Internal Control Weakness and The Asymmetrical Behavior of Selling, General, and Administrative Costs

Original Article
Journal of Accounting,
Auditing & Finance
Internal Control Weakness 1–34
ÓThe Author(s) 2019
and the Asymmetrical Article reuse guidelines:
sagepub.com/journals-permissions
Behavior of Selling, General, DOI: 10.1177/0148558X19868114
journals.sagepub.com/home/JAF
and Administrative Costs
Jeong-Bon Kim1, Jay Junghun Lee2 , and Jong Chool Park3
Abstract
Firms with internal control weakness (ICW) problems are less likely to provide managers
with timely and precise information useful for internal resource management. The real
options theory implies that managers in ICW firms, faced with information uncertainty, are
more likely to postpone downward adjustments of slack resources by exercising an option
to wait until more information about future business prospects becomes available. Based
upon this theory, we hypothesize and find that selling, general, and administrative (SG&A)
costs are stickier for ICW firms than for non-ICW firms. We also find that the effect of
ICW on SG&A cost stickiness is primarily attributable to internal information control prob-
lems, and becomes weakened significantly after firms remediate previously reported ICW.
This impact of ICW on SG&A cost stickiness is robust to controlling for the possible influ-
ence of omitted variables, accounting for potential endogeneity in the presence of ICW,
and using a firm-specific measure of cost stickiness. Our results are consistent with the pre-
diction of the real options theory in that poor information quality associated with ICW
incents managers to postpone downward adjustments of SG&A resources until the infor-
mation uncertainty is resolved.
Keywords
internal control weakness, internal information quality, cost asymmetry, cost stickiness,
selling, general, and administrative costs, real options theory
Introduction
Cooper and Kaplan (1992) and Noreen and Soderstrom (1997), among others, challenge
traditional cost models that assume mechanical and symmetric changes in costs with
respect to the changes in activity level. Subsequent studies by Anderson, Banker, and
Janakiraman (2003) and Balakrishnan, Petersen, and Soderstrom (2004) provide strong
1
City University of Hong Kong, Kowloon, Hong Kong
2
University of Massachusetts Boston, USA
3
University of South Florida, Tampa, USA
Corresponding Author:
Jay Junghun Lee, Department of Accounting and Finance, College of Management, University of Massachusetts
Boston, 100 Morrissey Blvd., Boston, MA 02125, USA.
Email: jay.lee@umb.edu
2 Journal of Accounting, Auditing & Finance
evidence that costs are sticky or asymmetric, meaning that costs increase as sales increase
but costs decrease, to a lesser extent, when sales decrease. Specifically, Anderson et al. pro-
vide the first large-sample evidence of cost stickiness using selling, general, and adminis-
trative (SG&A) cost data. They attribute the underlying cause of cost stickiness to
managers’ deliberate decisions on resource adjustment in response to demand fluctuation,
and claim that managers’ decisions on downward adjustment depend on the trade-off
between downsizing costs and retainment costs of slack resources.1 When demand falls
temporarily, managers would retain slack resources because the costs associated with
downward resource adjustments are greater than the costs of retaining slack resources.
However, when demand falls permanently, managers have to remove idle capacities and
unutilized resources because the costs of retaining slack resources exceed the costs of
downsizing such resources.
While emphasizing the role of the adjustment cost in explaining the sticky cost phenom-
enon, previous studies have, in large part, ignored the influence of informational uncer-
tainty faced by managers on resource adjustment decisions. In this article, we view
downward resource adjustments as investments2 and apply the real options theory to inves-
tigate the effect of internal information quality on the sticky cost phenomenon. According
to the real options theory, a firm with an ability to invest is holding an option analogous to
a financial call option, and its ability to delay an irreversible investment due to uncertainty
has a profound impact on its decision of whether and when to invest (e.g., Arya & Glover,
2001; Dixit & Pindyck, 1994; Mauer & Ott, 1995; McDonald & Siegel, 1986). Under the
real option framework, managers’ investment decisions involve the choice between invest-
ing immediately and postponing investment to the future until a substantial portion of the
uncertainty about the investment is resolved. Applying the real options theory, we posit
that when a firm cuts its slack resources, it gives up the real option to wait for the arrival
of new information that might affect the desirability or timing of downward resource
adjustments. Anderson et al. (2003) underscore the role of the real option to wait in man-
agerial resource adjustments by arguing that ‘‘managers facing a downturn in sales may
wait to obtain information that enables them to assess the permanence of the demand
reduction before making decisions to cut resources’’ (p. 50, emphasis added). Therefore,
the costs of postponing downward resource adjustments, or retaining slack resources, must
be weighed against the benefits of waiting for new information. That is, it is optimal to
retain idle capacities and unutilized resources if the option value of waiting exceeds the net
present value (NPV) of reduction in future costs from downward resource adjustments.
Because the option value of waiting increases with the level of uncertainty (McDonald &
Siegel, 1986), downward resource adjustments are expected to be delayed further as the
uncertainty about future benefits from resource adjustments increases.3 Therefore, the infor-
mational uncertainty that managers face in relation to their resource adjustment decisions is
likely to increase the degree of cost stickiness. An important insight from the real options
theory is that the quality of internal information that managers use to make resource adjust-
ments plays a central role in determining the degree of cost stickiness because internal
information quality directly influences the level of uncertainty.
Building on the crucial role of timely and accurate information in managerial decisions
to adjust corporate resources, we investigate the effect of internal information quality on
the asymmetric behavior of SG&A costs.4 Specifically, we hypothesize that SG&A costs
are stickier or more asymmetric in response to sales changes for firms with weaker internal
controls. Following Kim, Song, and Zhang (2011) and Gallemore and Labro (2015), we
use internal control weakness (ICW) disclosed under the Section 404 of the Sarbanes–
Kim et al. 3
Oxley Act (SOX 404) as an inverse measure of internal information quality. Feng, Li, and
McVay (2009) assert that ICW firms tend to provide their managers with low-quality inter-
nal information because the internal reporting systems under weak internal controls yield
inaccurate, incomplete, and untimely internal management reports. Consistent with this
notion, Feng et al. (2009) find that managers relying on internal information generated by
inadequate internal control systems tend to issue less accurate earnings guidance. More
important, Feng, Li, McVay, and Skaife (2015) provide evidence that managers relying on
ineffective internal control systems act on low-quality internal information when making
operational decisions. They further provide an explicit link between ICW and operating
performance by showing that firms with inventory-related ICW tend to have lower inven-
tory turnover ratios and less profitable operations. The results of these studies suggest that
managers of ICW firms are more likely to base their decisions on untimely, imprecise, and
unreliable internal information than those of non-ICW firms.
