What Factors are Linked with the Deterioration of Internal Controls

1、what factors are linked with the deterioration of internal controls?karen tonuniversity of southern californialos angeles, ca 90089september 2009abstractthe purpose of this study is to reevaluate the determinants of weaknesses in financial reporting controls and to identify factors linked

2、 with the deterioration of internal controls. i explore financial resources, recent organizational changes, entrance into new markets, and rapid growth as potential changes in the financial reporting process that impact financial reporting controls. i also evaluate auditor changes and propose to stu

3、dy management, audit committee, and board of director changes to assess whether changes with the participants involved with the financial reporting process impacts financial reporting controls. based on a preliminary analysis, i found that deteriorating internal control firms exhibit similar risk fa

4、ctors to that of ineffective internal control firms. deteriorating internal control firms are smaller, experience higher levels of financial distress, have higher proportions of receivables, engage in more foreign transactions, mergers and acquisitions and restructuring, and have more frequent audit

5、or changes.1. introductionspurred by a series of corporate and accounting scandals (i.e. enron, worldcom, tyco, adelphia, etc.), sections 302 and 404 of the sarbanes-oxley act (sox) were designed to improve internal controls over financial reporting and also provide investors with information of con

6、trol issues. once a company has successfully implemented effective internal controls, the question arises as to how or why financial reporting deficiencies continue to arise. the purpose of this study is to reevaluate the determinants of weaknesses in financial reporting controls and to identify fac

7、tors that lead to the deterioration of internal controls.in this study, i examine a sample of firms whose controls have deteriorated to identify factors linked with the deterioration of internal controls. although there are also firms that experience improvements in its internal controls, i focus on

8、 those with deteriorating internal controls because weaknesses in internal control are often associated with fraud, restatements, or financial reporting delays, which would have a negative impact on investors and the capital market. internal controls are most susceptible to failure during times of c

9、hange. changes make a company more susceptible to risk because it tests existing controls and may also identify the need for additional controls. i believe that changes in the financial reporting process or changes with the participants involved with the financial reporting process is positively ass

10、ociated with the deterioration of controls.i study a sample of 323 firms-years with internal controls that have deteriorated. i use managements sox section 404 internal control assessments as a proxy for internal control with those that issue an ineffective internal control report as firms with bad

11、internal controls and companies issuing effective internal control report as firm with good internal controls. firms that issue an ineffective internal control assessment subsequent to issuing an effective internal control assessment in the previous year are deemed to have deteriorating internal con

12、trols. i explore financial resources, recent organizational changes, entrance into new markets, and rapid growth as potential changes in the financial reporting process that would impact financial reporting controls. in addition, i introduce receivables as an additional determinant of ineffective an

13、d deteriorating internal controls. i also evaluate auditor changes and propose to study management, audit committee, and board of directors changes to assess whether changes with the participants involved with the financial reporting process impacts financial reporting controls. based on a prelimina

14、ry analysis, i found that deteriorating internal control firms exhibit similar risk factors to that of ineffective internal control firms. deteriorating internal control firms are smaller, experience higher levels of financial distress, engage in more foreign transactions, mergers and acquisitions a

15、nd restructuring, and have more frequent auditor changes. this study contributes to the literature on internal controls. previous studies have examined the characteristics of firms with effective and ineffective internal control structures but no studies have examined the characteristics of firms th

16、at experienced a downgrade of internal control. evaluating firms with deteriorating controls provides a better understanding of financial reporting risks. since reports are lagging indicators of financial reporting problems (jonas et al. 2006, jonas et al. 2007), this will enable users to critically

17、 evaluate firms with “effective” internal controls. the remainder of this paper is organized as follows: section 2 contains background information and a brief literature review. i develop my hypotheses in section 3 and discuss the research design, sample, and variables examined in this study in sect

18、ion 4. i discuss the preliminary results in section 5 and my proposal for future research in section 6.2a. backgroundprior to the enactment of sox, there were limited requirements on internal controls and disclosures of internal control deficiencies. firms were only required to report internal contr

19、ol problems in the firms 8-k when they change auditors and problems were pointed out by their predecessor auditors (sec 1988, krishnan 2005). doyle et al. (2007b) searched sec filings from august 1999 through august 2002 and found only 61 distinct disclosures of material weaknesses and 40 of these r

20、elated to mandatory disclosure in conjunction with auditor changes. the enactment of the fdic improvement act of 1991 (fdicia) by the banking industry in response to the savings and loan crisis was among initial regulation that required annual assessments by management of the effectiveness of intern

