of internal controls. Our findings also appear to be economically significant in identifying firms

with material weaknesses. For example, the joint marginal effect of our main model (i.e., the change in

the predicted probability of a material weakness when altering the independent variables in the predicted

direction between the 1st and 3rd quartiles or between zero and one for indicator variables) greatly

increases the predicted probability of a material weakness

—

from 3.75 percent to 26.41 percent.

In this paper, we focus solely on material weaknesses for two reasons. First, it is the most severe type of

internal control deficiency, and thus offers the greatest power for our determinants tests. Second, the

disclosure of material weaknesses is effectively mandatory, while the disclosure of “significant

deficiencies” is unambiguousl

y voluntary.

Focusing on these more mandatory disclosures helps avoid

self-selection issues associated with voluntary disclosures. Although disclosures of material weaknesses

3

are effectively mandatory, it is possible that individual firms or auditors apply different materiality

standards in deciding what to disclose. While we do not have a model of the materiality threshold of

material weaknesses (

Mayper, 1982

;

Mayper et al., 1989

;

Messier et al., 2005

), our determinants results

are similar to those documented by

Ashbaugh-Skaife et al. (2007)

who examine all types of significant

deficiencies (i.e., not just those internal control weaknesses that meet the threshold to be classified as

“material weaknesses”) and find that firms disclosin

g significant deficiencies typically have more complex

operations, recent changes in organization structure, more accounting risk exposure, and fewer

resources to invest in internal control. Therefore, it appears that our results extend to a broader sample

that does not rely on a potentially subjective judgment of what constitutes a “material weakness,”

although it is still possible that the broader sample in

Ashbaugh-Skaife et al. (2007)

suffers from the

same concern.

Since

Ashbaugh- Skaife et al. (2007)

focus on all significant deficiencies, including

unambiguously voluntary disclosures, they also include additional variables to model the choice to

disclose in their analyses. Since our focus is on material weakness disclosures, we do not include these

variables in our main analysis. In untabulated results, our results are robust to their inclusion, though

sales growth weakens considerably in the more restricted sample (with or without the additional

variables).

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4

In addition to our general findings about material weakness firms, discussed above, which complement

and corroborate the findings of concurrent studies, we differ from

Ashbaugh-Skaife et al. (2007)

and

others by examining the specific types of material weaknesses disclosed, and how the determinants of

internal control problems differ based on these types. We find that the type of internal control problem is

an important factor when examining determinants, and thus should be considered by future research on

internal control. Specifically, while we focus on material weaknesses, the most severe internal control

problems, these weaknesses vary widely with respect to severity and underlying reason. For example,

consider the two following material weakness disclosures:

As part of the annual audit process, a material weakness was identified in our controls related to the

application of generally accepted accounting principles, specifically related to the classification of the

Company's short- term investments, resulting in the Company reclassifying approximately $$34 million of

cash and cash equivalents to short-

term investments… (I

-Flow Corporation, 12/31/04 10-K).