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1、Internal Control Reporting and Accounting ConservatismMary Brooke BillingsNew York UniversityLeslie Davis HodderIndiana UniversityAbstract: One objective of the internal control reporting requirements of the Sarbanes-Oxley Act of 2002 (SOX) is to improve the quality of financial reporting. This stud
2、y examines whether a relation exists between internal control quality and accounting conservatism, which is an important feature of high financial reporting quality. Using a sample of firms which disclose material weaknesses (MWs) in internal control under SOX, we find that firms with MWs exhibit le
3、ss accounting conservatism than firms with no such weaknesses. However, firms that disclose MWs andwhose auditors subsequently confirm the remediation of these weaknesses exhibit more conservative accounting earnings than firms that continue to have MWs. We also find that the internal control report
4、ing requirements have a disciplining effect on firms financial reporting. Specifically, firms with MWs exhibit more conservative earnings after the disclosure of such weaknesses, regardless of whether or not these weaknesses are remediated. Overall, our results show that the quality of internal cont
5、rol affects accounting conservatism and underscore the importance of the internal control reporting requirements in enhancing the quality of financial reporting.Key words: internal control conservatism disclosure; 1. Introduction“This law (Sarbanes-Oxley Act) says to shareholders that the financial
6、information you receive from a company will be true and reliable.This law says to workers: we will not tolerate reckless practices that artificially drive up stock prices and eventually destroy the companies, and the pensions, and your jobs.”1 In 2002, following a series of high-profile cases of cor
7、porate improprieties, the U.S. Congress passed the Sarbanes-Oxley Act (SOX), which is widely considered to contain the most important and sweeping corporate reforms since the 1930s. As can be seen from the above excerpt from President Bushs speech, made during his signing of the Act, one of the obje
8、ctives of regulators in passing SOX is to ensure the reliability of financial reporting and to prevent companies from artificially driving up stock prices to mislead investors. 2 In this study, we examine whether the internal control reporting requirements of SOX help to enhance the quality of finan
9、cial reporting by ensuring conservative accounting practices.3Unlike Doyle et al. (2007a) and Ashbaugh-Skaife et al. (2008a), which examine the relation between internal control quality and accruals quality, we choose accounting conservatism as our measure of financial reporting quality. This is bec
10、ause Watts (2003a,2003b) argues that conservative accounting benefits the users of a firms accounting reports, by preventing managers from introducing bias and noise into contractual accounting measures in order to overpay themselves. Also, conservative accounting results in the early termination of
11、 negative NPV (Net Present Value) investments and mitigates the incentives of managers, in reporting accounting measures used in a contract, to undertake negative NPV project behavior. Therefore, the interests of stakeholders are better protected when managers practice conservative accounting than w
12、hen they do not. In sum, accounting conservatism is an important feature of high quality financial reporting.We first examine whether weak internal controls are associated with less conservative accounting. If such a relation exists, then the regulators emphasis on internal controls to prevent compa
13、nies from using overly aggressive accounting practices is justified and would benefit stockholders. In addition, in order to allow stronger inferences to be made about the effects of internal control weaknesses (ICWs) on accounting conservatism, we conduct inter-temporal tests of the changes in the
14、status of internal controls. We specifically examine whether firms that disclose, and later remediate, ICWs show greater accounting conservatism than firms that continue to have such weaknesses. Lastly, as Watts (2003a) contends that a demand for accounting conservatism arises from litigation, we ex
15、pect the disclosure of ICWs under SOX to potentially increase the litigation risks of these firms (i.e., as a result of their overly aggressive accounting practices or less conservative accounting). Hence, we also examine whether firms with ICWs report more conservatively after the disclosure of the
16、se weaknesses. Such conservative reporting behavior will provide evidence that the reporting requirements have a disciplining effect on firms to report conservatively and will mitigate investors concerns that earnings and net assets are overstated.Following Basu (1997) and Watts (2003a, 2003b), we d
17、efine conservatism as the application of a higher standard of verification for favorable information, whereby accounting income reflects “bad news” on a more timely basis than “good news.” We operationalize accounting conservatism in a number of ways. Two tests of conditional conservatism, based on
18、Basu, are widely applied in empirical accounting research. First, we use a piecewise linear regression of earnings on contemporaneous stock returns to examine whether weak internal controls are associated with lower timeliness to reflect bad news. Second, we examine whether weak internal controls ar
19、e negatively associated with the rate of the reversal of negative earnings changes. Finally, to overcome the potential limitations associated with the interpretations and assumptions underlying the approaches of Basu, we conduct additional tests of conditional conservatism as suggested by Ball and S
20、hivakumar (2005, 2006), namely accrual-based conditional conservatism.Using a sample of firms which disclosed at least one material weakness (MW) from January 2003 to November 2005, we find results that are generally consistent with our expectations.4 First, we find that firms with weak internal con
21、trols, as proxied by the existence of at least one MW, exhibit lower levels of accounting conservatism compared to control firms without such weaknesses. This result is in line with the expectation of regulators that weak internal controls result in a lower quality of financial reporting. Second, we
22、 find that firms that disclose and later remediate their MWs exhibit greater accounting conservatism than firms that continue to have these weaknesses. This finding suggests that the improvement in internal control quality result in more conservative accounting; this further strengthens the results
23、on the relation between internal control quality and accounting conservatism. Finally, we find that our sample of firms with MWs report more conservatively after the disclosure of these weaknesses, regardless of whether or not these weaknesses are remediated. This result suggests that the internal c
24、ontrol reporting requirements have a disciplining effect on firms with weak internal controls, possibly because of the increasing litigation risk following the disclosure of MWs. Overall, our results provide empirical evidence that supports the benefits of the internal control reporting requirements
