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Pertemuan 5a Mencegah Fraud 2018
Pertemuan 5a Mencegah Fraud 2018
*
All authors are from SUNY – Binghamton. We thank two anonymous reviewers for detailed and
insightful suggestions that have significantly improved the paper. We also thank workshop participants at
the 2006 American Accounting Association Auditing Midyear Meeting and the 2006 American Accounting
Association Annual Meeting for comments, and Raj Addepalli, Shanshan Chen, Yujing Pan, Gaurav
Rastogi, Eric Romanoff, Grace Witte, and Meng Zhao for research assistance. Please address all
correspondence to Jian Zhou, School of Management, SUNY – Binghamton, Binghamton, NY 13902-
6000; email: jzhou@binghamton.edu; phone: (607) 777 6067.
Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses
Abstract
In this paper we investigate the relation between audit committee quality, auditor
independence, and the disclosure of internal control weaknesses after the enactment of
the Sarbanes-Oxley Act. We begin with a sample of firms with internal control
weaknesses and, based on industry, size, and performance, match these firms to a sample
of control firms without internal control weaknesses. Our conditional logit analyses
indicate that a relation exists between audit committee quality, auditor independence, and
internal control weaknesses. Firms are more likely to be identified with an internal
control weakness, if their audit committees have less financial expertise or, more
specifically, have both less accounting financial expertise and non-accounting financial
expertise. They are also more likely to be identified with an internal control weakness, if
their auditors are more independent. In addition, firms with recent auditor changes are
more likely to have internal control weaknesses.
Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses
1. Introduction
The Sarbanes-Oxley Act (hereafter SOX) of 2002 went into effect on July 30,
2002 to address the increasing concern of investors about the integrity of firms’ financial
reporting, due to scandals involving once well-respected companies, such as Enron and
WorldCom and auditors, such as Arthur Andersen. One important aspect of SOX is that
it has two sections specifically focusing on internal control issues related to financial
weaknesses in internal control, when they certify the periodic, annual, and quarterly
statutory financial reports. Under Section 404, a firm is required to assess the
effectiveness of its internal control structure and procedures for financial reporting and
disclose such information in its annual reports. Furthermore, the firm’s auditor is required
to provide an opinion on the assessment made by the management in the same report.
Because such mandatory disclosure under SOX provides us with more information on
We begin with a sample of firms with internal control weaknesses, and, based on
industry, size, and performance, match these firms to a sample of control firms without
internal control weaknesses. Our conditional logit analyses indicate that a relation exists
between audit committee quality, auditor independence, and internal control weaknesses.
Firms are more likely to be identified with an internal control weakness, if their audit
committees have less financial expertise or, more specifically, have less accounting
financial expertise and non-accounting financial expertise. They are also more likely to
1
be identified with an internal control weakness, if their auditors are more independent. In
addition, firms with recent auditor changes are more likely to have internal control
weaknesses.
control weaknesses. Krishnan (2005) examines the period prior to the enactment of
SOX, when internal control problems are only disclosed in 8-Ks filed by firms when
changing auditors. With information collected from 8-K filings, she finds that
independent audit committees and audit committees with more financial expertise are
significantly less likely to be associated with the incidence of internal control problems.
Ge and McVay (2005) and Doyle et al. (2006a) find that material weaknesses in internal
control are more likely for firms that are smaller, less profitable, more complex, growing
rapidly, or undergoing restructuring. Ashbaugh-Skaife et al. (2006) find that firms with
the previous year, more accounting risk exposure, and less investment in internal control
important determinant of internal control weaknesses after the enactment of SOX. Our
findings thus complement those in Krishnan (2005), who studies the pre-SOX period.
information on internal control unleashed by SOX and to construct a sample of firms with
internal control problems from both mandated disclosures in the firms’ 10-Q and 10-K
filings under SOX and information disclosed in 8-K filings when firms change auditors.
Consisting of only those firms that change auditors in the pre-SOX period, the sample
2
firms in Krishnan (2005) tend to be smaller in size and are traded on smaller stock
exchanges. We avoid this sample selection bias by focusing on the post-SOX period,
given that all firms are required to disclose material internal control weaknesses under
internal control weaknesses. This adds to the literature that supports the hypothesis that
auditor independence matters, such as Frankel et al. (2002) and Krishnamurthy et al.
(2006). Different from other researchers who also focus on the post-SOX period, such as
Ge and McVay (2005), Doyle et al. (2006a) and Ashbaugh-Skaife et al. (2006), we show
that audit committee quality, characterized as having more financial expertise or, more
find that auditor independence, calculated as the ratio of audit fee to total fee, is also a
background and proposes our hypotheses. Section 3 describes the sample selection
procedures. Section 4 discusses the empirical findings, and Section 5 presents our
conclusions.