Given noisy signals collected from delayed and imprecise management reports, manag-
ers do not have to reduce committed resources immediately in response to sales decrease.
Instead, managers are likely to postpone the downward adjustment by exercising an option
to wait for more information until they become convinced of whether the observed sales
decrease is temporary or permanent. Therefore, the poor-quality information produced by
ineffective internal control systems would delay managers’ decisions about whether to
reduce or retain committed resources in response to sales decrease. In contrast, the low-
quality internal information is less likely to deter managers from adding new resources in
response to sales increase. The economics and strategy literature documents that when
there exist first-mover advantages, firms have an incentive to take preemptive actions to
gain a better competitive position (Lieberman & Montgomery, 1988; Porter, 1980; Shapiro,
1989).5 The literature finds that firms make strategic decisions to act early in many compet-
itive circumstances with uncertainty such as capacity investment, research and development
(R&D) competition, and patent races (Dasgupta & Stiglitz, 1980). We thus argue that first-
mover advantages are likely to mitigate managers’ incentives to wait for more information
in response to sales increase and, hence, the effect of internal information quality on man-
agerial resource adjustments is more pronounced for downward adjustments than for
upward adjustments. In other words, poor-quality internal information is more likely to
delay managerial decisions to reduce existing resources in response to sales decrease than
their decisions to add new resources in response to sales increase. Consequently, the degree
of SG&A cost stickiness is expected to be higher for ICW firms than for non-ICW firms.
Using a sample of firms that disclosed ICW under SOX 404 provisions, we find that
firms with ineffective internal controls exhibit stickier SG&A costs than other firms. In
other words, our results reveal that when sales decrease, ICW firms tend to decrease
SG&A costs, to a lesser extent, than non-ICW firms. Specifically, we find that whereas
non-ICW firms exhibit a 0.31% decrease in SG&A costs per 1% decrease in sales revenue,
ICW firms exhibit only a 0.19% decrease in SG&A costs per 1% decrease in sales revenue.
However, when sales increase, we find no significant difference in the change in SG&A
costs between ICW firms and non-ICW firms, consistent with our prediction that first-
mover advantages weaken managerial incentives to postpone their decisions to add
resources in the presence of information uncertainty. In addition, when we partition ICWs
into internal information control problems and other control problems, we find that the
degree of SG&A cost asymmetry is significantly associated with internal information con-
trol problems but not with other control problems. This finding is consistent with the view
that low-quality internal information arising from weak internal controls delays managers’
decisions to adjust SG&A costs downward in response to sales decrease. Moreover, we

find that the effect of ICW on cost stickiness weakens significantly after firms remediated
previously reported ICW. Our finding of the inverse relation between internal control qual-
ity and SG&A cost asymmetry remains robust to controlling for the potential influence of
omitted variables such as the economic determinants of SG&A cost asymmetry and those
of ICW incidences, accounting for potential endogeneity with respect to the presence of
ICW by applying the propensity score–matching analysis, and employing a firm-specific
measure of cost stickiness following Weiss (2010).
Our study is closely related to two studies, which examine the relation between uncer-
tainty and cost behavior. Kallapur and Eldenburg (2005) analyze the role of uncertainty in
determining the cost structure in the context of Medicare reimbursement for hospitals.
Applying the real options theory, Kallapur and Eldenburg (2005) provide evidence that as
uncertainty increases, firms choose technologies with low fixed and high variable costs.
Banker, Byzalov, and Plehn-Dujowich (2014) focus on demand uncertainty, and show that
greater demand uncertainty results in a more rigid short-run cost structure with higher fixed
and lower variable costs. Although both papers analyze the relation between uncertainty
and cost behavior, they do not examine the effect of internal information uncertainty on
asymmetric cost behavior. Our study extends and complements both studies by showing the
implications of the real options theory for the relation between informational uncertainty
and cost stickiness.
Our study makes two primary contributions. First, it adds to the growing body of litera-
ture on cost stickiness. An understanding of cost behavior is important for managers who
make decisions for cost management as well as for investors and analysts who are inter-
ested in predicting firm performance. A better understanding of factor(s) determining man-
agerial decisions on resource adjustments is essential in building a more complete model of
cost behavior. Whereas Anderson et al. (2003) and its follow-up studies are predominantly
concerned with economic factors and managerial incentives influencing the adjustment of
committed resources as main drivers of cost stickiness, our study focuses on internal con-
trol quality and its implication on the quality of internal information that managers rely on
to make resource adjustment decisions. Given the importance of the internal control sys-
tems as a means to improve internal information quality, our study contributes to the litera-
ture on cost stickiness by providing evidence that effective internal controls facilitate a
timely downward adjustment of slack resources during a period of weak demand.
Second, we extend the literature on the economic consequences of ICW. A large body
of accounting studies has examined the potential benefits of effective internal controls in
terms of financial reporting quality (Ashbaugh-Skaife, Collins, Kinney, & LaFond, 2008;
Doyle, Ge, & McVay, 2007), a firm’s cost of equity and debt capital (Ashbaugh-Skaife,
Collins, Kinney, & LaFond, 2009; Beneish, Billings, & Hodder, 2008; Costello &
Wittenberg-Moerman, 2011; Dhaliwal, Hogan, Trezevant, & Wilkins, 2011; Kim et al.,
2011; Ogneva, Subramanyam, & Raghunandan, 2007), the accuracy of management gui-
dance (Feng et al., 2009), and the degree of tax avoidance (Gallemore & Labro, 2015). As
these studies have mainly examined the economic consequences of internal control prob-
lems from the perspective of external users of accounting information, they have paid less
attention to the effect of internal control problems from the perspective of internal users.6
Our study fills this void by documenting that a firm’s internal control quality affects man-
agers’ (i.e., internal users’) operating decisions, as reflected in the asymmetry of SG&A
costs with respect to the changes in sales activities.
