The-Effect-of-SOX-Internal-Control-Deficiencies-an

217THEACCOUNTINGREVIEWVol.83,No.12008pp.217–250TheEffectofSOXInternalControlDeficienciesandTheirRemediationonAccrualQualityHollisAshbaugh-SkaifeUniversityofWisconsin–MadisonDanielW.CollinsTheUniversityofIowaWilliamR.Kinney,Jr.TheUniversityofTexasatAustinRyanLaFondMassachusettsInstituteofTechnologyandAlgertColdironInvestorsABSTRACT:Thispaperinvestigatestheeffectofinternalcontroldeficienciesandtheirremediationonaccrualquality.Wefirstdocumentthatfirmsreportinginternalcontroldeficiencieshavelowerqualityaccrualsasmeasuredbyaccrualnoiseandabsoluteabnormalaccrualsrelativetofirmsnotreportinginternalcontrolproblems.Second,wefindthatfirmsthatreportinternalcontroldeficiencieshavesignificantlylargerpositiveandlargernegativeabnormalaccrualsrelativetocontrolfirms.Thisfindingsuggestsinternalcontrolweaknessesaremorelikelytoleadtounintentionalerrorsthataddnoisetoaccrualsthanintentionalmisstatementsthatbiasearningsupward.Third,wedoc-umentthatfirmswhoseauditorsconfirmremediationofpreviouslyreportedinternalcontroldeficienciesexhibitanincreaseinaccrualqualityrelativetofirmsthatdonotremediatetheircontrolproblems.Finally,wefindfirmsthatreceivedifferentinternalcontrolauditopinionsinsuccessiveyearsexhibitchangesinaccrualqualityconsistentwithchangesininternalcontrolquality.Collectively,ourcross-sectionalandintertem-poralchangetestsprovidestrongevidencethatthequalityofinternalcontrolaffectsthequalityofaccruals.Keywords:SOX;internalcontrol;accrualquality;financialreportingreliability.WethankseminarparticipantsatEmoryUniversity,UniversityofHoustonAccountingResearchConference,PennStateResearchConference,UniversityofTechnology–Sydney,WashingtonUniversityinSt.Louis,andtheUni-versityofWisconsin–Madisonandtwoanonymousreviewersforhelpfulcommentsonpreviousversionsofthispaper.Editor’snote:ThispaperwasacceptedbyDanDhaliwal.SubmittedJune2006AcceptedAugust2007218Ashbaugh-Skaife,Collins,Kinney,andLaFondTheAccountingReview,January2008I.INTRODUCTIONThereliabilityoffinancialreportingisclaimedtobeafunctionoftheeffectivenessofafirm’sinternalcontrol(PCAOB2004;Donaldson2005).1However,researchtodateprovidesmixedevidenceonwhetherinternalcontrolweaknessesadverselyaf-fectaccrualquality,animportantcomponentofreliablefinancialstatements(HoganandWilkins2005;Bedard2006;Doyleetal.2007).Thispaperusesrecentlyavailabledataontheeffectivenessoffirms’internalcontrolsmandatedbytheSarbanes-OxleyAct(SOX)andthePCAOB’sAuditingStandards(AS)No.2toinvestigatehowinternalcontrolqualityaffectsthereliabilityoffinancialinformation(U.S.Congress2002;PCAOB2004).Wepositthatifafirmhasweakinternalcontrol,managersarelessabletodeterminereliableaccrualamounts,andaconsequenceoftheseunintentionalmisrepresentationsisthatfinan-cialinformationismorenoisyandlessreliable.Inaddition,managersoffirmswithweakinternalcontrolcanmorereadilyoverridethecontrolsandintentionallypreparebiasedaccrualestimatesthatfacilitatemeetingtheiropportunisticfinancialreportingobjectives.Thus,regardlessofwhethermisstatementsareunintentionalorintentional,thequalityofaccrualsislikelydiminishedwhenfirmshaveweakinternalcontrols.WeuseSOX-mandatedinternalcontroldeficiency(ICD)disclosuresandexternalau-ditoropinionsoninternalcontroltoconductbothcross-sectionalandwithin-firmintertem-poralchangetestsofwhethertheeffectivenessoffirms’internalcontrolaffectthequalityofreportedaccruals.Specifically,wetestwhether:(1)firmsthathaveICDsexhibitnoisieraccrualsandlargerabnormalaccruals(bothabsoluteandsigned)relativetofirmsnotdis-closingICDs;(2)firmswhoseexternalauditorsverifyremediationofpreviouslydisclosedICDssubsequentlyexhibithigherqualityaccrualsrelativetofirmsfailingtoremediatetheircontrolproblems;and(3)firmsthatreceivedifferentSOX404auditopinionsinsuccessiveyearsexhibitimprovements(declines)inaccrualqualityconsistentwithstrengthened(weakened)internalcontrolsindicatedbythedifferentopinions.Toconductourtests,weidentifyasampleoffirmsthathaveatleastoneSOX404auditopiniononinternalcontrol(i.e.,acceleratedfilers).WelookbacktodeterminewhetherasamplefirmdisclosedanICDunderSOX302andlookforwardtoseeifthefirmreceivedasecondSOX404opinion.2Managements’priorinternalcontroldisclosuresincombinationwithexternalauditreportsallowustoconductchangeanalysisteststoprovidestrongevidenceonwhetherweakinternalcontroldiminishesthequalityoffirms’reportedaccruals.Incross-sectiontests,wefindthatICDfirmshavelargerabsolute,largerpositive,andlargernegativeabnormaltotalandabnormalworkingcapitalaccrualsrelativetonon-ICD1InAuditingStandardsNo.2,thePublicCompanyAccountingOversightBoard(PCAOB2004)states:‘‘TheBoardbelievesthateffectivecontrolsprovidethefoundationforreliablefinancialreporting.Congressbelievedthistoo,whichiswhythenewreportingbymanagementandtheauditorontheeffectivenessofinternalcontroloverfinancialreportingreceivedsuchprominentattentioninthe[SOX]Act.Internalcontroloverfinan-cialreportingenhancesacompany’sabilitytoproducefairandcompletefinancialreports.Withoutreliablefinancialreports,makinggoodjudgmentsanddecisionsaboutacompanybecomesverydifficultforanyone,includingtheboardofdirectors,management,employees,investors,