A Review of Academic Literature on Internal Control Reporting Under SOX

Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) mandates reporting on the effectiveness of internal control over financial reporting (ICFR) by public company management and auditors. Such reporting began for fiscal years ended Nov 15, 2004 for accelerated filers and is scheduled to be fully implemented for non-accelerated filers in mid-2010. Section 404(a) of SOX requires public company management to include an assessment of the effectiveness of the company\u27s ICFR in its annual internal control report, and Section 404(b) requires attestation by the company\u27s auditor. The authors review the literature on internal control reporting under both Sections 302 and 404 in the post-SOX period. The internal control literature has grown substantially since the passage of SOX due to the availability of data regarding ICFR effectiveness that were not previously available. They conducted a literature search through mid-2009 resulting in the inclusion of many published papers and working papers that address ICFR issues covered in our taxonomy

Determinants of the Relations between Transitory Earnings and CEO Cash Compensation in the USA

Prior research documents that gains from non-recurring transactions flow through to CEOs\u27 compensation, but that losses from non-recurring transactions do not. This paper extends extant literature by exploring the determinants of this phenomenon. We provide evidence that the prior findings of the asymmetric weighting of transitory gains over losses are more prominent for firms where CEOs are also Chairmen of the Board (duality effect). This asymmetry, however, weakens in firms with a high level of external monitoring, such as those in regulated industries (monitoring effect). The compensation weight on transitory gains also increases as earnings predictability declines (uncertainty effect), as CEOs get closer to retirement (retirement effect), and as the absolute magnitude of the non-recurring earnings increases relative to total earnings (magnitude effect). This study has practical implications for regulators, corporations and investors, both in the USA and abroad

SOX Section 404 Material Weaknesses and Shareholder Dissatisfaction with Directors

Given the board of directors’ oversight role with respect to internal control systems, we examine how disclosures of internal control material weaknesses under Sarbanes-Oxley Section 404 affect shareholders’ voting in director elections. We find that the presence of material weaknesses is associated with shareholder voting, but the effect varies with the type of director (overall board, managers, and audit committee members), the type of material weakness, and the company’s restatement status. In both the board and manager samples, shareholders react negatively to account balance-level material weaknesses when there is no restatement (directors are possibly sharing the blame for an adverse internal control opinion viewed as unduly harsh in the absence of a restatement) and react negatively to company-level material weaknesses where there is a restatement (this reaction is more negative than for account balance-level weaknesses; thus, directors are possibly sharing the blame for very serious accounting problems). By contrast, regardless of restatement status, audit committee directors are not penalized for material weaknesses, but these directors are penalized for certain restatements. We also find, across all three samples, that shareholders are more satisfied with directors when a Big 4 auditor is in place, but less satisfied when nonaudit fees are higher. Overall, the results provide new insights into the effects of internal control strength, restatements, and auditor quality on shareholder dissatisfaction with directors. We also discuss implications and avenues for future research

Auditor Failure and Market Reactions: Evidence from China

Zhongtianqin, the largest Chinese auditor in 2000, collapsed in 2001 owing to its audit failure. This study examines how the market reacted to the audit scandal in the Chinese institutional setting. Chinese investors are entitled to recover their investment losses from auditors owing to audit failure. However, civil lawsuits against auditors have not succeeded in the past. Therefore, Chinese auditors do not face the real threat of shareholder litigation. They only have the threat of costly governmental penalties for violating the regulations. Even so, we demonstrate that Chinese audit still contains both assurance and insurance values. Also, the entire market reacted to the scandal. Moreover, we show that investors differentiate audit quality in stock valuation. Finally, companies audited by international auditors suffered less value losses. This study adds to the worldwide literature on auditor failure

Adverse Section 404 Opinions and Shareholder Dissatisfaction toward Auditors

Auditors issuing adverse Section 404 internal control opinions may be viewed as too conservative, or they may be blamed for being partly responsible for the existence of the internal control material weaknesses. Using a sample of 240 companies with adverse internal control opinions and 240 matched “clean” companies in their first year of Section 404 compliance, we examine how shareholder dissatisfaction with the auditors varies depending on material weakness existence/type (company-level versus noncompany-level) and the presence of recent accounting restatements. In the full sample, we find a significant positive interaction between restatement and company-level material weakness—company-level material weaknesses have a greater effect on shareholder dissatisfaction when a restatement has occurred. To provide insight, we partition our sample based on whether test companies have had recent accounting restatements. In the nonrestatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 internal control opinion because of noncompany-level material weaknesses. Shareholders may view the auditor as being too conservative when no company-level material weaknesses are cited and no recent accounting restatements have been issued. In the restatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 opinion with or without company-level material weaknesses cited—but with shareholder dissatisfaction greater for companies with company-level material weaknesses. Hence, in companies with recent accounting restatements, shareholders may blame the auditor for being partly responsible for the existence of material weaknesses (i.e., low audit quality). Overall, the results provide insights into shareholders\u27 perceptions of auditing and suggest that existing shareholders may sometimes prefer less conservative auditors. We encourage additional research on the role of auditors in protecting current versus prospective shareholders

Auditor failure and market reactions: evidence from China

Zhongtianqin, the largest Chinese auditor in 2000, collapsed in 2001 owing to its audit failure. This study examines how the market reacted to the audit scandal in the Chinese institutional setting. Chinese investors are entitled to recover their investment losses from auditors owing to audit failure. However, civil lawsuits against auditors have not succeeded in the past. Therefore, Chinese auditors do not face the real threat of shareholder litigation. They only have the threat of costly governmental penalties for violating the regulations. Even so, we demonstrate that Chinese audit still contains both assurance and insurance values. Also, the entire market reacted to the scandal. Moreover, we show that investors differentiate audit quality in stock valuation. Finally, companies audited by international auditors suffered less value losses. This study adds to the worldwide literature on auditor failure.assurance effect; audit quality; auditor failure; China; domestic auditors; international auditors; government penalties; insurance effect; market reactions; stock value.

