Determinants of weaknesses in internal control over financial reporting and the implications for earnings quality* Jeffrey Doyle David Eccles School of Business University of Utah 1645 East Campus Center Drive Salt Lake City, UT 84112 [email protected] Weili Ge Ross School of Business University of Michigan 701 Tappan Street Ann Arbor, MI 48109 [email protected] Sarah McVay Stern School of Business New York University 44 West Fourth Street, Suite 10-94 New York, NY 10012 [email protected] March 1, 2005 * We would like to thank the following for their helpful comments and suggestions: Brad Barrick, Eli Bartov, Patty Dechow, Nader Hafzalla, Kalin Kolev, Feng Li, Russ Lundholm, Suzanne Morsfield and Cathy Shakespeare. Determinants of weaknesses in internal control over financial reporting and the implications for earnings quality Abstract We examine determinants of internal control deficiencies and their effect on earnings quality using a sample of 261 firms that disclosed material weaknesses from August 2002 to November 2004. We find that material weaknesses in internal control are more likely for firms that are smaller, less profitable, more complex, growing rapidly, or undergoing restructuring. These findings are consistent with firms struggling with their financial reporting controls in the face of a lack of resources, complex accounting issues, or a rapidly changing business environment. Next, we show that firms with material weaknesses in internal control have lower earnings quality, as measured by the extent to which accruals map into cash flows. This relation is robust to the inclusion of discretionary accruals as a proxy for managerial opportunism, as well as proxies for inherent difficulty in accrual estimation (Dechow and Dichev, 2002). Thus, internal control appears to be one of the fundamental drivers of earnings quality. Furthermore, we find that earnings quality is especially poor for those material weaknesses that relate to overall company-level controls, which may be more difficult to “audit around.” JEL Classification: M41 Keywords: Internal Control; Material Weakness; Earnings Quality; Sarbanes-Oxley 1. Introduction In this paper we examine the determinants of internal control deficiencies and the effect that these deficiencies have on earnings quality. We use a sample of companies that disclosed material weaknesses in internal control over financial reporting under Section 302 of Sarbanes- Oxley from August 2002 to November 2004.1 As part of the Sarbanes-Oxley Act of 2002, SEC registrants’ executives are now required to certify that they have evaluated the effectiveness of their internal controls over financial reporting and indicate in their public filings whether there are any significant changes in internal control (Section 302).2 If management identifies a material weakness in internal control, they are precluded from reporting that the internal controls are effective and must disclose the identified material weakness. 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 very limited set of disclosures (Krishnan, 2005), no evidence exists on internal control quality for firms in general. Furthermore, the literature on earnings quality has largely ignored the fundamental importance of the internal control system, despite the fact that internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting for 1 Although internal control is defined in terms of achieving 1) the effectiveness and efficiency of operations, 2) reliability of financial reporting, and 3) compliance with applicable laws and regulations (Statements on Auditing Standards, Section 319), Sarbanes-Oxley only pertains to internal control related to the reliability of financial reporting. For purposes of Sarbanes-Oxley, the SEC defines internal control as “a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the reliability of financial reporting.” 2 In addition, 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, which is required to be attested to by the firm’s public accountants. Section 302 of the Sarbanes-Oxley Act became effective in August 2002. Section 404 became effective in November 2004. 1 external reporting in accordance with generally accepted accounting principles (PCAOB, 2004).3 We begin our study by hypothesizing that internal control problems result from firm- specific characteristics that make it more difficult to maintain an effective system of controls. In our determinants tests, we investigate whether material weaknesses in internal control are associated with 1) firm size, measured by market value and book value of equity, 2) financial health, measured by return on assets and a loss indicator variable, 3) financial reporting complexity, measured by the number of operating segments, the number of geographic segments, and foreign operations, 4) rapid growth, measured by merger and acquisition activity and annual sales growth, and 5) restructurings, measured by special items.4 We find that material weaknesses in internal control are more likely for firms that are smaller, less profitable, more complex, growing rapidly, and/or undergoing restructuring. These findings are consistent with firms struggling with their financial reporting controls in the face of a lack of resources, complex accounting issues, or a rapidly changing business environment. Next, we examine the impact of poor internal control on the earnings quality of the firm.5 Since 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, emphasis added), we hypothesize that reported material weaknesses will be associated with lower earnings quality. A weak control environment has the potential to allow both 1) intentionally biased accruals through earnings management (e.g., lack of 3 For example, neither of the two recent publications on earnings quality (Schipper and Vincent, 2003, and Dechow and Schrand, 2004) mentions the relation between internal control and earnings quality. 4 The basic relations between internal control determinants, internal control, and earnings quality are presented in Figure 1. Note that Figure 1 is simplified to show the basic relations in this study merely for illustrative purposes. Other, more complex, relations between the variables shown may also exist, but they are not the focus of this study. 5 Other possible secondary consequences of weaknesses in internal control (generally resulting from poor earnings quality) that we do not currently examine include delayed filings, earnings restatements, and negative stock market reactions (see Figure 1). 2 segregation of duties) and 2) unintentional errors in accrual estimation (e.g., lack of expertise in estimating pension expense). We focus on accrual quality as our measure of earnings quality and use a metric that gauges the extent to which accruals map into past, present, and future cash flows (Dechow and Dichev, 2002).6 We use this measure because it is able to effectively capture both intentional and unintentional errors in accruals (i.e., overall accrual quality), which we predict are the result of internal control weaknesses. We find that weak internal controls are associated with lower quality accruals, as measured by weaker mappings of accruals into cash flows. This relation is robust to the inclusion of discretionary accruals as a proxy for managerial opportunism, as well as proxies for inherent difficulty in accrual estimation (Dechow and Dichev, 2002). Thus, internal control appears to be one of the fundamental drivers of earnings quality. Moreover, this relation holds after controlling for the underlying determinants of material weaknesses, such as firm size, profitability, firm complexity, and restructuring, which may also be correlated with earnings quality. This supports the notion that it is the material weakness per se that results in lower earnings quality. Finally, we categorize material weakness disclosures into groups related to the type of weakness disclosed. We investigate the determinants of each type of material weakness and also hypothesize that more serious material weaknesses related to company-level controls (e.g., tone at the top, fraud prevention, etc.) will result in the lowest levels of earnings quality since these types may be more difficult to “audit around.”7 We find that these company-level deficiencies in 6 We also use a measure of “discretionary” accruals (Rangan, 1998; Teoh, et al., 1998a, 1998b; Kothari, et al., 2005) as a proxy for earnings quality and find similar results. It is possible that weaknesses in internal control could lead to non-accrual based earnings quality issues, but out focus in this paper is on the quality of accruals. 7 See Doss and Jonas (2004). This classification of different types of material weaknesses is explained further in Section 2.2 and in the appendix. 3 internal control are indeed