Kim et al. 5
The article proceeds as follows. Section ‘‘Hypothesis Development’’ reviews the rele-
vant literature and develops hypotheses. Section ‘‘Research Design’’ explains the measure-
ment of variables and specifies empirical models, whereas section ‘‘Sample and Data’’
describes the sample and data. Section ‘‘Empirical Results’’ presents our regression results
and tests our hypotheses. The final section concludes the article.
Hypothesis Development
Prior empirical research shows that costs increase, to a greater extent, when activity rises
than they decrease when activity falls by an equivalent amount. Anderson et al. (2003) doc-
ument the first large-sample evidence of this cost asymmetry using SG&A cost data. They
conjecture that SG&A cost asymmetry reflects the managers’ deliberate decisions on
resource commitment in the presence of adjustment costs (e.g., hiring, training, and firing
costs for labor or installation and disposal costs for equipment). Anderson et al. further
claim that SG&A cost asymmetry arises mainly from asymmetric frictions in making man-
agerial resource adjustments: The downward adjustment is more costly than the upward
adjustment.7 Given these asymmetric adjustment costs, managers can restrain the down-
ward adjustment during a period of weak demand, to a greater extent, than the upward
adjustment during a period of strong demand.
Since Anderson et al.’s (2003) study, the phenomenon of cost asymmetry (also labeled
‘‘cost stickiness’’) has increasingly received much attention in recent accounting literature.
This cost stickiness literature documents that firm-specific factors, including capacity utili-
zation (Balakrishnan et al., 2004), operational criticality (Balakrishnan & Gruca, 2008),
firm-specific cost structure (Balakrishnan, Larbo, & Soderstrom, 2014), the time-series pat-
tern of sales changes (Banker, Byzalov, Ciftci, & Mashruwala, 2014), and the asymmetric
adjustment of selling prices (Cannon, 2014), contribute to the cross-sectional variation in
asymmetric cost behavior.8 Another line of recent research shows that managerial incen-
tives to engage in empire building (Chen, Lu, & Sougiannis, 2012) and earnings manage-
ment (Dierynck, Landsman, & Renders, 2012; Kama & Weiss, 2013) also influence SG&A
cost stickiness.
While emphasizing the role of resource adjustment costs in explaining SG&A cost
asymmetry or stickiness, the existing literature has paid relatively little attention to the
quality of internal information for the resolution of uncertainty on resource adjustments.
According to the real options theory, investment decisions involve a choice between invest-
ing immediately and postponing investment to the future to gain more information about
the value of the investment and to take advantage of any improvements in business condi-
tions that occur in the meantime (Arya & Glover, 2001; Dixit & Pindyck, 1994; Mauer &
Ott, 1995; McDonald & Siegel, 1986). Because costly resource adjustments (either upward
or downward) can be viewed as investments in a broad sense, the real options theory can
be applied to this setting. We argue that when a firm cuts its resource commitment, it exer-
cises its option to remove slack resources by giving up the option to wait until new infor-
mation arrives, which helps managers resolve uncertainty about future business prospects.
This lost option value of waiting is an opportunity cost that must be included as part of the
cost of the downward resource adjustments. That is, it is optimal to retain idle capacities
and unutilized resources if the option value of waiting exceeds the value of reduction in
future costs from downward resource adjustments.
In sum, the real options theory suggests that cost stickiness can arise from information
uncertainty about future benefits from downward resource adjustments, and, thus, the
quality of internal information that managers use to make resource adjustment decisions
should play a central role in determining the degree of cost stickiness. Specifically, if inter-
nal management reports provide a noisy signal about future demand, managers do not need
to exercise an option to reduce committed resources immediately in response to sales
decrease. Instead, managers are likely to postpone the downward adjustment by exercising
an option to wait until the arrival of new information that helps them resolve uncertainty
about whether the observed sales decrease is temporary or permanent. As the uncertainty
caused by poor internal information quality increases the option value of waiting, managers
become more cautious in making downward resource adjustments and prefer to wait until
the uncertainty is resolved (McDonald & Siegel, 1986). In other words, when managers
face high uncertainty driven by low-quality internal information, they are likely to delay
their decisions about whether to reduce or retain committed resources in response to sales
decrease. Therefore, poor-quality internal information increases the degree of cost
stickiness.
As noted by Kinney (2000), an effective internal control process is essential for provid-
ing information useful to support management decision processes. We postulate that weak
internal controls affect SG&A cost stickiness by generating low-quality internal informa-
tion. We expect ineffective control systems to generate erroneous and stale internal man-
agement reports. Inadequate internal controls hinder management from dealing with rapidly
changing economic and competitive environments, shifting customer demands and priori-
ties, and restructuring for future growth (Committee of Sponsoring Organizations of the
Treadway Commission, 2013). The absence of effective internal controls makes it difficult
to generate timely and accurate operating and financial information, which, in turn, con-
strains effective internal communication. As a result, internal information relevant to man-
agerial decisions is less likely to flow down, across and up the organization.
For example, 3D Systems Corp. disclosed material weaknesses in internal control related
to its enterprise resource planning (ERP) system in 10-K filing for fiscal year 2006:
As a result of the disruptions resulting from the implementation of our ERP system, our supply
chain staffing issues and our outsourcing activities and the discovery of these errors in our
financial statements, we determined and disclosed that deficiencies exist relating to the design
and implementation of our internal controls with respect to the following matters: The timeli-
ness and accuracy of our period-end financial statement closing process and our procedures for
reconciling and compiling financial records; Our processing and safeguarding of inventory;
Our invoicing and processing of accounts receivable and applying customer payments; and The
timeliness and accuracy of the monitoring of our accounting function and oversight of financial
controls.
This example suggests that ICW firms may lack internal information technology (Li,
Peters, Richardson, & Watson, 2012; Masli, Peters, Richardson, & Sanchez, 2010) and/or
personnel with adequate expertise (Choi, Choi, Hogan, & Lee, 2013) to generate the infor-
mation needed by management on a timely basis and to facilitate effective communication
between operating and financial departments.9
Consistent with ineffective internal controls causing errors and delays in internal man-
agement reports, Feng et al. (2009) find a positive association between internal control
quality and the accuracy of management guidance. They argue that material weaknesses in
internal control are likely to induce erroneous internal management reports that are seldom
detected by audit committees but subsequently increase errors in management guidance.
