Are Companies That Report Material Weaknesses in Internal Control More Likely to Restate Their Financial Statements

ABSTRACT This study provides empirical evidence on the relationship between reported material weaknesses in internal control and the probability of a company restating its earnings, based on a sample of 518 restating companies and 518 matching companies selected from the period January 1, 2004 through December 31, 2005. First, this study finds a significant relationship between the incidence of material weaknesses reported by the firm and the probability of a firm restating its earnings. Second, the magnitude or frequency of material internal control weaknesses reported by the firm is significantly related to the probability of a firm restating its earnings. The higher the number of material weaknesses reported by a company, the greater the probability that the company will restate. Finally, the type of material internal control weakness is significantly related to the probability of a firm restating its earnings. This study finds that companies reporting material weakness in accounting related areas such as accruals, revenue recognition, period-end closings and accounting policies, and complex areas such as derivative and lease accounting are more likely to restate earnings than those companies reporting material weakness in non-accounting areas such as training, segregation of duties, senior management, and subsidiary specific areas (ProQuest: . denotes formula omitted.) INTRODUCTION The purpose of this study is to enhance the understanding of the relationships between material weaknesses in internal control and restatements of financial reports (for purposes of this paper, the terms "restatements of financial reports" and "earnings restatements" are used interchangeably). Specifically, we investigate the association between the report of, the number of, and the type of reported internal control weaknesses and earnings restatement. Earnings restatement by publicly traded companies can have multiple adverse consequences including SEC investigation, replacement of top executives, and possibly firm's penalization by investors. Previous studies show that earnings restatements were increasing in the years prior to the Sarbanes-Oxley (SOX) Act of 2002 (FEI, 2001; Moriarty & Livingston, 2001; GAO, 2005; Weil, 2001). Part of the reasoning behind SOX is to increase transparency of financial statements while reducing the number and magnitude of earnings restatements. However, restatements have risen five-fold from 2002 until 2005 (Glass, Lewis & Co., 2006). Companies with U.S. listed securities filed 1,295 financial restatements in 2005, nearly double the previous year, including 182 "stealth" restatements filed without amended filings, 8-K filings, or other public announcements (Glass, Lewis & Co., 2006). Firms audited by non-Big 4 auditors were six times as likely to restate as those audited by Big-Four firms. Perhaps most troubling is that over half of the restating companies filed financial statements claiming effective internal controls prior to the restatement (Glass, Lewis & Co., 2006). The economic burden of these reporting errors falls on investors. Disclosure of material internal control weakness is also increasing, totaling 314 in 2004 and 424 in 2005 (Compliance Week, 2006). Of the 424 disclosures in 2005, 87 percent of the firms previously certified controls as effective, with over 40 percent (171 firms) not warning investors of an imminent adverse audit opinion. A possible explanation for the increase in disclosure of material weaknesses in internal control is the reporting requirements of SOX sections 302 and 404. SOX Section 302 establishes the management responsibility to design, maintain, evaluate the effectiveness of the internal control system, and to report on any identified deficiencies or weaknesses. SOX Section 404 relates to the management assessment of the internal control system. This issue is important and timely because the quality of financial reporting in general is of increasing concern to investors, managers, regulators, auditors, boards of directors, and academics and the accounting characteristics (antecedents) of earnings restatements have not been fully explored. …