25、 of SOX against the widely documented costs of these requirements (SEC 2006).First, it examines the implications of the internal control reporting requirements of SOX on the financial reporting quality of firms. This issue is timely and important given the controversies surrounding the internal cont
26、rol reporting requirements of SOX, such as the high costs of compliance. Given that accounting conservatism is universally demanded by stakeholders (Ball et al. 2000; Basu et al. 2001) and is an important feature of high quality financial reporting, examining the association between internal control
27、 quality and accounting conservatism can provide insights into the efficacy of the internal control reporting requirements. With regard to financial reporting, our results show that mandating firms to assess their internal controls and to disclose the ICWs discovered in the process can have a discip
28、lining effect on firms to report more conservatively. The remediation of previously identified ICWs also makes firms more conservative in their financial reporting. Hence, the internal control reporting requirements of SOX provide benefits to market participants by ensuring that financial reporting
29、is both more conservative and of a higher quality.Second, prior research finds that conditional conservatism, as measured by asymmetric timeliness, varies across the characteristics and economic contexts of firms (Basu et al. 2001; Ball et al. 2000, 2003; Beekes et al. 2004; Ball and Shivakumar 2005
30、; Bushman and Piotroski 2006; Ahmed and Duellman 2007). This study extends this line of research by suggesting that internal control quality is a potential factor that drives the observed differences in conservatism between public companies. Specifically, higher internal control quality could lead t
31、o a higher level of conservative reporting. Also, we show that firms report more conservatively after the disclosure of MWs, which is consistent with the argument of Watts (2003a) that a demand for accounting conservatism arises from litigation.Third, prior research finds that firms with ICWs presen
32、t higher information risk to investors relative to firms having effective internal controls, resulting in higher cost of equity (Ashbaugh-Skaife et al. 2008b). Hence, firms with ICWs potentially increase agency costs between management and outsiders. Watts (2003a, b) argues that accounting conservat
33、ism has evolved as part of an efficient contracting technology that helps in reducing deadweight losses resulting from agency problems. Our findings that strong internal controls are associated with higher accounting conservatism provide additional evidence on the efficacy of conservatism in reducin
34、g potential agency costs of firms.Finally, this study complements related studies examining the relation betweeninternal control and financial reporting quality. Doyle et al. (2007a) and Ashbaugh-Skaife et al. (2008a) find that internal control quality is positively related to earnings quality, as m
35、easured by the extent to which accruals are realized as cash flows. This study finds that internal control quality is positively related to accounting conservatism, which is another important element of earnings quality. 2. Hypothesis developmentFama and Jensen (1983) contend that the modern large c
36、orporation is characterized by the absence of the classical entrepreneurial decision maker. Instead, the companys residual claims are diffused among many shareholders, who vest their decision rights in the companys managers. Agency costs are created because the managers who initiate and implement im
37、portant decisions do not bear a major share of the wealth effects of their decisions. To mitigate agency problems, shareholders align managerial incentives by linking managerial compensation to firm performance. This, in turn, incentivizes managers to overstate firm performance in the short term, in
38、 order to extractgreater compensation forthemselves.Once managers make excessive distributions to themselves, it is extremely difficult to recover these distributions, especially once the managers retire or leave the firm. Watts (2003a) points out that this effectively implies a limited liability of
39、 managers with respect to shareholders.Watts (2003a) also argues that such moral hazard problems will exist in financial reporting as long as the reports accounting measures inform investors about managerial performance and will affect the asset allocation decisions of investors and the welfare of m
40、anagers. These effects on their welfare will motivate managers to introduce bias and noise into the same accounting measures that regulators hope will inform investors, just as they motivate managers to introduce bias and noise into contractual accounting measures. The absence of constraints on this
41、 opportunistic managerial behavior means that the accounting measures in financial reports that, a priori, appear neutral will, in practice, be significantly biased and noisy.Watts (2003a) argues that conservative accounting is a means of addressing the moral hazard caused by the parties to a firm h
42、aving asymmetric information, asymmetric payoffs, limited horizons, and limited liability. For example, conservatism can constrain the managements opportunistic behavior in reporting the accounting measures used in a contract. In practice, conservatism more than offsets managerial bias, and, on aver
43、age, also defers earnings and understates cumulative earnings and net assets. In contracts these effects increase a firms value because they constrain the managements opportunistic payments to themselves and to other parties, such as the shareholders. This increased value is shared among all parties
44、 to the firm, increasing everyones welfare. In this sense, conservatism is an efficient contracting mechanism.Despite the importance of conservative accounting in promoting efficient contracting between managers and shareholders, little is understood about the mechanisms that can facilitate conserva
45、tive accounting. The importance of internal controls, such as a monitoring mechanism, has long been highlighted by researchers. The SEC (Securities and Exchange Commission) defines internal control as “a process, effected by an entitys board of directors, management and other personnel, designed to
46、provide reasonable assurance regarding the reliability of financial reporting.” Hence, effective internal controls can facilitate conservative accounting by preventing management from introducing bias and noise into accounting measures and by requiring stricter standards in recognizing good news as
47、gains rather than bad news as losses.For instance, an important internal control over financial reporting is the maintenance of proper accounting policies and procedures and of adequate controls over non-routine transactions. When proper accounting policies and procedures are absent or inadequate, m
48、anagement is more likely to introduce bias and noise into accounting measures, in order to expedite the recognition of revenues/gains and to defer the recognition of expenses/losses. On the other hand, when accounting policies and procedures are clearly stipulated, management has less room to use aggressive accounting practices to increase their compensation.Another important internal control that can facilitate conservative accounti