2.1. Background
3
framework.1 SOX Section 302 (hereafter SOX 302), which went into effect on August
29, 2002, requires management to disclose significant internal control deficiencies, when
they certify annual or quarterly financial statements. Specifically, the signing officers,
being responsible for internal controls, have evaluated the internal controls within the
previous ninety days and reported in their findings: (1) a list of all deficiencies in the
internal controls and information on any fraud that involves employees who are involved
with internal control activities; (2) any significant changes in internal controls or related
Section 404 took this reporting a step further. It not only requires management to
information concerning the scope and adequacy of the internal control structure and
procedures for financial reporting in their annual reports. This statement shall also assess
the effectiveness of such internal controls and procedures. The registered auditing firm
shall, in the same report, attest to and report on the effectiveness of the internal control
structure and procedures for financial reporting. According to the rulings of the
comply with SOX Section 404 (hereafter SOX 404) for its first fiscal year ending on or
after November 15, 2004. A non-accelerated filer must begin to comply with these
requirements for its first fiscal year ending on or after July 15, 2007. A foreign private
1
COSO stands for the Committee of Sponsoring Organizations of the Treadway Commission, who
undertook an extensive study of internal control to establish a common definition that would serve the
needs of companies, independent public accountants, legislators, and regulatory agencies and to provide a
broad framework of criteria, against which companies could evaluate the effectiveness of their internal
control systems. COSO published its Internal Control -- Integrated Framework in 1992.
2
An “accelerated filer” is defined in Exchange Act Rule 12b-2. Generally, it refers to a U.S. company that
has equity market capitalization over $75 million and has filed an annual report with the SEC.
4
issuer that files its annual report on Form 20-F or Form 40-F must begin to comply with
the corresponding requirements in these forms for its first fiscal year ending on or after
under SOX 302 and SOX 404 are related to financial systems and procedures. This
processes. For example, United Stationers disclosed problems with “the design and
rank as the second largest category of weakness disclosures. This category is related to
the poor segregation of duties, inadequate staffing, or other related training or supervision
appropriate qualifications and training in certain key accounting roles.” Other common
controls (e.g. security and access controls, backup and recovery issues). In addition,
issues related to international operations and mergers and acquisitions are sources of
Based on their severity, these internal control problems are classified into three
3
The SOX compliance information is from www.sec.gov, and the SOX summaries are from
www.soxlaw.com.
5
Standard (hereafter AS) No. 2 defines a material weakness as “a significant deficiency, or
combination of significant deficiencies, that results in more than a remote likelihood that
initiate, authorize, record, process, or report external financial data reliably in accordance
with genernally accepted accounting principles such that there is more than a remote
that is more than inconsequential will not be prevented or detected.” A control deficiency
occurs “when the design or operation of a control does not allow management or
detect misstatement on a timely basis.” Since only material weaknesses are required to
be publicly disclosed under SOX 302 and SOX 404, we follow Doyle, Ge, and McVay
(2006a; 2006b), and focus on firms that disclosed material weaknesses in our study.4 For
the sake of brevity, we will refer to material internal control weaknesses as internal
Since an entity’s internal control is under the purview of its audit committee
(Krishnan, 2005), we investigate the relation between audit committee quality and
internal control weaknesses. The audit committee not only plays an important
monitoring role to assure the quality of financial reporting and corporate accountability
4
This is also driven by the fact that Compliance Week lists only firms with material weaknesses starting
March 2005.
6
(Carcello and Neal, 2000), but also serves as an important governance mechanism,
because the potential litigation risk and reputation impairment faced by audit committee
members ensure that these audit committee members discharge their responsibilities
effectively. We thus expect that firms with high-quality audit committees are less likely
to have internal control weaknesses than firms with low-quality audit committees.
Corporate Audit Committees (BRC)’s (1999) recommendation that each audit committee
should have at least one financial expert highlights the importance of the financial
literacy and expertise of audit committee members.5 Section 407 of the SOX
incorporates the above suggestion and requires firms to disclose in periodic reports,
whether a financial expert serves on a firm’s audit committee and, if not, why not. Such
financial expertise of audit committee members has been shown to be important for
dealing with the complexities of financial reporting (Kalbers and Fogarty, 1993) and for
DeZoort and Salterio (2001) find that audit committee members with financial reporting
and auditing knowledge are more likely to understand auditor judgments and support the
Moreover, financially knowledgeable members are more likely to address and detect
material misstatements. Audit committee members with financial expertise can also
5
The Report of the BRC’s recommendation related to Audit Committee Competence states that “the audit
committee should consist of at least three members, each of whom is "independent" (defined in the Report
as having "no relationship to the corporation that may interfere with the exercise of their independence
from management and the corporation") and "financially literate" (defined as "the ability to read and
understand fundamental financial statements"). At least one member of the audit committee should have
accounting or financial management expertise (defined as past employment or professional certification in
accounting or finance, or comparable experience including service as a corporate officer with financial
oversight responsibility)”.