Shareholder Proposals on the Auditor–Client Relationship: The Case of Nonaudit Service Purchases

This article provides empirical evidence on shareholder proposals seeking to restrict nonaudit service (NAS) purchases by public companies from their independent auditors. Our analysis is based on 104 instances of shareholder proposals seeking to restrict NAS provided by independent auditors, received by 94 firms during a unique period from 2001 to 2004 (when the Securities and Exchange Commission [SEC] allowed such proposals to proceed to shareholder votes), and a control sample that did not receive such proposals. We find that firms targeted by shareholders had higher nonaudit fee ratios. We also find that firms receiving such shareholder proposals are likely to have steeper subsequent declines in the nonaudit fee ratio than firms not receiving such proposals. Finally, considering only the subset of firms that have a shareholder vote on proposals seeking to restrict NAS purchases, the subsequent reduction in the nonaudit fee ratio is positively related to the magnitude of the proportion of votes in favor of the shareholder proposal. Our findings suggest that permitting shareholder participation in issues related to the auditor–client relationship can lead to significant changes in the nature of the auditor’s relationship with the client, and they call into question recent SEC actions permitting companies to restrict shareholder participation in issues related to auditor selection

Corporate Governance Research in Accounting and Auditing: Insights, Practice Implications, and Future Research Directions

Over the past two decades, the corporate governance literature in accounting and auditing has grown rapidly. To better understand this body of work, we discuss 12 recent literature review or meta-analysis papers and summarize selected results (i.e., clusters of papers with new and interesting results) from recent empirical research papers, after reviewing the findings of over 250 studies. Our corporate governance focus is primarily on corporate board and audit committee issues. We discuss the major insights from this literature and the practice implications of these findings. In addition, we identify a number of opportunities for future research. In particular, we make suggestions for: (1) improved research paradigms in corporate governance, (2) extensions of existing research, and (3) new or emerging lines of research

Accounting Restatements Arising from PCAOB Inspections of Small Audit Firms

The article presents an analysis made by authors of PCAOB small firms inspection reports in order to examine the types of accounting restatements triggered by PCAOB inspections of small audit firms. The PCAOB Inspection Process is elaborated. The result of the analysis of the authors of PCAOB-triggered restatements by clients of small audit firms reveal that complex, technical accounting areas account for the majority of restatements. Particular attention to unique, complex and accounting issues is encouraged for issuers and small audit firms

What Do Compensation Committees on the Boards of Public Companies Do? Comparisons of Indian and U.S. Process Differences Juxtaposing Complementary Theoretical Lenses

This study examined the processes undertaken by compensation committees (CCs) on Indian public company boards building on the CC process study of U.S. public company boards reported in Hermanson et al. (2012). The Indian data reported here were gathered through scripted, in-depth, semi-structured interviews of 21 Indian directors (17 CC members, two Management Committee members and two directors, all of whom dealt with compensation matters on their boards). In keeping with agency theory predicates, Indian CC processes were designed to safeguard the independence, knowledge and expertise of CC members, while ensuring they had access to the resources needed to make sound and informed decisions. Compensation principles emphasized paying for performance, ensuring a proper mix of compensation, benchmarking to market practices and retaining good talent. There were some process differences among Indian organizational archetypes like family businesses, public sector firms, multinational subsidiaries (MNCs) and promoter-controlled firms, suggestive of neo-institutional theory influences. Notable differences from U.S. CC practices were that Indian CC practices were less formal, and directors were seen to be more partners of management playing broader roles extending beyond traditional agency-theory-driven fiduciary responsibilities. Some of these differences could portend the existence of secondary (principal-principal) agency problems. There were other process differences from U.S. practices, arising from institutional and cultural variations. In particular, institutional frameworks and statutory limits appeared to circumscribe the Indian CCs\u27 role, enabling greater managerial oversight of CC processes and engendering a more collectivist ethos among CCs in India. CC practices in the Indian context also lead us to discern some elements of an underlying tension between agency theory and institutional theory. These underlying tensions are further compounded by firm ownership differences (family, business group, MNC subsidiary, government owners, majority control, etc.). This is where we argue that neo-institutional influences based on ownership structure differences manifest themselves. To the best of our knowledge, our study represents a pioneering attempt at depicting these latent tensions between agency and institutional theory, and in teasing out how neo-institutional influences impact CC practices, thereby furthering our understanding of these phenomena. Cumulatively, these findings provide important directions for advancing theory, and enabling a more grounded and holistic understanding of CC processes. Since CCs were not mandatory for Indian public companies at the time this study was conducted, requiring CCs on all Indian company boards (as the revised 2013 Indian Companies Act has mandated ) would provide an added fillip to legitimizing and formalizing the role of this committee. However, because of the existing differences in the institutional and socio-cultural contexts, it is unlikely that CC processes across the Indian and U.S. company boards will converge and become completely uniform or homogeneous