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1、Characteristics of Firms with Material Weaknesses in Internal Control: An Assessment of Section 404 of Sarbanes Oxley Stephen Bryan Babcock Graduate School of Management Wake Forest UniversitySteven LilienBaruch CollegeCity University of New YorkAbstract The legislation known as Sarbanes Oxley (SOX)
2、 requires firms to assess their internal controls over financial reporting and to report material weaknesses, as defined by the Public Accounting Oversight Board. Based upon early evidence, we find that firms with material weaknesses are, on average, both smaller and worse performers than their matc
3、hed industry counterparts. We also find that firms with material weaknesses, on average, have higher betas, suggesting a higher discount by the market for these firms. From a macro-economic view, the total market value of firms with reported material weaknesses is only 1.28% of the market value of t
4、he S&P 500 firms. Finally, although we document negative stock returns on the date of the announcement of the material weakness, over a narrow interval, the returns are insignificant.Identifying small firms that collectively constitute a minor portion of the economy at a very high cost to all public
5、 firms seems out of balance. Whether SOX will yield benefits to corporations through better operations, reduced cost of capital, or other means remains to be seen. Moreover, if these benefits materialize, whether they should, in effect, be legislated is a matter of debate. Although some maintain tha
6、t SOX will reduce earnings management, firms continue to manage earnings through pro forma earnings. Furthermore, although the SECs Reg G, also enacted as part of SOX legislation, makes the “managed disclosure system” through pro forma earnings more transparent, it fails to exercise control over the
7、 reconciliation process that firms use both to set and to meet analyst earnings estimate.IntroductionThe goal of the “The Public Companies Oxley (SOX), is restoration of investor confidence, which had been shaken by Enron et al. Supposedly, improved investor confidence will flow from improved disclo
8、sures of financial information and better corporate governance, including internal control over accounting measurement, recognition and disclosure presses. SOX is an attempt to legislate better disclosure and internal control.Of SOXs many requirements, the main one for this study is Section 404, “En
9、hanced Financial Disclosures, and Management Assessment of Internal Control. Section 404 requires companies to assess the effectiveness of their internal controls over financial reporting and report that assessment in their annual filings with the SEC (Form 10-K) 1Firms are encouraged to include the
10、 report on internal controls in the “glossy” annual report to shareholders, as well as in the 10-K. Moreover, companies external auditors will not only audit the financial statements, as before, but now they will also audit managements assessment of their internal controls over financial reporting a
11、nd perform their own independent audit of the same control system. Priorto SOX, auditors assessed internal controls but only in conjunction with planning the audit, i.e., they did not formally audit the internal control system, nor formally report on the results of that audit.Although a major purpos
12、e of the internal control audit is deterrence from fraudulent financial reporting, the ramifications of which include severe market reactions and legal liabilities, regulators also maintain that better internal control will have broader favorable impacts on companies, such as reduced cost of capital
13、 and better access to capital markets.For instance, to underscore the possible positive benefits of Section 404, William Donaldson, Chairman of the SEC remarked, simply complying with the rules is not enough. Companies should, as I have said before, make this approach part of their . DNA. For compan
14、ies that take this approach, most of the major concerns about compliance disappear. Moreover, if companies view the new laws as opportunities opportunities to improve internal controls, improve the performance of the board, and improve their public reporting they will ultimately be better run, more
15、transparent, and therefore more attractive to investors. (Speech at the National Press Club on July 30, 2003).Notwithstanding the alleged benefits, the private costs are not insignificant and are likely to become a permanent addition to firms administrative burden. In a survey of 224 firms conducted
16、 by Financial Executives International (in July 2004), respondents revealed that they will spend in the first year of SOX, on average, an extra $3 million in order to comply with Section 404. The largest companies (those with over $5,000 million in revenues) will spend an average of $8 million. Resp
17、ondents stated that audit fees are expected to increase, on average, by 53% in order to pay for the attestation over internal control. The professional accounting firms are admonishing clients about the importance of subsequent steps to insure sustainability of the control system so that “backslidin
18、g” will not occur. (Deloitte and Touche, 2005). Additionally, the costs associated with these steps include not only “out-of-pocket” costs but also the indirect costs of diverting managerial attention from the critical decisions that pertain to operating and investing activities of the firm.SOX also
19、 directed the SEC to set up the Public Company Accounting Oversight Board (PCAOB), which was charged with determining auditing standards to implement Section 404. In June 2003, the SEC approved rules implementing Section 404, and the following year, the PCAOB issued standards for auditor attestation
20、 of firms internal controls. The SEC rules and PCAOBs Auditing Standard No. 2 (“An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements”) require both the management report and the auditors reports.In addition to Section 404, SOX contains
21、the related Section 302 (“Corporate Responsibility”), which requires a companys CEO and CFO to certify each quarterly and annual report. The certification states that the financial statements are presented fairly in all material respects; that they do not contain untrue statements of material fact o
22、r fail to state a material fact; that the CEO and CFO are responsible for establishing and maintaining controls over the financial reporting system; that the CEO and CFO have evaluated the effectiveness of the controls; that the CEO and CFO have disclosed all significant deficiencies and material we
23、aknesses to the auditors and audit committee; and that the CEO and CFO are responsible for establishing and maintaining internal control over financial reporting and for providing reasonable assurance of the reliability of the financial reporting and for preparing the financial statements in conform
24、ity with GAAP. Finally, the CEO and CFO must report any changes in the companys internal control over the financial reporting during the most recent quarter.Disciplinary actions against firms and the above named officers are stipulated in Section 906 (“White-Collar Crime Penalty Enhancements”).Secti
