How Effective Is Internal Control Reporting under SOX 404? Determinants of the (Non-)Disclosure of Existing Material Weaknesses

Authors

  • SARAH C. RICE,

    1. University of Connecticut. We appreciate helpful comments from the editor, two anonymous reviewers, Brad Badertscher, Jean Bedard, Lisa Bryant-Kutcher, John Campbell, William Greene, Shane Heitzman, Linda Hughen, Bjorn Jorgensen, Reuven Lehavy, Andy Leone, Sarah McVay, Dave Papandria, Emma Peng, Bill Waller, Mike Willenborg, Teri Yohn, and workshop participants at the University of Arizona, Colorado State University, and the 2011 American Accounting Association Annual Meeting.
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  • DAVID P. WEBER

    1. University of Connecticut. We appreciate helpful comments from the editor, two anonymous reviewers, Brad Badertscher, Jean Bedard, Lisa Bryant-Kutcher, John Campbell, William Greene, Shane Heitzman, Linda Hughen, Bjorn Jorgensen, Reuven Lehavy, Andy Leone, Sarah McVay, Dave Papandria, Emma Peng, Bill Waller, Mike Willenborg, Teri Yohn, and workshop participants at the University of Arizona, Colorado State University, and the 2011 American Accounting Association Annual Meeting.
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ABSTRACT 

We study determinants of internal control reporting decisions under Section 404 of the Sarbanes-Oxley Act (SOX 404) using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non-audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.

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