21、al control over financial reporting and a related attestation report from the auditor (altamuro and beatty 2007). sox mandated new assessments and disclosures of internal controls. considering the high costs associated with the implementation of sox (charles river associates 2005, sneller and langen

22、dijk 2007) and the little information on internal control systems required prior to sox, it is likely that most firms had to undergo extensive efforts to identify, implement, evaluate, and test its internal controls when sox was enacted. the years following the enactment of sox is a regulatory trans

23、ition period. sox was issued with numerous rules and requirements surrounding controls and procedures. however, review procedures were not specified, limited guidance was available, and firms and auditors struggled to interpret and apply these requirements. as a result, there may be a wide variation

24、 in terms of what constitutes an internal control deficiency during this regulatory transition period. previous studies have been conducted to identify determinants of internal control weaknesses (ge and mcvay 2005, doyle et al. 2007b and ashbaugh-skaife et al. 2007). however, most of these studies

25、spanned the period shortly before or after sox was enacted. further, their samples are comprised of internal control deficiencies reported under both section 302 and section 404 of sox. ashbaugh-skaife et al. (2007) studied firms that reported internal control deficiencies in their section 302 discl

26、osures from 2001 to 2003, the period after section 302 became effective but before the section 404 effective date. as a result, their definition of internal control weakness includes all levels of control deficiencies (material weaknesses, significant deficiencies, and control deficiencies) and incl

27、udes firms of all sizes. doyle et al. (2007b) examined both section 302 and 404 disclosures from 2002 to 2005. to illustrate the potential impact of the sample and the sample window, the following is a brief discussion on the development of sox.title iv of sox requires enhanced financial disclosures

28、. section 302 requires management to evaluate and report the effectiveness of disclosure controls and procedures and disclose any significant changes in internal control since the most recent form 10-k or 10-q filing (sec 2002). management is required to report material weaknesses to the audit commi

29、ttee and the external auditor but it is ambiguous whether this must be disclosed in its sec filings (ashabaugh-skaife et al. 2007). section 404 or “management assessment of internal controls” was effective for fiscal years ending after november 15, 2004. this section requires issuers to publish info

30、rmation regarding the adequacy of its internal accounting control structure and procedures for financial reporting. internal control problems classified as a material weakness, which is the most severe type of internal control deficiency, must be disclosed under section 404. management is required t

31、o assess the effectiveness of internal controls and procedures. the registered accounting firm is also required to attest to and report on managements assessment of the companys internal control over financial reporting (sec 2003). the results of evaluating and testing the effectiveness of internal

32、controls and procedures are summarized in the internal controls reports issued by management and the auditor. an ineffective internal controls report is issued if the company has one or more material weaknesses. according to pcaob auditing standard no. 5, a material weakness is a deficiency, or a co

33、mbination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility an event is reasonable possibility when the likelihood of the event is either reasonably possible or probable, as defined in financial accounting standards board statement no. 5, acco

34、unting for contingencies (fas 5). that a material misstatement of the companys annual or interim financial statements will not be prevented or detected on a timely basis. otherwise, an effective internal controls report is issued. although material weaknesses are now clearly defined, regulatory guid

35、ance defining the various levels of control deficiencies were not released until auditing standard no. 2 was issued in march 2004. many firms issued section 302 reports prior to this release so internal control weaknesses reported may vary in terms of severity. in decreasing levels of severity, inte

36、rnal control deficiencies include material weaknesses, significant deficiencies a significant deficiency is an internal control deficiency or combination of control deficiencies that adversely affects the companys ability to initiate, authorize, record, process, or report external financial data rel

37、iably in accordance with gaap. in such an occurrence, there will be a more-than-remote likelihood that a misstatement of the companys annual or interim financial statements that is more than inconsequential would not be prevented or detected (sec 2007)., and control deficiencies.the development of s

38、ox suggests there was limited guidance on the definition and classifications of control deficiencies and management had considerable discretion in terms of disclosure during the regulatory transition period. as a result, internal control weaknesses identified in the early stages of sox may vary in t

39、erms of severity and the sample may be skewed due to inconsistent disclosure requirements. further, section 404 disclosures were not required until november 2004 so most of the internal control deficiencies in previous studies were identified under section 302. however, glass, lewis & company studie

40、d disclosures as of march 2005 and found that 87% of companies that previously did not identify internal control deficiencies pursuant to section 302 announced control issues pursuant to section 404. most of the related internal controls studies were conducted during the regulatory transition period