25、on 906 imposes criminal penalties for officers who provide certifications known to be untrue.The SEC has granted postponement of the reports on internal controls, as firms have been unable to meet the initial deadlines. Specifically, accelerated filers may amend their 10-K filings with the internal
26、control reports up to 45 days after the deadline for the 10-K, beginning with fiscal years ending on or after November 15, 2004. (SEC, January 21, 2005)To gear up ahead of the deadlines, firms and their auditors instituted expanded procedures to assess their internal controls over the financial repo
27、rting process. In certain instances, the expanded procedures have identified material weaknesses in advance of the deadlines for disclosures. Over the past several months, some firms have made their findings public in 8-K filings. Some have done so in conjunction with 8-K filings about accounting re
28、statements and/or changes in auditors. Others have apparently done so voluntarily. That is, for firms with a material weakness that is not associated with a concomitant accounting error or auditor switch, there does not appear to be a compelling reason for disclosing the material weakness, if the fi
29、rm ascertains that it can remediate the weakness by the disclosure date. The Chief Accountant of the SEC, Donald Nicolaisen, noted that it is essentially the responsibility of investors to evaluate the nature of each SOX disclosure of material weakness to make an informed assessment of its implicati
30、ons. The Chief Accountant of the SEC, Donald Nicolaisen, noted that it is essentially the responsibility of investors to evaluate the nature of each SOX disclosure of material weakness to make an informed assessment of its implications.The Chief Accountant of the SEC, Donald Nicolaisen, noted that i
31、t is essentially the responsibility of investors to evaluate the nature of each SOX disclosure of material weakness to make an informed assessment of its implications.Samuel DiPiazza, CEO of PWC, forecasts that approximately 10% of U.S. firms will either disclose material weaknesses or will disclose
32、 that they are unable to certify their internal control procedures by their reporting date. Internal control weaknesses will likely cluster around industry and firm characteristics. For instance, small firms and those in the technology sector will likely be heavily represented (Bulkeley, 2005).Early
33、 evidence that internal control disclosures could have real economic consequences comes from the decision by Moodys Investor Services, which in October 2004, indicated its approach in evaluating the SOX reports and in determining the effects of material weaknesses on credit ratings. Echoing the abov
34、e quote of the Chief Accountant, Moodys does not believe all material weaknesses in internal control will have severe negative effects on the firm.We are less concerned about material weaknesses that relate to controls over specific account balances or transaction-level processes. We refer to these
35、material weaknesses as “Category A” material weaknesses. In most cases, we believe that the auditor can effectively “audit around” these material weaknesses by performing additional substantive procedures in the area where the material weakness exists. We expect to give companies reporting Category
36、A material weaknesses the benefit of the doubt and not take any related rating action, assuming management takes corrective action to address the material weakness in a timely manner.Other material weaknesses, which we refer to as “Category B” material weaknesses, relate to company-level controls an
37、d may result in us bringing a company to rating committee to determine whether a rating action is necessary. (Moodys Investor Services, 2004)Moodys cites examples of what they would consider to be Category B weaknesses, such as the “tone at the top” that is not conducive to an effective control envi
38、ronment. Specific indicators could include lack of consistent policies or lack of a company-wide code of conduct.Additionally, Moodys states that the Category B type weaknesses not only cast a bad light on the integrity of the financial reporting process but also on managements ability to run the bu
39、siness.If a material weakness means that there is more than a remote likelihood of a material misstatement of the external financial statements, what does that imply about the quality of internal data that management uses to make decisions?Purposes of StudyThe ability to document in a direct test th
40、e effectiveness of SOXs goal of restoring investor confidence is difficult. We can however attempt to assess SOX along a number of dimensions, from which we can begin to draw certain inferences. Our conclusions are limited for two main reasons. First, the implementation date has just recently passed
41、, subject to deferrals as mentioned previously. Second, certain effects of the legislation are not directly detectable for the following reasons.Conceivably a firm may uncover a material weakness and provide an effective remedy before a disclosure date (e.g., fiscal year end);Beneficial externalitie
42、s might accrue to the firm because of SOX but the specification of the model to detect and measure these benefits and their causal factors is elusive. For instance, a report by McKinsey (2000) claims that money spent on internal control has positive effects beyond mere compliance. McKinsey claims th
43、at investors are willing to pay a significant premium for firms with “good corporate governance,” of which internal control systems are a component. However, measurement error still surrounds corporate governance, although various metrics have been offered in the literature (Gompers,2002).Given the
44、above limiting factors, our goals are to identify with material weaknesses and to measure stock market effects on and around the disclosure date of the material weakness. We provide two cases (McAfee Inc. and Eastman Kodak) by way of illustrations. We draw initial conclusions about the mandate of Se
45、ction 404 and offer avenues for further research.Related literatureSOX has generated much academic interest, particularly among legal scholar. For instance, Ribstein (2002) notes that governance failures (particularly reliance on contracting devices) reinvigorated legislative responses to corporate
46、oversight, but he also argues that the new legislation will have only limited effectiveness and will not necessarily do a better job than markets themselves, especially given the high cost of implementation. Further, SOX represents a federal insertion into corporate governance and it may not only be
47、 ineffective, it could cause harm to the extent it reduces incentives for managers to increase shareholder value and misleads market participants into thinking that regulation has solved the problems of corporate governance and improved the integrity of the reporting process.Perino (2002) expresses
48、concerns over SOX due to inconsistencies in the legislation, which he attributes to the rush through the legislative process. Additionally, he argues that the deterrent effect of longer penalties and increased statute of limitations on securities fraud will be minimal. On the other hand, more resources (at the SEC) for detection may be effective.Li, Pincus, and Rego (2004) look at market reactions on significant dates leading up to passage of SOX to try to gauge whether the markets viewed th