7
perform their oversight roles in the financial reporting process more effectively, such as
Indeed, Abbott et al. (2004) find a significantly negative association between an audit
committee having at least one member with financial expertise and the incidence of
financial restatement. Krishnan (2005) presents evidence that audit committees with
financial expertise are less likely to be associated with the incidence of internal control
Hypothesis 1: Firms with greater audit committee financial expertise are less likely to
suggesting that audit committees with accounting financial expertise improve corporate
accounting financial expertise and non-accounting financial expertise and test the relation
definition adopted in SOX Section 407, and, more specifically, modify the definition
she can be classified into the following two categories: (a) an accounting financial expert
who has experience as a public accountant, auditor, principal or chief financial officer,
8
expert who has experience as the chief executive officer, president, or chairman of the
board in a for-profit corporation, or who has experience as the managing director, partner
audit committee members who are financial experts. We further separate audit
measured as the percentage of audit committee members who are accounting financial
problems. When there is a strong economic bond between an auditor and a client firm,
the auditor has an incentive to ignore potential problems and issue a clean opinion on the
client firm’s internal controls. While some studies (DeFond et al., 2002; Ashbaugh et al.,
2003; Chung and Kallapur, 2003; Reynolds et al., 2002; Francis and Ke, 2003) find no
relation between non-audit fees and auditor independence and argue that an auditor’s
concern with maintaining its reputation for providing high quality audits could restrain it
from undertaking activities that jeopardize independence, since the revenue from each
client will be a small percentage of the auditor’s total revenue, other studies suggest that
Frankel et al. (2002) find that non-audit services are associated with increased discretionary
accruals and the achievement of certain earnings benchmarks and Krishnamurthy et al.
9
(2006) document that the abnormal returns for Andersen’s clients around Andersen’s
indictment are significantly more negative, when the market perceived the auditor’s
auditor independence (RATIO) as the ratio of the audit fee to the total fee, and propose
control weaknesses.
we control for audit committee independence, since Krishnan (2005) finds that there is a
positive relation between audit committee independence and the quality of internal
control prior to the enactment of SOX.6 While SOX requires that audit committees be
composed of all independent directors for firms traded on an organized stock exchange
exemptions may be given by the SEC, if it determines that it is appropriate under certain
circumstances. We thus still control for audit committee independence (ACIND), defined
as the percentage of independent directors on the audit committee. Under SOX, an audit
committee member is independent, if he or she is not affiliated with the firm and does not
6
Previous research has also found an association between audit committee independence and the quality of
accounting information (e.g., Klein, 2002b; Abbott et. al., 2004).
10
accept any consulting fees.
We next control for the natural logarithm of audit committee size (ACSZ),
measured as the number of audit committee members, because research suggests that a
large audit committee tends to enhance the audit committee’s status and power within an
organization (Kalbers and Fogarty, 1993), to receive more resources (Pincus et al., 1989),
and to lower the cost of debt financing (Anderson et al., 2004). We thus expect that a
large audit committee is more likely than a small one to improve the quality of internal
controls, because increased resources and enhanced status will make the audit committee
(ACMEET), measured as the number of audit committee meetings held each year,
because research shows that effective audit committees meet regularly (Menon and
Williams, 1994; Xie et al., 2003).7 Consistent with this hypothesis, McMullen and
Raghunandan (1996) find that the audit committees of firms with SEC enforcement
actions or earnings restatements are less likely to have frequent meetings than those
without and Lennox (2002) finds that there is a significant increase in the number of audit
committee meetings during an auditor dismissal year. However, it is also possible that an
audit committee meets more frequently to discuss internal control issues, when there are
prediction on the relation between the number of audit committee meetings and the
7
Hymowitz and Lublin (2003) report that “many audit committees are spending far more time than they
used to reviewing financial statements and overseeing auditors, meeting 10 or 11 times a year, up from
three or four times.”
11
2.4.2. Board of directors
control environment that includes the board of directors and the audit committee
percentage of outside directors on the board,8 because research suggests that board
enforcement actions (Beasley, 1996; Dechow et al., 1996). We also control for the
natural logarithm of board size (BDSZ), measured as the number of directors on the
board. While some researchers find that a large board has more expertise than a small
one (Dalton et al., 1999), that it tends to be more effective in monitoring accruals (Xie et
al., 2003), and that it leads to a lower cost of debt (Anderson et al., 2004). Others suggest
that a small board is more effective in mitigating the agency costs associated with a large
board (Yermack, 1996; Eisenberg et al., 1998; Hermalin and Weisbach, 1998, 2003).
Given the mixed empirical evidence on board size, we expect that the relation between
board size and the likelihood of internal control weaknesses is indeterminate. Finally, we
control for the natural logarithm of board meetings (BDMEET), as measured by the
number of board meetings held each year. While Conger et al. (1998) suggest that board
meeting frequency is important to improve board effectiveness, Vafeas (1999) finds that
it is inversely related to firm value, because of the increased board activities following
share price declines. Since board independence, size, and meeting frequency all
influence a board’s effectiveness, they, in turn, are related to the quality of internal
controls.