Kim et al. 7
Moreover, Feng et al. (2015) provide evidence that managers relying on lax internal con-
trols act on delayed and inaccurate internal information when making inventory manage-
ment decisions.
Anderson et al. (2003, pp. 50) underscore the role of timely information in managerial
resource adjustments by arguing that ‘‘managers facing a downturn in sales may wait to
obtain information that enables them to assess the permanence of the demand reduction
before making decisions to cut resources’’ (emphasis added). Delayed and inaccurate
management reports provide a noisy signal about future demand. The real option theory
expects that higher uncertainty increases the option value of waiting and thus deters man-
agers from adjusting SG&A expenditure downward in a timely manner in response to
sales decrease.
The following excerpt from Krispy Kreme Doughnuts Inc.’s 2005 10-K filing shows
that material weakness in the company’s returned goods policy resulted in untimely and
erroneous accounting information for customer returns:
Sales department and warehouse department failed to follow the policy of returned goods to
timely handle the returned goods from customers, which was a material weakness. This weak-
ness relating to the failure to follow company’s returned goods policy was based primarily on
the lack of clarity among the company’s financial personnel as to their respective assignments
and duties with respect to the company’s returned goods policy. As a result, there was a break-
down in communication between the warehousing and financial departments, and no person
made an accounting of returned goods when those goods were returned by customers.
If customer returns are not recorded on a timely basis, net sales data in internal manage-
ment reports will be overstated and net sales data may not be consistent with other data in
the management reports. Due to this untimeliness and inconsistency, it is highly likely that
ineffective internal control systems create uncertainty about future demand and, conse-
quently, increase the option value of waiting. Therefore, managers become more cautious
in reducing committed resources in response to sales decrease and prefer to wait until the
uncertainty is resolved. In contrast, the poor-quality internal information is less likely to
delay managers’ decisions to add new resources in response to sales increase. The econom-
ics and strategy literature has explicitly recognized that competitive forces may provide
managers with incentives to act early in an expanding market, emphasizing the first-mover
advantages of early commitment. The existence of the first-mover advantages suggests that
managers should consider the trade-off between commitment and flexibility when making
resource allocation decisions in response to sales increase (Smit & Trigeorgis, 2017).
Consequently, the effect of internal information quality on managerial resource adjustments
is more pronounced for downward adjustments than for upward adjustments. Therefore, the
degree of cost stickiness is expected to be higher for ICW firms with low internal reporting
quality than for non-ICW firms.
An important implication from the above discussions is that the lack of effective internal
controls is likely to increase the degree of SG&A cost asymmetry. To provide systematic
evidence on this underresearched issue, we propose and test the following hypothesis in
alternative form:
Hypothesis 1 (H1): The degree of SG&A cost asymmetry is higher for ICW firms
than for non-ICW firms, all else equal.
Research Design
Measurement of Internal Control Quality
The effectiveness of internal control that facilitates managerial SG&A spending decisions
is unobservable to corporate outsiders including researchers. We thus measure internal con-
trol quality by the presence of material weakness in internal control over financial reporting
under SOX 404 provisions. SOX 404 mandates management to identify and document
internal control deficiencies over financial reporting, and further requires auditors to test
and opine on internal control effectiveness in their audit reports. According to SOX 404,
ICW discovered and not remediated by the report date must be publicly disclosed
(Securities and Exchange Commission 2003). We obtain the SOX 404 disclosures from
Audit Analytics to identify the material weakness in internal controls. We define ICW
firms as firms that received an adverse internal control audit opinion under SOX 404 provi-
sions and non-ICW firms as firms that received an unqualified internal control audit
opinion.
This measurement of internal control quality can be justified for two reasons. First, man-
agers rely on internal information generated from the internal control system to manage
operations, monitor performance, create forecasts, and report results to shareholders, and,
therefore, internal control quality is likely to affect various management decisions (Cheng,
Goh, & Kim, 2018; Feng et al., 2009; Feng et al., 2015; Li et al., 2012). Higher quality
information and better internal controls over financial reporting influence managers’ real
decisions within the firm such as SG&A spending decisions, and have an impact on the
quality of operating decisions (Ashbaugh-Skaife et al., 2009). Second, material weakness
detected by external auditors reflects more serious control problems than those raised by
corporate insiders (Kim et al., 2011; Skaife, Veenman, & Wangerin, 2013). The internal
reports generated by such faulty control systems are likely to deter managers from making
timely decisions in relation to SG&A cost management.
To further test the effect of internal information quality on SG&A cost asymmetry, we
partition ICW cases into two distinct categories, that is, (a) internal information control
problems and (b) other control problems, depending on the underlying reasons of ICW.10
We classify ICWs as internal information control problems if they arise from (a) informa-
tion technology, software, security, and access issue; (b) accounting personnel resources,
competency, training, experience, and/or adequacy; (c) inadequate disclosure controls in
terms of timeliness, accuracy, and completeness; or (iv) untimely or inadequate account
reconciliations.11 We classify all other ICW as other control problems. We focus on infor-
mation technology problems because information technology controls, as a part of manage-
ment information system, affect the quality of the information produced by the system. We
thus expect that information technology controls are critical to improving the timeliness
and accuracy of internal managerial reports (Li et al., 2012; Masli et al., 2010). We also
consider accounting personnel problems because even firms with sophisticated information
and operating systems may fail to enhance internal reporting quality if they lack accounting
personnel with adequate expertise to use the systems properly and generate timely and
accurate information (Choi et al., 2013).12 In addition, inadequate disclosure controls and
untimely account reconciliations can mirror the poor quality of internal reporting. If a
faulty control system yields untimely, inaccurate, and incomplete information for corporate
disclosures and account reconciliations, it is also likely to generate low-quality internal
reports for managerial decision making (Feng et al., 2009; Li et al., 2012).
Kim et al. 9
Empirical Models
To examine whether and how the asymmetric behavior of SG&A costs is associated with
internal control quality, we rely on the empirical model developed by Anderson et al.
