Material Internal Control Weaknesses And Earnings Management In The Post-SOX Environment

Abstract

Prior studies found that companies with internal control deficiencies incorporate abnormal accounting accruals into their financial statements. However, these studies did not consider the materiality of abnormal accruals. Abnormal accruals should be within materiality when financial statements receive clean audit opinions. When material internal control weaknesses (MICW) exist, to compensate for additional risk, auditors should apply more audit effort to gain the quantity and quality of evidence necessary to obtain a reasonable degree of assurance to support their audit reports. We find evidence of this because audit fees are significantly higher for MICW companies than those for effective internal controls (EIC) companies in our sample. Accordingly, financial statements receiving clean audit opinions should not contain material abnormal accruals irrespective of whether controls are effective EIC or ineffective MICW. To examine this issue, we use post-SOX data to estimate abnormal accruals using a revenue-based accrual model for a matched sample of companies with clean audit opinions on their financial statements: one-half EIC and the other half with MICW. Then, we establish material abnormal revenue accruals (MARA), which is the difference between estimated abnormal revenue accruals and a quantitative materiality based on assets. Finally, we compare MARA between EIC and MICW companies. We find no significant difference in MARA between EIC and MICW companies. We provide a summary of important findings in Table 3, and conclude with suggestions to further improve audit and financial reporting quality.