8
Outside directors are those who are not affiliated with the firm, other than serving on its board. We first
exclude those directors who are the firm’s officers and major shareholders, and then further exclude those
who have consulting relationships or other related-party transactions with the firm.
12
2.4.3. Auditor Types
decision to hire a Big 4 auditor is likely to be associated with internal controls for several
reasons. Doyle et al. (2006a) find that smaller and less profitable firms are more likely to
have internal control problems than larger or more profitable ones. On the one hand,
such firms with internal control problems are less likely to hire a Big 4 auditor, because
they are constrained by financial resources and cannot afford it. On the other hand, they
might also be avoided by the Big 4 auditors, because they are perceived as being risky
and may expose the Big 4 to potential litigations. Given that a firm shunned by a Big 4
auditor may signal that it has potential internal control problems, we introduce the
Ashbaugh-Skaife et al. (2006) find that firms with recent auditor changes are
likely to have internal control problems. On the one hand, auditors may drop risky
clients as part of their risk management strategies, since firms with material internal
control weaknesses may represent high audit failure risk. On the other hand, firms may
dismiss auditors for lack of performance, when the firms discover material internal
13
We also control for firm characteristics that may be associated with internal control
problems. Since Doyle et al. (2006a) show that small and high growth firms are likely to
have internal control weaknesses, in our model, we control for size, measured as the
sales growth (ADJSALEGR). It may take some time for a firm that recently engaged in
mergers and acquisition to integrate different internal control systems; consequently, such
a firm is more likely to have internal control problems. We thus introduce a dummy
variable (ACQUISITION), which takes the value of one, if a firm engages in acquisitions
during 2003, 2004 and from January to July of 2005, and zero otherwise. Since a firm
experiencing restructuring is also likely to have internal control problems, because of the
loss of experienced and valuable employees and because of the dramatic changes
associated with such an event, we follow Ashbaugh-Skaife et al. (2006) and use a dummy
and zero otherwise.10 Because firms with greater complexity and scope of operations are
more likely to have internal control problems than those without, we also include the
natural logarithm of the number of business segments (BUS) and an indicator variable for
foreign currency translation (FOREIGN) in our model (see Ashbaugh-Skaife et al., 2006;
10
A firm is engaged in a restructuring, if it has non-zero values of COMPUSTAT data #376, #377, #378, or
#379.
14
Table 1 provides the details for the sample selection. Our initial sample is from
Compliance Week, an electronic newsletter that searchs through 8-Ks, 10-Qs, and 10-Ks
for all public companies to identify any firms with internal control problems. While
Compliance Week discloses firms with internal control problems on a monthly basis
starting from November 2003, we examine the period from November 15, 2004 to July
required in our study.11 For our sample period, there are 372 firms identified by
Compliance Week as having various types of internal control problems under SOX 302 or
and control deficiency. 13 We exclude ten firms without Cusip numbers, nine firms not in
EBITDA profit margin,14 54 non-material weakness firms,15 and 21 firms without proxy
information. This leaves us with a final sample of 208 firms with material internal
obtain the acquisition information from Securities Data Company, acquire the business
segment information from COMPUSTAT Segment files, and hand-collect all audit and
non-audit fee, audit committee, and board information from the firms’ proxy statements
11
We start from November 15, 2004, given that there is increasing attention to internal control issues, since
SOX 404 became effective for accelerated filers.
12
We exclude 31 duplicate appearances during the sample period.
13
“Reportable conditions” is an old term, which was defined by AICPA as “a significant deficiency in the
design or operation of the internal control structure that could adversely affect the company’s ability to
record, process, summarize, and report financial data consistent with the assertions of management in the
financial statements.” Compliance Week lists some of the early firms under this term.
14
We include this filter because our match firms are selected based on sales and EBITDA profit margin
(EBITDA/sales). If a firm has a missing value for sales, it will also have a missing value for EBITDA
profit margin.
15
These firms are identified as having significant deficiencies, control deficiencies, or reportable
conditions. Starting from March 2005, Compliance Week lists only firms with material weaknesses.