(2003). They estimate the degree of SG&A cost asymmetry using Equation 1:
DlogðSG&Ai, t Þ = a0 + a1 DlogðSalesi, t Þ + a2 DecDummyi, t 3DlogðSalesi, t Þ + ei, t ð1Þ
where, for firm i and year t, log(.) denotes the natural logarithm function; SG&Ai,t and
Salesi,t represent SG&A costs and sales revenue, respectively; DecDummyi,t is an indicator
variable that equals 1 if sales revenue in year t is less than that in year t 2 1, and 0 other-
wise. The dependent variable, Dlog(SG&Ai,t), represents the change in natural logarithm of
SG&A costs between year t and t 2 1.13 The right-hand side of the equation includes the
change in log of sales revenue between year t and t 2 1, Dlog(Salesi,t), and its interaction
with the sales decrease dummy, DecDummy 3 Dlog(Salesi,t). The change form and log
transformation enhances the comparability of the regression coefficients across firms, and
mitigates the effect of heteroskedasticity (Anderson et al., 2003). See the appendix for the
details of variable definitions.
Equation 1 is based on the nonlinear asymmetric relation between SG&A costs and
sales revenue. The coefficient a1 reflects the percentage change in SG&A costs for a 1%
increase in sales revenue; it captures the sensitivity of change in SG&A costs to the change
in sales revenue when the sales revenue increases from year t 2 1 to year t (DecDummy =
0). The coefficient a1 is expected to be positive if managers increase their SG&A spending
during the sales growth period. However, the sum of coefficients a1 and a2 captures the
percentage change in SG&A costs for a 1% decrease in sales revenue. Hence, the coeffi-
cient a2 measures the incremental sensitivity of change in SG&A costs to the contempora-
neous change in sales revenue when the sales revenue decreases from year t 2 1 to year t
(DecDummy = 1). This coefficient a2 is expected to be negative if managers make less
adjustment on SG&A costs during the sales contraction period than during the sales growth
period.
Anderson et al. (2003) show that the degree of SG&A cost asymmetry is affected by
various economic factors by modeling the extent of cost stickiness as a linear combination
of such factors. Following the specifications of Banker and Byzalov (2014), we expand the
coefficients a0, a1, and a2 in Equation 1 as linear functions of an ICW indicator as well as
four economic factors used by Anderson et al. to test the incremental impact of ICW on
SG&A cost asymmetry:
a0 = g0 + g1 ICWi, t + gk SControlsi, t, k
= g0 + g1 ICWi, t + g2 Successive Decreasei, t + g3 GDP Growthi, t ð2-1Þ
+ g4 Fixed Asset Intensityi, t + g5 Employee Intensityi, t
a1 = d0 + d1 ICWi, t + dk SControlsi, t, k
= d0 + d1 ICWi, t + d2 Successive Decreasei, t + d3 GDP Growthi, t ð2-2Þ
+ d4 Fixed Asset Intensityi, t + d5 Employee Intensityi, t
a2 = u0 + u1 ICWi, t + uk SControlsi, t, k
= u0 + u1 ICWi, t + u2 Successive Decreasei, t + u3 GDP Growthi, t ð2-3Þ
+ u4 Fixed Asset Intensityi, t + u5 Employee Intensityi, t
where, for firm i and year t, ICWi,t takes the value of 1 if the auditor concludes that a
firm’s internal control over financial reporting is not effective under SOX 404, and 0 other-
wise. SControlsi,t are four economic factors of SG&A cost asymmetry as documented in
Anderson et al. (2003). Successive Decreasei,t takes the value of 1 when sales revenue in
year t 2 1 is less than sales revenue in year t 2 2, and 0 otherwise. GDP Growthi,t is the
percentage growth in real GDP in year t. Fixed Asset Intensityi,t is fixed assets divided by
total assets in year t. Employee Intensityi,t is the number of employees divided by sales rev-
enue in year t.
Finally, we obtain Equation 3 by substituting Equations 2-1, 2-2, and 2-3 into Equation
1 as follows:
DlogðSG&Ai, t Þ = b0 + b1 ICWi, t + b2, k SControlsi, t, k + b3 DlogðSalesi, t Þ

+ b4 ICWi, t 3 DlogðSalesi, t Þ
+ b5, k SControlsi, t, k 3 DlogðSalesi, t Þ + b6 DecDummyi, t 3 DlogðSalesi, t Þ
+ b7 ICWi, t 3 DecDummyi, t 3 DlogðSalesi, t Þ
+ b8, k SControlsi, t, k 3 DecDummyi, t 3 DlogðSalesi, t Þ
+ Year Dummies + IndustryDummies + ei, t
ð3Þ
where ICWi,t and SControlsi,t,k are activated when sales revenue decreases as well as when
sales increase.14 When sales increase by 1%, SG&A costs increase by b3 percent for non-
ICW firms and by (b3 + b4) percent for ICW firms. When sales decrease by 1%, SG&A
costs decrease by (b3 + b6) percent for non-ICW firms and by (b3 + b4 + b6 + b7) per-
cent for ICW firms. That is, cost stickiness can be captured by b6 for non-ICW firms and
by (b6 + b7) for ICW firms, respectively. We thus expect the coefficient b7 to be signifi-
cantly negative if the SG&A costs of ICW firms are stickier than those of non-ICW firms
(as predicted in H1). Anderson et al. (2003) document that the stickiness of SG&A costs
is less pronounced when sales also declined in the preceding period, and is more pro-
nounced in the period of macroeconomic growth and in firms with a large amount of
fixed assets and a large number of employees. We thus expect the coefficient b8,1 on the
three-way interaction with Successive Decreasei,t to be positive and the coefficients b8,2,
b8,3, and b8,4 on the three-way interactions with GDP Growthi,t, Fixed Asset Intensityi,t,
and Employee Intensityi,t to be negative, respectively. Equation 3 also includes year and
industry dummies to control for the time and industry fixed effects. Industries are identi-
fied using Fama–French 12 industry classification.15 Variable definitions are detailed in
the appendix.
