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Review of Quantitative Finance and Accounting

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01.07.2012 | Original Research

Internal control material weakness, analysts’ accuracy and bias, and brokerage reputation

verfasst von: Li Xu, Alex P. Tang

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 1/2012

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Abstract

The main purpose of this paper is to examine the impact of internal control material weaknesses (ICMW hereafter) on sell side analysts. We find that ICMW reporting firms have less accurate analyst forecasts relative to non-reporting firms when the reported ICMWs belong to the Pervasive type. ICMW reporting firms have more optimistically biased analyst forecasts compared than non-reporting firms. The optimistic bias exists only in the forecasts issued by the analysts affiliated with less-highly-reputable brokerage houses. The differences in accuracy and bias between ICMW and non-ICMW firms disappear when ICMW disclosing firms stop disclosing ICMWs. Collectively, our results suggest that the weaknesses in internal control increases forecasting errors and upward bias for financial analysts. However, a good brokerage reputation can curb the optimistic bias.

Vorheriger Artikel Decision-making in sequential projects: expected time-to-build and probability of failure

Nächster Artikel Does foreign institutional ownership motivate firms in an emerging market to increase voluntary disclosure? Evidence from Taiwan

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Key points of Section 302 include: (1) The signing officers must certify that they are responsible for establishing and maintaining internal control and have designed such internal controls to ensure that material information relating to the registrants and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared. (2) The officers must “have evaluated the effectiveness of the registrant’ internal controls as of a date within 90 days prior to the report and have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date.

Key points of Section 404 include: (1) Management is required to produce an internal control report as part of each annual Exchange Act report. (2) The report must affirm the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. (3) The report must also contain an assessment, as of the end of the most recent fiscal year of the registrant, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. (4) External auditors are required to issue an opinion on whether effective internal control over financial reporting was maintained in all material respects by management. This is in addition to the financial statement opinion regarding the accuracy of the financial statements.

For example, Donald J. Peters, a portfolio manager at T. Rowe Price Group, says: "The accounting reforms [of SOX] have been a win. It is [now] much easier for financial statement users to have a view of the true economics" of a company (Wall Street Journal, January 29th, 2007).

A recent working paper by Kim et al. (2009) confirms our results. They find that internal control quality is inversely associated with analysts’ error and forecast dispersion.

For example, Dyntek Inc. disclosed the following deficiencies in their 2004, 10-K: The material weaknesses that we have identified relate to the fact that our overall financial reporting structure and current staffing levels are not sufficient to support the complexity of our financial reporting requirements. We have experienced employee turnover in our accounting department including the position of Chief Financial Officer. As a result, we have experienced difficulty with respect to our ability to record, process and summarize all of the information that we need to close our books and records on a timely basis and deliver our reports to the Securities and Exchange Commission within the time frames required under the Commission's rules.”

For example, Westmoreland Coal Inc. disclosed the following deficiencies in their 2005, 10-K: “The company’s policies and procedures regarding coal sales contracts with its customers did not provide for a sufficiently detailed, periodic management review of the accounting for payments received. This material weakness resulted in a material overstatement of coal revenues and an overstatement of amortization of capitalized asset retirement costs”. Moody’s suggests that these types of material weaknesses are “auditable,” and thus do not represent as serious a concern regarding the reliability of the financial statements.

The detailed classification of Pervasive and Contained ICMWs is provided in “Appendix 1”.

The conclusions of this paper remain the same if we classify G2 firms as firms disclosing only Pervasive ICMWs.

Our sample period starts after the introduction of Regulation Fair Disclosure (Reg. FD). The goal of Reg. FD is to prohibit management from selectively disclosing private information to analysts. However, as pointed out by recent research (see for example, Ke and Yu 2006; Kanagaretnam et al. 2004), there is no empirical evidence of management relations incentive weakening after Reg. FD. In the post-Reg. FD period, there are other incentives for analysts to please management, such as to gain favored participation in conference calls (Libby et al. 2008; Mayew 2008). Anecdotal evidence also shows that Reg. FD does not prevent a company from more subtle forms of retaliations against analysts who issue negative research reports (Solomon and Frank 2003).

Note that our hypothesis is still valid if the forecasts have been made before the disclosure of ICMWs. Doyle et al. (2007a) argue that Sarbanes–Oxley has led to the disclosure of ICMWs that might have existed for some time. Indeed, they find that accrual quality has been lower for ICMW firms relative to non-ICMW firms even in the periods prior to the disclosure of ICMWs.

Brown et al. (2009) document stock market responds to an analyst’s recommendation change and the difference between the analyst’s recommendation and the consensus recommendation. The market’s reaction is strongly influenced by the analyst’s reputation.

It could be argued that our sample might miss some firms which have ICMWs but choose not to disclose them. However, discovery and disclosure of material weaknesses are mandatory according to 2004 SEC FAQ #11. We, therefore, use the disclosure of ICMW as a proxy for the existence of ICMW.

We thank Sarah McVay for making the data available on her website (http://pages.stern.nyu.edu/~smcvay/research/Index.html).

If a firm in our final sample reports internal material weaknesses in multiple years, the firm will show up in our sample multiple times. We have 599 distinct firms showing up once in our final sample and 64 firms showing up twice in our sample. The conclusions of this paper remain the same if we exclude these 64 firms from our analyses.

Note that the ACCURACY is defined so that larger errors correspond to a lower level of accuracy.

As a sensitivity test, we calculate ACCURACY and BIAS using the simple average of the measures across the 6 or 12 monthly reporting periods on the IBES before the company’s fiscal year end. In other words, we choose all median forecasts across the six or twelve monthly reporting periods on IBES before the company’s fiscal year end, and then average the median forecasts to create our ACCURACY and BIAS variables. The results are similar to what we report in this paper (not tabulated). When we use forecasts from the prior year instead of the current year, we also get similar results (not tabulated).

Note that the differences in the earnings quality could also be the consequences of the existence of ICMWs. By controlling for absolute abnormal accruals, we may over-control the impact of ICMWs. But it will bias against us finding any results.

Fan and Yeh (2006) find that forecasting error is a negative function of firm size.

The results are similar if we use value-weighted market adjusted cumulative returns.

We thank an anonymous referee for pointing this out to us.

When we use forecasts from the prior year instead of the current year, we also get similar results (not tabulated).

We exclude earnings volatility (EPSVOL) variable because the variable is significantly correlated with SKEW variable. In a sensitivity test, we replace SKEW by EPSVOL, the results are similar to what we report in the paper.

See Shiller (1997) on anchoring behavior of financial analysts.

For firms that disclose ICMWs for multiple years, the last year in which ICMWs are disclosed for the firms in our sample period is used.

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Titel: Internal control material weakness, analysts’ accuracy and bias, and brokerage reputation
verfasst von: Li Xu
Alex P. Tang
Publikationsdatum: 01.07.2012
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 1/2012
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-011-0243-2

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