Internal Control Weaknesses and Information Precision Zi-Chin Weng Chen-Lung Chin Be Veg, Go Green, 2 Save Planet

Internal Control Weaknesses and Information Precision

Zi-Chin Weng

Chen-Lung Chin

Be Veg, Go Green, 2 Save Planet

Section 404 of the SOX Act requires

Management to report the effectiveness of Internal Controls Auditor to attest the validity of these reports

Cons and pros: cost/benefit trade-off Regulators:

higher quality financial reporting/ lower cost of capital Firms:

cost exceeds their perceived benefits. Empirical evidence:

Mixed: Accrual quality: Doyle et al. (2007); Ashbaugh-Skaife et al. (2008). Cost of capital: Ogneva et al. (2007); Ashbaugh-Skaife et al. (2008).

Introduction

Introduction

The objective Directly examines the information

production process in ICW setting. Overall information environment

Public (idiosyncratic) information Private (common) information


Introduction

The purposes of this paper The relation between internal control

weakness (ICW) and information precision. Public information precision Private information precision

Relative effects of degree of ICW severity on the precisions of public and private information.

Whether remediation of previously ICW Enhances the precisions of public and private

information.

Research structure

ICW

Public information precision

Private information precision

Information environment


Contributions

IC quality is a critical determinant of information precision.

provide evidence that ICW leads to reduced quality of overall information environment as well as public and private information precisions.

Public and private information precisions are complementary effect.


Literature and hypothesis

The impact of ICW on information precision Inf. market participant use is provided by firms ICW firms introduce misstatements into the

F/S and exhibits greater information noise Earnings quality↓ (Ashbaugh-Skaife et al., 2008) Analysts’ forecasts dispersion ↑ (Kim et al.,2008) Market return (Hammersley et al. 2007) More accurate analyst earnings forecasts (Hope, 2003a) Lower cost of capital and information asymmetry (Ramnath et al.,

2008) H1a: ICW is negatively related to public information

precision.


Information environment is comprised of Private / public information Two opposite perspectives

Substitute perspective (Verrecchia 1982) Higher public info. precision reduces market

participants' incentives to generate more precise private information.

Complementary perspective (McNichols and Trueman, 1994) A public release of information=> analysts with diverse

information-processing new private skills to generate information

Private (Substitute) (+)

=> ICW Public information precision

Private (Complementary)(-)

H1b: ICW is associated with the private information precision.


The severity of ICW and information precision The ICW severity varies substantially within the

material weakness classification (Moody’s, 2006) Account-specific weaknesses Firm-level weaknesses

ICW firms with firm-level weaknesses have lower accruals quality relative to ICW firms

with account-specific weaknesses (Doyle et al. 2007).

H2: Firm-level ICW have a stronger association with information

precision than account-specific ICW.


Remediation of ICW

The effect of remediation of ICW firms Remediation firms exhibit significant improvements

Accrual quality (Ashbaugh-Skaife et al. 2008 ) The quality of new CFO (Li et al. 2007)

H3a: Remediation firms exhibit an increase in public

information precision relative to non-remediation firms. There are two opposite perspectives about the relation

between public and private information precisions substitute and complementary effects

H3b: Remediation firms exhibit an association with private

information precision relative to non-remediation firms.

Research Design and Data Sources

The impact of ICW on information precision Test H1a and H1b

ICW =1 if firms has ICW (+)


Research Design

Following Barron (1998) RPUBIIC=fractional rank of public information precision (Barron et

al.1998; Botosan et al.2004 )

RPRIVATE=fractional rank of private information precision (Barron et al.. 1998; Botosan et al.2004 )

SE=expected square error in the mean forecast D=expected forecast dispersion N= the number of forecasts


Research Design

H2: The impact of ICW severity on information precision

WHERE ICW_acc = 1 if the firm discloses account-specific ICW, and 0 otherwise. ICW_firm = 1 if the firm discloses firm-level ICW, and 0 otherwise.

H2: a1 > a2


Research Design

H3: The impact of ICW firms with remediation

Independent variables Weakness = 1 if the firm received an adverse SOX 404 opinion in the current or prior year, and zero otherwise. Remediation= 1 if the firms received an adverse SOX 404 opinion in the current year,

but received an unqualified SOX 404 opinion in successive years. H3: m2 > 0, n2 > 0.

Sample

Sample period: 2004 to 2007. Data requirements

accelerated filers in the U.S. Financial statement data are available from I/B/E/S,

Audit Analytics , COMPUSTAT North America The severity of ICW

10-Ks in the EDGAR from November 2004 to December 2007


Empirical results Descriptive statistics

Average rank portfolio

Pearson correlation matrix


Table 5_Test H1

Further analysis

The impact of ICW on overall information environment Model:

Overall information uncertainty (UNCER) is defined as follows (Barron et al., 1998):

UNCER = fractional rank of uncertainty for firm i, year t. Uncertainty is drawn from Barron et al. (1998) and can be defined as follows:

PRIVATEPUBLIC 1

Table 6_The impact of ICW on overall information environment


Table 7_Test H2

Table 8_Test H3

Sensitivity Analyses (1)

Controlling the endogeneity effect (Doyle et al. (2007a; Ashbaugh-Skaife et al. (2007). Two stage treatment effect model.

First: ICW=δ0+δ1Market+δ2 others+ε Second: equation (1) or (2)

Panel A of Table 9: Robust!


• Controlling the endogeneity effect

Sensitivity Analyses (2)

Change model, not level model Contemporary relation (cause-effect) Overcome omitted variables

Model

Improve=1 if firm remediate this year (+) △= change Panel A of Table 9: Robust !


• The results of change sample

Internal control weakness counts


Conclusions

ICW firms have less precise public and private information and lower level of overall information environment

relative to non-ICW firms. Public information precision is lower for firms

with firm-level ICW than account-specific ICW. ICW firms with remediation in following year

will increase information precision relative to ICW firms

without remediation.


事务所行业专长、市场化程度对于自愿性内部控制鉴证报告披露的影响


中国财政部等五部门于 2008年发布《企业内部控制基本规范》要求上市公司披

露关于企业内部控制报告及审计师对其进行鉴证。

執法上並未強制 Us: mandatory China: voluntary

Introduction


H1：事务所行业专长对于自愿性内部控制鉴证报告的披露正相关。 Signaling

Auditor quality: Datar et al. (1991) Auditors’ expertise: (Balsam, 2003)

Auditor specialists

Introduction


H2：在市场化程度高的地区注册的公司，更有可能提供内部控制鉴证报告。整体的政治、法律与经济机制 ( 为市场化程度 ) 会影响公司行为 /该地区的财务报导与会计质量 (Ball, et al.,

2000)，会计师的选择 (Wang et al, 2008)。

市场化程度高=>竞争激烈=>从而迫使管理层通过加强内部控制建设以适应激烈的市场化竞争的需要。

Research Design


事务所行业专长（ AS ） : AS=

分子 : 事务所 i在特定行业 k 的客户营业总收入，分母 : 代表 K 行业中全部客户营业总收入

市场化程度中国市场化指数——各地区市场化相对进程 2006 年度报告 ( 樊纲、

王小鲁、朱恒鹏， 2007) Model Probit (AS=1) = a0 + a1 (AS) + a2 control. (+)

Introduction

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Internal Control Weaknesses and Information Precision Zi-Chin Weng Chen-Lung Chin Be Veg, Go Green, 2 Save Planet