To investigate the impact of internal information quality on SG&A cost asymmetry,
we disaggregate ICWi,t in Equation 3 into ICW_Infoi,t and ICW_Othersi,t as follows:
Kim et al. 11
DlogðSG&Ai, t Þ = b0 + b1 ICW Infoi, t + b2 ICW Othersi, t + b3, k SControlsi, t, k

+ b4 DlogðSalesi, t Þ + b5 ICW Infoi, t 3DlogðSalesi, t Þ
+ b6 ICW Othersi, t 3DlogðSalesi, t Þ + b7, k SControlsi, t, k 3DlogðSalesi, t Þ
+ b8 DecDummyi, t 3DlogðSalesi, t Þ
+ b9 ICW Infoi, t 3 DecDummyi, t 3DlogðSalesi, t Þ
+ b10 ICW Othersi, t 3 DecDummyi, t 3DlogðSalesi, t Þ
+ b11, k SControlsi, t, k 3 DecDummyi, t 3DlogðSalesi, t Þ
ð4Þ
where, for firm i and year t, ICW_Infoi,t takes the value of 1 if a firm reports ICW related
to internal information problems, and 0 otherwise. ICW_Othersi,t takes the value of 1 if a
firm does not report ICW related to internal information problems but reports other ICW
problems, and 0 otherwise. Using Equation 4, we compare the degree of SG&A cost asym-
metry among three groups: ICW firms with internal information control problems, ICW
firms with other control problems, and non-ICW firms (as a baseline group). The coeffi-
cient b9 (b10) is expected to be significantly negative if SG&A costs are stickier for ICW
firms with internal information (other) control problems than for non-ICW firms. More
important, we expect b9 to be less (i.e., greater in absolute value) than b10 if SG&A cost
asymmetry is more pronounced for ICW firms with internal information problems than
those with other control problems.
In all regression analyses, we winsorize each of the continuous variables at the first and
99th percentiles to alleviate the undue influence of extreme observations and exclude
observations with SG&A costs exceeding sales revenue.16 Throughout the article, t statis-
tics for all regressions are based on robust standard errors corrected for heteroskedasticity
and firm and year clustering (Petersen, 2009).
Sample and Data

Sample Selection
Our sample consists of accelerated filers that are included in Compustat for fiscal years
2004 to 2016. The sample period begins in 2004 because SOX 404 became effective for
accelerated filers for fiscal years ending after November 15, 2004 (see figure 1 of Beneish
et al., 2008, for the history of internal control regulations). We focus on accelerated filers
following Feng et al. (2015) because these firms have reported both the manager’s assess-
ment under SOX Section 404(a) and the auditor’s attestation under SOX Section 404(b) in
their 10-K filings since 2004, whereas nonaccelerated filers have reported only the manag-
er’s assessment under SOX Section 404(a) since 2007. We use the SOX 404(b) data from
Audit Analytics to construct our test variables ICW, ICW_Info, and ICW_Others. Next, we
merge these ICW variables with financial statement data from Compustat. We also require
that there should be no missing value for all variables included in our regression.
Table 1, Panel A, presents the ICW distribution in our sample. Our final sample includes
24,483 firm–year observations from 4,184 unique firms.17 The full sample contains 1,751
observations from ICW firms and 22,732 observations from non-ICW firms. Among the
ICW firms, 1,058 observations have internal information control problems and 693 obser-
vations have other control problems. Table 1, Panel A, also reports the frequencies of sales
Table 1. Sample Distribution.
Panel A: Sample Distribution by the Type of ICW.

Firm–years with Firm–years with
Sample composition Firms Firm–years sales increase sales decrease
Firms with ineffective internal control 598 1,751 1,221 530
(ICW = 1)
Firms with internal information control 355 1,058 721 337
problems (ICW_Info = 1)
Firms with other control problems 243 693 500 193
(ICW_Others = 1)
Firms with effective internal control 3,586 22,732 16,378 6,354
(ICW = 0)
Full sample (fiscal years 2004-2016) 4,184 24,483 17,599 6,884
Note. ICW = internal control weakness.
Panel B: Sample Distribution by Industry.
Sample with ineffective Sample with effective

internal control internal control
Full sample (ICW = 1) (ICW = 0)
Fama–French industry Number Percent Number Percent Number Percent

Consumer nondurables 1,483 6.06 98 5.60 1,385 6.09
Consumer durables 854 3.49 69 3.94 785 3.45
Manufacturing 3,341 13.65 252 14.39 3,089 13.59
Oil, gas, and coal 1,226 5.01 57 3.26 1,169 5.14
Chemical products 835 3.41 51 2.91 784 3.45
Business equipment 6,053 24.72 485 27.70 5,568 24.49
Telephone and television 1,049 4.28 77 4.40 972 4.28
Utilities 66 0.27 4 0.23 62 0.27
Wholesale and retail 3,092 12.63 208 11.88 2,884 12.69
Health care 2,199 8.98 154 8.79 2,045 9.00
Finance 565 2.31 34 1.94 531 2.34
Other 3,720 15.19 262 14.96 3,458 15.21
Total 24,483 100.00 1,751 100.00 22,732 100.00
Note. This table reports the sample distribution by the type of ICW in Panel A and the sample distribution by
Fama–French industry in Panel B. Variable definitions are presented in the appendix. ICW = internal control
weakness.
increase and sales decrease in the full sample and its subsamples. The proportion of firm–
years with sales increase (sales decrease) is 72% (28%) of the full sample and remains sim-
ilar across our subsamples.
Table 1, Panel B, presents the sample distribution sorted by the Fama–French industry
classification. The business equipment industry takes the largest portion (24.7%) of the full
sample and the utilities industry takes the smallest portion (0.27%).18 Notably, the industry
distribution is fairly similar between ICW firms and non-ICW firms. Therefore, it is
unlikely that our results are unduly influenced by ICW incidences concentrated in specific
industries.
Kim et al. 13
Table 2. Descriptive Statistics.
Panel A: Summary Statistics for the Full Sample (N = 24,483).

Variable Mean Q1 Median Q3 SD
Salesi,t (US$ million) 5,219.46 292.04 868.46 2,863.51 20,992.02
SG&Ai,t (US$ million) 903.42 64.00 168.54 520.44 3,244.71
SG&Ai,t /Salesi,t 0.26 0.12 0.22 0.37 0.19
Dlog(SG&Ai,t) 0.08 –0.01 0.07 0.16 0.16
Dlog(Salesi,t) 0.08 –0.01 0.07 0.17 0.21
DecDummyi,t 0.28 0.00 0.00 1.00 0.45
Successive Decreasei,t 0.24 0.00 0.00 0.00 0.43
GDP Growthi,t 3.23 1.87 3.00 4.87 2.42
Fixed Asset Intensityi,t 0.26 0.08 0.18 0.37 0.23
Employee Intensityi,t 0.51 0.21 0.35 0.55 0.73
Firm Sizei,t 7.03 5.79 6.89 8.09 1.66
Agei,t 2.80 2.30 2.83 3.33 0.76
Segmentsi,t 1.60 1.10 1.61 2.08 0.66
Sales Growthi,t 0.12 0.01 0.08 0.18 0.28
Inventoryi,t 0.11 0.01 0.08 0.16 0.13
Lossi,t 0.22 0.00 0.00 0.00 0.42
Foreign Salesi,t 0.66 0.00 1.00 1.00 0.47
Note. SG&A = selling, general, and administrative; GDP = gross domestic product.