15
3.2. Control firms’ selection
pairs design. Although using matched samples when the number of treatment firms is not
estimates (Palepu, 1986), we adopt this approach to make it feasible for us to hand-collect
audit committee and board information from the proxy statements. The 208 control firms
without internal control weaknesses are matched to the 208 sample firms with internal
follow Purnanandam and Swaminathan (2004), who use selected publicly traded firms in
the same industry as comparable firms.16 Since their procedure balances between
matching based on industry or sales, which can be too approximate, and matching based
find match firms, we adapt their procedure to create our sample of match firms. The
(1) We select all firms in 2004 COMPUSTAT. From these firms, we eliminate
(2) We use COMPUSTAT SIC codes to group the remaining firms into 48
(3) The remaining firms in each industry are sorted into three portfolios by sales,
and then each sales portfolio is sorted into three portfolios by EBITDA profit
16
taxes, depreciation, and amortization. As a result, we have 9 (3x3) portfolios of
comparable firms in each industry. If there are not enough firms in an industry
(4) We obtain sales and EBITDA margin for our sample firms from the 2004
COMPUSTAT and also classify them into different industries, according to the
that portfolio, one firm with the closest total sales is selected as the match firm. If
the match firm does not file a proxy or have sufficient information in proxy or has
Following the same procedure as for the sample firms, we obtain all the
information from COMPUSTAT and proxy statements for our control firms. Table 2
provides summary statistics for our sample firms and control firms. While the mean
(median) sales for sample firms is $2701.43 million ($375.02 million), the mean
(median) sales for match firms is $1745.72 million ($365.11 million). While the mean
(median) EBITDA profit margin for sample firms is –0.14 (0.11), the mean (median)
EBITDA profit margin for match firms is –0.45 (0.11). The large difference in the mean
comparison of sales is driven by General Electric (GE), which has substantially larger
sales than its closest match firm has. Without GE and its match firm, the mean (median)
sales for the sample and control will be 1983.57 million (372.50 million) and 1742.15
17
We check the Compliance Week list and 10-Ks to ensure that a match firm does not have internal control
weaknesses. A match firm is replaced, if it appears on the Compliance Week list from November 2003 to
July 2005 or is flagged with internal control weaknesses in its 10-K filed prior to July 2005.
17
million (364.18 million), respectively.18 If we exclude GE and its match firm, sample
and control firms share similar characteristics in terms of sales and EBITDA profit
margin, since our selection procedure for match firms is based on these two variables.
4. Empirical results
Table 2 provides mean and median comparisons of the sample and control firms
for our variables of interest. Because our sample firms are matched with control firms on
a one-to-one basis, we use the paired t-test to test the difference in means and the
Wilcoxon signed rank test to test the difference in medians.19 There are several
noticeable differences between these two groups of firms. On average, 75 percent of the
audit committee members of the sample firms are financial experts, while 83 percent of
the audit committee members of the control firms are financial experts. This difference,
significant at the one-percent level, implies that firms with more audit committee
financial expertise are less likely to have internal control problems, providing initial
support for Hypothesis 1. We further separate audit committee financial experts into
accounting financial experts account for 22 percent of the sample firms’ and 23 percent
of the control firms’ audit committee members, while non-accounting financial experts
account for 53 percent of the sample firms’ and 59 percent of the control firms’ audit
18
We find that our main results in Table 4 remain unchanged, when we exclude GE and its match firm in
our conditional logit regressions.
19
The Wilcoxon signed rank test is the nonparametric analog of the paired t-test.
18
We use the ratio of audit fee to total fee to measure auditor independence, where a
low ratio indicates that the firm’s auditor provides more non-audit services and thus lacks
independence. The average audit fee ratios are 78 percent for the sample firms and 75
percent for the control firms. This significant difference indicates that independent
auditors are more likely to uncover internal control problems, providing initial support
for Hypothesis 2. In addition, the sample firms have more audit committee and board
Table 3 presents the correlation coefficients for the dependent and independent
variables after we pool the sample and control firms together. We create a dummy for
internal control weaknesses (ICW), which takes the value of one if a firm belongs to the
sample firm group, and zero if it belongs to the control firm group. This dependent
expertise, indicating that firms with greater audit committee financial expertise are less
correlated with the audit fee ratio, indicating that firms with more independent auditors
are more likely to uncover internal control weaknesses. These results again provide
preliminary support for Hypotheses 1 and 2. In addition, the internal control weakness
dummy variable is positively correlated with the natural logarithms of audit committee
meeting frequency and board meeting frequency. Thus, the audit committee and board of
a firm with internal control weaknesses appear to hold additional meetings, dealing with
the firm’s internal control problems. Further, the internal control weakness dummy is
19
positively correlated to the variables for audit change and restructuring, suggesting that
firms with recent auditor changes or restructuring activities are more likely to have
We use the conditional logit regression models to test our hypotheses that audit
committee financial expertise and auditor independence are related to internal control
an outcome (whether the firm is a sample firm with internal control weaknesses or a
control firm without such weaknesses) and a set of prognostic factors in a matched-pairs
study. We match control firms to sample firms to minimize inherent variations in those
factors. Because the traditional logistic regression cannot take into account the
using the conditional logistic regression that takes into account the non-random nature of
the data. For each matched set consisting of one sample firm and one control firm, the
'
∏ (1 + exp(−β ( x i1 − xi 0 ))) −1
i
where xi1 and xi 0 are vectors of the prognostic factors for the sample and control firm,
respectively, of each ith matched set (Breslow, 1982; Hosmer and Lemeshow, 2000).