41、. these studies were conducted during a unique period when firms were undergoing massive changes to comply with new regulatory requirements. also, there was an inconsistent definition and disclosure of internal control deficiencies during the regulatory transition period. as such, findings from thes

42、e previous studies may reflect a unique environment and time period. i reevaluate the findings from previous studies to determine if they continue to apply in the current environment before evaluating their impact on the deterioration of controls.2b. prior researchsox was developed with the aim of i

43、mproving the integrity of company filings and informing investors about internal controls. there have been a number of studies that has shown that sox internal control reports has improved the financial reporting process. negative market reaction to ineffective section 302 internal control reports (

44、beneish et al. 2008) and the varying severity of the control weakness (hammersley et al. 2008) as well as section 404 reports (de franco et al. 2005) suggests that these reports provide new and value-relevant information. studies examining earnings quality have found that firms with ineffective cont

45、rols ex-ante generally have low quality accruals (doyle et al. 2007a, ashbaugh-skaife et al. 2008) and accrual quality changes in the same direction as internal control changes (ashbaugh-skaife et al. 2008). studies have also shown that internal control weaknesses may be associated with cost of equi

46、ty (ogneva et al. 2007, beneish et al. 2008, ashbaugh-skaife et al. 2009).most of these studies examine the impact of sox subsequent to the issuance of an internal control opinion. to gain an understanding of what an ineffective control report suggests, several studies have performed exploratory ana

47、lysis to determine plausible determinants of internal control weaknesses. krishnan (2005) examined a limited sample of firms that switched auditors in the pre-sox era and found that governance structure (independent audit committees and audit committees with more financial expertise) is associated w

48、ith internal control weaknesses and zhang et al. (2007) finds similar results with a sample of firms in the post-sox era. other studies in the post-sox era have identified that internal control weaknesses are associated with auditor changes (zhang et al. 2007, ashbaugh-skaife et al. 2007) and firms

49、that are smaller, younger, financially weaker, have more complex operations, recent organizational changes, growing rapidly, and have greater accounting risk (ge and mcvay 2005, ashbaugh-skaife et al. 2007, doyle et al. 2007b). since most of these studies were conducted during the regulatory transit

50、ion era, i first reexamine some of the characteristics previously identified to be associated with internal control deficiencies to determine if they are generalizable to the current environment. i extend the previous studies by examining the characteristics of firms that experienced deterioration i

51、n controls and examine several additional variables to identify possible determinants of the deterioration of controls.3. hypothesesinternal control deficiencies arise when a company undergoes significant changes because it is susceptible to environment changes. changes in the environment increases

52、internal control risk because it tests existing controls and may also identify the need for additional controls. i believe that changes in the financial reporting process or changes with the participants involved with the financial reporting process is positively associated with the deterioration of

53、 controls. based on the findings of ashbaugh-skaife et al. (2007) and doyle et al. (2007b), i explore financial resources, recent organizational changes, entrance into new markets, and rapid growth as potential changes in the financial reporting process that would impact financial reporting controls

54、.change in financial resources may affect priorities, management incentives, trigger debt covenants, etc. along with the financial challenges of the situation, management will have to discuss the changes with investors, analysts, and bankers. the additional internal and external oversight and monito

55、ring may increase the likelihood that internal control deficiencies are identified. i expect that decline in financial resources positively related with deterioration in controls.deterioration in controls may also result from organizational changes that impact financial reporting. in a restructuring

56、 where the company is modifies its debt, operations or structure, the company will have to manage the loss of employees and assets. in a merger/acquisition, the company will have to integrate different systems, employees, policies, etc. to standardize practices across the firms. both of these change

57、s require unique accounting treatment that management may not be familiar with. i expect organizational changes to be positively related with organizational changes.entrance into new markets also exposes the financial reporting process to additional risks. the launch of a new product or segment requ

58、ires additional reporting and consolidation requirements. in addition, entrance into foreign markets may require foreign currency translation as well as adjustments to comply with us gaap. i expect that entrance into new markets in positively associated with deterioration in controls.firms that unde

59、rgo rapid growth or contraction will also be subject to internal control risk. internal controls are typically designed with consideration to size, risk, and frequency of transactions. firms that undergo dramatic changes will have to reevaluate its controls to see if existing controls are sufficient for the changes in the companys environment. i expect that rapid growth/contraction is positively related with deterioration in controls.hypothesis 1: chan