(continued)
Descriptive Statistics
Table 2, Panel A, provides the summary statistics of research variables for the full sample.
The mean (median) sales revenue is US$5,219 (US$868) million, whereas the mean (median)
SG&A cost is US$903 (US$169) million, suggesting that both distributions are positively
skewed. The mean (median) SG&A cost as a percentage of sales revenue is 26% (22%). The
means of DecDummy and Successive Decrease suggest that annual sales revenue declined in
the current year (relative to the previous year) for 28% of the observations (i.e., DecDummyi,t =
1), and dropped in the preceding year (relative to the 2 years ago) for 24% of the observations
(i.e., Successive Decreasei,t = 1).19 On average, fixed assets account for 26% of total assets,
whereas 0.51 employee generates a million dollars of sales revenue. These descriptive statistics
are comparable with those illustrated in Anderson et al. (2003) and Chen et al. (2012).
Table 2, Panel B, presents the univariate comparison between subsamples partitioned by
the presence and the types of ICW. Columns 1 and 2 of Panel B compare the means of
research variables between ICW firms and non-ICW firms. ICW firms are significantly
smaller than non-ICW firms in terms of sales revenue, SG&A costs, and total assets, which
is consistent with the findings of Ashbaugh-Skaife, Collins, and Kinney (2007) and Doyle
et al. (2007). ICW firms spend more SG&A costs as a percentage of sales revenue than non-
ICW firms, suggesting that the former is less efficient in SG&A cost management than the
latter.20 Moreover, ICW firms exhibit a larger (log) increase in annual SG&A costs than non-
ICW firms, whereas the (log) increase in sales revenue is not significantly different between
the two groups. The results indicate that the increase (decrease) in SG&A costs surpasses
(lags) that in sales revenue for ICW firms. Furthermore, ICW firms have lower fixed asset
intensity, higher employee intensity, younger age, a smaller number of segments, higher
(unlogged) sales growth, and higher likelihood of loss occurrence than non-ICW firms.
Table 2. (continued)
Panel B: Summary Statistics for Subsamples Partitioned by ICW.
Full sample Sample with ICW

N = 24,483 N = 1,751 (ICW = 1)
(1) (2) (3) (4)
Sample with Sample with Sample with Sample with
effective internal control internal information other internal
internal control weakness control problems control problems
(ICW = 0) (ICW = 1) (ICW_Info = 1) (ICW_Others = 1)
N = 22,732 N = 1,751 N = 1,058 N = 693
Variable Mean Mean Mean Mean

Salesi,t (US$ million) 5,466.66 2,010.30*** 1,944.14 2,111.29
SG&Ai,t (US$ million) 944.83 365.71*** 360.97 372.96
SG&Ai,t /Salesi,t 0.26 0.30*** 0.31 0.29*
Dlog(SG&Ai,t) 0.08 0.11 0.11 0.10
Dlog(Salesi,t) 0.08 0.08 0.08 0.09
DecDummyi,t 0.28 0.30 0.32 0.28*
Successive Decreasei,t 0.24 0.25 0.27 0.22**
GDP Growthi,t 3.14 4.40*** 4.28 4.58***
Fixed Asset Intensityi,t 0.26 0.23*** 0.22 0.25***
Employee Intensityi,t 0.50 0.61*** 0.62 0.60
Firm Sizei,t 7.08 6.34*** 6.34 6.35
Agei,t 2.81 2.69*** 2.68 2.70
Segmentsi,t 1.60 1.57*** 1.60 1.51***
Sales Growthi,t 0.12 0.14** 0.14 0.15
Inventoryi,t 0.11 0.11 0.11 0.12
Lossi,t 0.21 0.39*** 0.41 0.37**
Foreign Salesi,t 0.66 0.67 0.71 0.62***
Note. This table shows the descriptive statistics of research variables. Panel A reports the summary statistics for
the full sample. Panel B presents the summary statistics for samples partitioned by the presence of ICW in
columns 1 and 2 and those for samples partitioned by the types of ICW in columns 3 and 4. Panels B also shows
the significance of mean differences between subsamples. See the appendix for variable definitions. ICW = internal
control weakness; SG&A = selling, general, and administrative; GDP = gross domestic product.
*Statistical significance at 10% level. **Statistical significance at 5% level. ***Statistical significance at 1% level.
Columns 3 and 4 of Panel B show the univariate comparison between ICW firms with
internal information problems and ICW firms with other control problems. The levels and
log changes in sales revenue and SG&A costs are not significantly different between the two
groups. However, ICW firms with internal information problems have more frequent sales
decreases, lower fixed asset intensity, a larger number of segments, higher likelihood of loss
occurrence, and higher likelihood of having foreign sales than those with other control prob-
lems. The results support the choice of these control variables in regression models.
Empirical Results
ICW and SG&A Cost Asymmetry
To test the effect of ICW on the asymmetric behavior of SG&A costs, we first estimate
Equation 3. Table 3 provides the results of ordinary least squares (OLS) regressions for the
Kim et al. 15
Table 3. ICW and SG&A Cost Asymmetry.