20
4.2.2. Conditional logit regression results
Tables 4 and 5 present the regression results using conditional logit analyses. All
variable definitions are provided in the Appendix. Table 4 presents four models with
different measures of audit committee quality. Models 1 and 2 use audit committee financial
expertise (ACFE) to measure audit committee quality. Klein (2002a) finds that the main
committee characteristics and board characteristics are highly correlated. In order to avoid
and LOG(ACMEET)), along with audit fee ratio (RATIO), in Model 1.20 We further control
for auditor type (BIG4), auditor change (AUDCHG), size (LOG(TA)), growth
significant at the one-percent level, and the coefficient on RATIO is significant at the five-
percent level. This supports Hypothesis 1 and rejects the null of Hypothesis 2. Our evidence
suggests that firms are more likely to be identified with an internal control weakness, if their
audit committees have less financial expertise or their auditors are more independent.
However, our result on auditor independence should be interpreted with caution, as there is
an alternative explanation for this positive coefficient on RATIO. Clients that purchase fewer
non-audit services may have fewer discretionary resources. This lack of discretionary
resources may lead to a lack of investment in internal controls, resulting in internal control
20
Following Klein (2002a), we take the natural logarithms of ACSZ, ACMEET, BDSZ, and BDMEET.
Our results remain unchanged, if we use the raw variables.
21
In an early version of Doyle et al. (2006a), restructuring is measured as special items (#17) divided by
lagged total assets (#6). We replace RESTRUCTURE with this measure in Models 1 and 2 of Table 4 and
find that our results remain unchanged. We also measure size as log of total assets (#6) and find that our
results in Table 4 remain unaltered.
21
weaknesses. In addition, the coefficient on AUDCHG is significant at the one-percent level
with Doyle et al. (2006a) and Ashbaugh-Skaife et al. (2006), our findings imply that firms
with recent auditor changes or restructuring activities are more likely to have internal control
weaknesses. Finally, it is worth noting that a few of the insignificant results, noticeably the
one on size, might be due to the matched sample design used in this study.
LOG(BDMEET)) to Model 1, and find that our results on ACFE, RATIO, AUDCHG and
RESTRUCTURE remain unchanged. Moreover, firms with a large board are less likely to
have internal control weaknesses. Klein (2002a) finds that board size is positively associated
with audit committee independence, implying that firms with a large board are more likely to
have effective audit committees and thus are more likely to demand high quality auditing
services. Thus, our finding on board size is consistent with that in Klein (2002a). Finally,
Therefore, firms with internal control weaknesses are more likely to hold additional
meetings, dealing with their internal control problems. We do not find the relation between
audit committee independence and internal control weaknesses in Models 1 and 2, as does
Krishnan (2005), because SOX requires audit committees to be composed of all independent
board members.
Models 3 and 4 replicate Models 1 and 2 by replacing ACFE with two separate
are all significant at the one-percent level, suggesting that both accounting and non-
22
accounting financial experts are helpful in improving internal controls. Other results are
similar to those reported for Models 1 and 2. Thus, our findings are robust to different ways
Some board variables, namely board size and board meeting frequency, are found
to be related to internal control weaknesses in Table 4. This suggests that firms with
strong corporate governance may be less likely to have internal control problems. As a
al. (2005, pp. 168-170). They capture the strength of the governance environment using a
summary measure that combines the following six governance characteristics into a
single dichotomous variable: board size, board independence, audit committee size, audit
Gompers, Ishii, and Metrick (2003), and institutional ownership. Because the G index
information is only available for 52 pairs of our sample and control firms,22 we adapt the
procedure in DeFond et al. (2005) and create our governance variable (GOVERN) based
on the following dichotomous measures of the five governance characteristics for each
firm.
1) Board size — We code firms 1 (for strong governance), if the firm’s board
22
When we run regressions based on these 52 pairs for Models in Table 5, we have one-tailed significance
at the ten-percent level for the coefficient on audit committee financial expertise in Model 1 and the
coefficient on non-accounting financial expertise in Model 2, respectively.
23
2) Board independence — We code firms 1 (for strong governance), if 60%
audit committee size to its full board size is greater than the sample
otherwise.23
We first summarize the five dichotomous measures for each firm and then create a
dichotomous variable based on the median of the summed values. This governance
measure is equal to one, indicating strong governance, if it is equal to or greater than the
median summed values and zero, otherwise. Note that the number of observations for
Table 5 is 206 pairs or 412 firms, because the institutional ownership information is
Table 5 presents the empirical results after controlling for the above summarized
ACSZ, BDIND, and BDSZ in our models, because these variables are incorporated into
GOVERN. The findings in Table 5 are very similar to those in Table 4. To measure
23
We retrieve the institutional ownership information from Compact D and supplement thirteen firms that
have missing ownership data with information collected from Yahoo! Finance. Our results in Table 5 are
unchanged, when these thirteen firms are excluded from our analyses.
