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Review of Quantitative Finance and Accounting

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17.04.2019 | Original Research

The SOX 404 control audit and the effectiveness of additional audit effort in lowering the risk of financial misstatements

verfasst von: Chan Li, K. K. Raman, Lili Sun, Rong Yang

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2020

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Abstract

We examine the effectiveness of additional audit effort in lowering the risk of financial misstatements for companies with internal control material weaknesses during three separate post-SOX time periods. Our findings suggest that additional audit effort (as proxied by abnormal audit fees) is effective in lowering the risk of financial misstatements for clients with weak internal controls during the Auditing Standard No. 2 regime (2004–2006), but not during the extant Auditing Standard No. 5 (AS5) regime or the earlier 2002–2004 pre-404 audit (but still post-SOX) time period. We contribute to the on-going debate about the potential benefits associated with the SOX 404 audit and, in particular, the emerging literature on the effectiveness, or lack thereof, of the SOX 404 audit in improving the assessment of control risk under the extant AS5 regime (Schroeder and Shepardson in Account Rev 91(5):1513–1541, 2016). Collectively, our findings are consistent with the notion that extant PCAOB concerns about internal control quality under AS5 may be valid.

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The 404 control audit was mandated by Section 404(b) of the 2002 Sarbanes–Oxley Act (SOX) and became effective for so-called accelerated SEC filers (i.e., companies with a market float of at least $75 million) for fiscal years ending on or after November 15, 2004. The intent of the 404 audit is to improve the reliability of the information in financial statements by requiring the auditor to test and issue an opinion on the effectiveness of the client’s internal control over financial reporting (PCAOB 2007). The auditor is required to issue an adverse 404 audit opinion if there are one or more material weaknesses (MW) in the client’s internal control that have not been remediated as of the balance sheet date. During its first three years the 404 audit was governed by Auditing Standard No. 2 (AS2), and subsequently by Auditing Standard No. 5 (AS5).

Schroeder and Shepardson (2016) point out that the 404 audit can provide three potential direct benefits to stakeholders: (1) improved internal control systems, (2) better quality financial statement audits due to improved control risk assessments, and (3) more accurate internal control material weakness disclosures. Our study pertains to the second potential benefit.

Financial misstatements are indicative of an audit failure and harmful because they provide a defective resource allocation signal (Schipper and Vincent 2003; Palmrose et al. 2004). Further, subsequent restatements of misstated financials are associated with significant losses of investor wealth (GAO 2006; Nguyen and Puri 2014). Separately, to vary the exposition, we use the terms poor internal control quality, weak internal controls, ineffective internal controls, and internal control material weaknesses (ICMW) interchangeably.

SOX Section 302 required companies to disclose internal control deficiencies beginning with the fiscal year ending November 15, 2003. Hogan and Wilkins (2008) implicitly assume that the internal control deficiencies disclosed by companies during November 2003 through November 2004 were present during the preceding year as well, which is a reasonable assumption. An important issue not examined in Hogan and Wilkins (2008) is whether the higher audit fees—for clients subsequently disclosing internal control deficiencies under SOX Section 302—are associated with a reduced likelihood of financial report misstatements.

Notably, our analysis incorporates both subsequent year financial re-statements as well as subsequent year re-statements of originally issued clean 404 audit opinions. Thus, our analysis includes internal control material weaknesses (ICMW) that were undetected in the original reporting year but identified and disclosed in a subsequent year. The inclusion of ICMW undetected in the original reporting year but disclosed in a subsequent year better captures the actual level of low internal control quality in the original reporting year.

We examine announcements of restatements through December 31, 2010 to identify financial misstatements during our sample period (FYs ending on or between November 14, 2002 through December 31, 2009). In the Audit Analytics restatement database, 90% of misstatements are discovered and announced within two and a half years of the issuance of the original financial statements. To the extent that we omit restatements (if any) past December 31, 2010 or exclude unidentified misstatements that do not result in restatements, such omissions are likely to lower the power of the tests and bias our study against rejecting the null.

We follow Doyle et al. (2007) which assume that “the [newly disclosed] weaknesses, on average, have existed several years prior to their disclosure, if not since the firm’s inception” (Doyle et al. 2007, p. 1151). In addition, we perform sensitivity test by excluding companies that disclosed ICMW in the initial year of SOX 404 and using only SOX 302 disclosure as a source for identifying ICMW. We rerun the logistic regression of misstatement for the pre-404 period with this reduced sample (2781 observations). The coefficient on the interaction between ICMW and ABAFEE remains insignificant (coefficient = − 0.159, z-value = − 0.66).

Our audit fee model controls for ICMW, and as one would expect ICMW is positively associated with audit fees. Our inferences remain unchanged when we exclude ICMW from the audit fee model in estimating abnormal fees.

Potentially, even properly-targeted audit effort can fail in detecting financial misstatements. However, this is likely to bias our study against finding a significant negative relation between our test variable ICMW × ABAFEE and the dependent variable MISSTATE in all three time periods examined in our study.

All control variables are held at mean values.

Our results hold if we alternatively adjust the z-statistics using the Stata 12 command “inteff” as recommended by Norton et al. (2004). The adjusted z-statistic is − 2.67 (p value = 0.008, two-tailed) in AS2 time period, − 1.24 (p value = 0.215, two-tailed) in the pre-404 (but post-SOX) time period, and − 0.86 (p value = 0.390, two-tailed) in the AS5 time period.

The sum of the coefficients for variables ICMW × ABAFEE and ICMW during AS2 is 1.206 and significant at p < 0.01 level (untabulated results), which suggests that even during the AS2 regime additional audit effort is effective in lowering but not eliminating the risk of financial misstatements for clients with ICMW.

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Titel: The SOX 404 control audit and the effectiveness of additional audit effort in lowering the risk of financial misstatements
verfasst von: Chan Li
K. K. Raman
Lili Sun
Rong Yang
Publikationsdatum: 17.04.2019
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2020
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-019-00814-7

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