24
audit committee quality, we use ACFE in Model 1, and ACCT_ACFE and
the one-percent level, whereas the coefficient on GOVERN is not significant. After we
control the influence of corporate governance, the relation between audit committee
quality and internal control weaknesses still holds. In addition, the coefficients on
RATIO and AUDCHG are significant at the five-percent level or better. Thus, auditor
independence and auditor change continue to be positively associated with the disclosure
We perform the following additional tests to verify that our results in Tables 4 and 5
are robust.
(1) We use the natural logarithm of sales or market value of equity instead of the
(2) We use the acquisition value defined in Doyle et al. (2006a), instead of the
acquisition dummy.
(3) We use raw ACSZ, ACMEET, BDSZ, and ACMEET, instead of the natural
In all these cases, our results are robust to these alternative specifications, adding
5. Conclusion
24
Because of missing information, there are only 206 pairs or 412 firms, when we use the market value of
equity.
25
In this paper, we examine the relation between audit committee quality, auditor
independence, and disclosure of internal control weakness after the enactment of the
Sarbanes-Oxley Act. We begin with a sample of firms with internal control weaknesses
and, based on industry, size, and performance, match these firms to a sample of control
firms without internal control weaknesses. The results from our conditional logit
analyses suggest that a relation exists between audit committee quality, auditor
independence, and internal control weaknesses. Firms are more likely to be identified
with an internal control weakness, if their audit committees have less financial expertise
or, more specifically, have less accounting financial expertise and non-accounting
financial expertise, as well. They are also more likely to be identified with an internal
control weakness, if their auditors are more independent. In addition, firms with recent
26
Appendix
Variable Definitions
Note:
COMPUSTAT item numbers are in parentheses.
27
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31
Table 1. Sample Selection Procedure
The sample consists of firms identified by Compliance Week as having material internal control
weaknesses from November 15, 2004 to July 31, 2005. We exclude firms without Cusip numbers
or not in COMPUSTAT, foreign firms or subsidiaries, firms with missing values for operating
margin, non-material weakness firms, and firms without proxy information. Data in parentheses
indicate the number of firms removed from the full set of 372 firms to obtain the final sample of
208 companies.
Excluding firms with missing values for EBITDA profit margin (57)
(COMPUSTAT #13/COMPUSTAT #12)
32
Table 2. Mean and Median Comparison for Sample and Control Firms
The 208 control firms that have no internal control problems are matched to the 208 sample firms that do
have internal control problems, one-on-one, based on industry, size, and performance. Financial variables
are retrieved from COMPUSTAT; the acquisition variable is obtained from Securities Data Company; the
business segment variable is acquired from COMPUSTAT segment files; and audit committee-, board-, and
fee variables are hand-collected from the proxy statements. Because sample firms are matched to control
firms on a one-to-one basis, we use the paired t-test to test the differences in mean and the Wilcoxon signed
33
rank test to test the differences in median. All variable definitions are in the Appendix. Two-tailed p-
values are reported in parentheses.
* The large difference in the mean comparison of sales is driven by General Electric, which has
substantially larger sales than does its closest match firm. Without GE and its match firm, the mean
(median) sales in millions for the sample and control will be 1983.57 (372.50) and 1742.15 (364.18),
respectively. We find that our main results in Table 4 remain unchanged, when we exclude GE and its
match firm in our conditional logit regressions.
34
Table 3. Pearson (Upper Right) / Spearman (Lower Left) Correlation Coefficients
ACCT_ NONACCT_ LOG LOG(AC BD LOG LOG(BD AUD ADJ ACQUI RESTRU LOG FOR
ICW ACFE ACFE ACFE RATIO ACIND (ACSZ) MEET) IND (BDSZ) MEET) BIG4 CHG LOG(TA) SALEGR SITION CTURE (BUS) EIGN
ICW -0.16*** -0.04 -0.11** 0.08* -0.03 -0.03 0.11** -0.06 -0.04 0.13*** 0.03 0.09* 0.04 -0.03 0.04 0.08* 0.03 0.01
ACFE -0.14*** 0.25*** 0.64*** -0.05 0.06 -0.01 -0.07 0.13*** -0.01 -0.05 0.13*** -0.04 0.00 0.07 0.02 0.07 0.02 0.06
ACCT_
ACFE -0.05 0.27*** -0.54*** 0.06 0.01 -0.12*** 0.02 0.05 -0.03 -0.01 0.04 0.06 -0.02 -0.02 -0.01 0.02 0.01 -0.02
NONACCT_
ACFE -0.09* 0.67*** -0.52*** -0.09* 0.04 0.09* -0.08 0.07 0.02 -0.04 0.08* -0.08* 0.02 0.08 0.03 0.04 0.01 0.07
RATIO 0.09** -0.10** 0.06 -0.11** 0.01 0.03 0.09** -0.04 -0.02 0.02 0.07 -0.09* -0.10** 0.05 0.02 0.00 -0.03 -0.01
ACIND 0.01 0.06 0.01 0.06 0.02 -0.01 -0.10** 0.48*** -0.01 -0.07 0.03 -0.04 -0.03 0.07 0.06 -0.05 -0.06 0.04
LOG(ACSZ) 0.00 -0.05 -0.19*** 0.06 0.02 -0.01 0.12*** 0.26*** 0.41*** 0.07 -0.01 -0.07 0.35*** -0.14*** -0.07 0.04 0.15*** -0.06
LOG(AC
MEET) 0.10** -0.05 0.06 -0.10** 0.12** -0.08* 0.19*** 0.06 0.25*** 0.41*** 0.22*** -0.01 0.35*** -0.01 0.03 0.14** 0.05 0.11**
BDIND -0.05 0.11** 0.03 0.07 -0.07 0.43*** 0.27*** 0.10** 0.16*** 0.02 0.15*** -0.07 0.23*** -0.08* -0.06 0.11** 0.06 0.08*
LOG(BDSZ) -0.03 -0.01 -0.06 0.02 -0.04 -0.03 0.38*** 0.26*** 0.21*** 0.15*** 0.04 -0.11** 0.60*** -0.03 -0.06 0.02 0.15** -0.03
LOG(BD
MEET) 0.10** -0.01 -0.01 -0.01 0.02 -0.03 0.10** 0.34*** 0.04 0.14*** 0.01 0.02 0.19*** 0.07 -0.02 0.05 -0.03 -0.02
BIG4 0.03 0.12*** 0.03 0.06 0.06 0.04 -0.00 0.21*** 0.15*** 0.06 0.01 -0.30*** 0.17*** -0.12*** -0.06 0.21*** 0.23*** 0.18***
AUDCHG 0.09* -0.04 0.06 -0.08 -0.07 -0.01 -0.02 -0.01 -0.07 -0.12** 0.01 -0.30*** -0.12** 0.01 0.12*** -0.01 -0.06 -0.04
LG(TA) 0.01 0.02 -0.02 0.02 -0.14*** -0.03 0.30*** 0.36*** 0.27*** 0.58*** 0.18*** 0.15*** -0.11** -0.08 -0.06 0.08* 0.21*** 0.02
ADJ
SALEGR -0.04 0.03 0.06 -0.03 -0.08 0.09* -0.12*** -0.01 -0.08* -0.10** -0.07 -0.04 0.04 -0.01 0.20 -0.09* -0.09* -0.00
ACQUI
SITION 0.04 0.01 -0.01 0.04 0.02 0.07 -0.06 0.02 -0.08 -0.06 -0.01 -0.06 0.12 -0.07 0.03 -0.004 -0.03 -0.04
RESTRU
CTURE 0.08* 0.06 0.01 0.03 -0.02 -0.02 0.04 0.16*** 0.13*** 0.03 0.05 0.21*** -0.01 0.11** -0.17*** -0.004 0.17*** 0.30***
LOG(BUS) 0.02 0.03 0.00 0.01 -0.03 -0.07 0.16*** 0.06 0.06 0.15*** -0.02 0.23*** -0.06 0.16*** -0.11** -0.03 0.17*** 0.04
FOREIGN 0.01 0.07 -0.01 0.06 -0.04 0.05 -0.07 0.09* 0.07 -0.03 -0.01 0.18*** -0.04 0.01 -0.04 -0.04 0.30*** 0.05
All variable definitions are in the Appendix. *, **, and *** denote the two-tailed significance at the ten-, five-, and one-percent levels, respectively.
35
Table 4. Conditional Logit Analysis of Determinants of Internal Control Weaknesses
This table presents the conditional logit analysis for matched-pair regressions. The 208 control firms that
have no internal control problems are matched to the 208 sample firms that do have internal control
problems, one-on-one, based on industry, size, and performance. The dependent variable ICW takes a
value of 1, if a firm has internal control weaknesses and 0, otherwise. All variable definitions are in the
Appendix. *, **, and *** denote significance at the ten-, five-, and one-percent levels, respectively, on a
one-tailed test for coefficients with sign prediction and a two-tailed test without sign predictions.
36
Table 5. Conditional Logit Analysis of Determinants of Internal Control Weaknesses:
Controlling for Overall Measure of Corporate Governance
This table presents the conditional logit analysis for matched-pair regressions. The 206 control firms that
have no internal control problems are matched to the 206 sample firms that do have internal control
problems, one-on-one, based on industry, size, and performance. The dependent variable ICW takes a
value of 1, if a firm has internal control weaknesses and 0, otherwise. We lost two pairs of observations,
since we cannot find the institutional ownership data which are necessary to calculate the overall
governance measure. All variable definitions are in the Appendix. *, **, and *** denote significance at the
ten-, five-, and one-percent levels, respectively, on a one-tailed test for coefficients with sign prediction and
a two-tailed test without sign predictions.
37