Dependent variable = Dlog(SG&Ai,t)
(1) (2) (3)
Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic
Constant (b0) 0.029 5.30*** 20.001 20.21 0.044 3.78***

ICW (b1) 0.010 1.32 0.016 2.29** 0.012 2.11**
Successive Decrease (b2,1) 20.017 23.55*** 20.003 20.72
GDP Growth (b2,2) 0.004 5.37*** 0.004 5.53***
Fixed Asset Intensity (b2,3) 0.003 1.38 0.002 1.30
Employee Intensity (b2,4) 20.008 24.51*** 20.004 21.79*
Firm Size (b2,5) 20.003 23.50***
Age (b2,6) 20.007 24.04***
Segments (b2,7) 0.001 0.21
Sales Growth (b2,8) 0.114 2.79***
Inventory (b2,9) 20.001 20.09
Loss (b2,10) 20.010 22.68***
Foreign Sales (b2,11) 20.009 22.71***
Sales Change (b3) + 0.566 21.66*** 0.697 14.90*** 0.373 5.38***
Two-way interaction terms
(Variable 3 Sales Change)
ICW (b4) 0.046 1.05 20.007 20.16 0.022 0.65
Successive Decrease (b5,1) 20.226 27.06*** 20.190 24.95***
GDP Growth (b5,2) 20.009 21.43 20.002 20.45
Fixed Asset Intensity (b5,3) 20.041 23.13*** 20.041 23.47***
Employee Intensity (b5,4) 0.089 9.52*** 0.075 5.58***
Firm Size (b5,5) 0.045 6.04***
Age (b5,6) 20.015 21.45
Segments (b5,7) 20.030 21.56
Sales Growth (b5,8) 20.121 23.19***
Inventory (b5,9) 20.086 21.07
Loss (b5,10) 20.008 20.35
Foreign Sales (b5,11) 0.068 2.40**
DecDummy (b6) 2 20.254 27.19*** 20.416 26.07*** 20.176 21.48
Three-way interaction terms
(Variable 3 DecDummy 3 Sales Change)
ICW (b7) 2 20.170 22.41** 20.138 22.13** 20.176 23.00***
Successive Decrease (b8,1) + 0.336 6.05*** 0.300 6.82***
GDP Growth (b8,2) 2 0.008 0.79 0.002 0.21
Fixed Asset Intensity (b8,3) 2 0.026 1.30 0.027 1.92**
Employee Intensity (b8,4) 2 20.054 23.22*** 20.027 21.06
Firm Size (b8,5) 20.036 21.99**
Age (b8,6) 0.023 1.36
Segments (b8,7) 0.033 1.02
Sales Growth (b8,8) 0.223 1.33
Inventory (b8,9) 0.377 2.93***
(continued)
(1) (2) (3)
Loss (b8,10) 20.093 22.73***

Foreign Sales (b8,11) 20.028 20.55
Year Dummies Yes Yes Yes Yes Yes Yes
Industry Dummies Yes Yes Yes Yes Yes Yes
Total observations 24,483 24,483 24,483
Adjusted R2 (%) 43.32 47.11 49.68
Note. This table reports the estimation results of the SG&A cost asymmetry model in Equation 3. Column 1
presents the results of OLS regression without control variables and columns 2 and 3 report the results of OLS
regressions including control variables. All reported t values are based on standard errors adjusted for
heteroskedasticity and firm and year clustering (Petersen, 2009). See the appendix for variable definitions. ICW =
internal control weakness; SG&A = selling, general, and administrative; GDP = gross domestic product; OLS =
ordinary least squares.
full sample. Column 1 does not include the main and interaction terms of control variables,
whereas columns 2 and 3 include them. As shown in column 1, the coefficient on Sales
Change (b3) is significantly positive and the coefficient on DecDummy 3 Sales Change
(b6) is significantly negative. This result is consistent with the presence of cost stickiness
in SG&A expenditure for non-ICW firms; SG&A costs increase when sales increase, but
SG&A costs decrease to a lesser degree when sales decrease. Specifically, the estimated
value of b3 (= 0.566) and the combined value of b3 + b6 (= 0.566 2 0.254) indicate that
whereas SG&A costs increase by 0.566% per 1% increase in sales revenue, SG&A costs
decrease by 0.312% per 1% decrease in sales revenue for non-ICW firms. More important,
the coefficient on the three-way interaction term with ICW (b7) is negative and significant,
whereas that on the two-way interaction with ICW (b4) is not significant.21 The combined
value of b3 + b4 + b6 + b7 (= 0.566 + 0.046 2 0.254 2 0.170) indicates that SG&A costs
decrease by only 0.188% per 1% reduction in sales revenue for ICW firms. The significant
difference in SG&A cost asymmetry between ICW and non-ICW firms supports our H1
that ICW is associated with stickier SG&A costs.
Column 2 includes four control variables that might affect the degree of SG&A cost
asymmetry. Overall, the results are robust to adding potential economic determinants of
cost stickiness. Whereas the coefficient on Sales Change (b3) is significantly positive, the
coefficient on DecDummy 3 Sales Change (b6) is significantly negative. The significantly
negative coefficient on the three-way interaction term with ICW (i.e., b7 = 0.138 with t =
22.13) is consistent with our H1, suggesting that SG&A costs are stickier for ICW firms
than for non-ICW firms. Among the control variables, the coefficient on the three-way
interaction term with Successive Decrease is significantly positive but the counterpart with
Employee Intensity is significantly negative. The coefficients on the three-way interaction
terms with GDP Growth and Fixed Asset Intensity are statistically indifferent from zero.22
Column 3 further includes firm-specific control variables that may determine the pres-
ence of ICW. Although column 2 based on Equation 3 includes the key economic factors
of SG&A cost asymmetry as in Anderson et al. (2003), there might be omitted variables
Kim et al. 17
that affect both the degree of SG&A cost asymmetry and the occurrence of ICW problems.
To ensure that our ICW variable does not merely represent some other inherent operating
factors that may influence cost stickiness, we expand Equation 3 by adding a set of ICW
determinants documented by Ashbaugh-Skaife et al. (2007) and Ashbaugh-Skaife, Collins,
Kinney, and LaFond (2009): firm size, firm age, the number of segments, sales growth,
inventory holdings, a loss indicator, and a foreign sales indicator. In column 3, the coeffi-
cient on Sales Change (b3) is significantly positive and the coefficients on DecDummy 3
Sales Change (b6) and the three-way interaction with ICW (b7) are significantly negative.
The overall results suggest that the positive relation between ICW occurrence and SG&A
cost stickiness is not sensitive to the inclusion of potential ICW determinants to the
regressions.
We conduct two additional tests to check the robustness of our results. First, we perform
industry-level regressions over Fama–French 12 industries. Specifically, we estimate the
industry-specific coefficients for each of the 12 industries and perform statistical tests with
the mean coefficients and t statistics based on the standard errors of the 12 sets of industry-
specific coefficients. We employ the industry-level analyses to see whether our results
remain robust after controlling for the potential systematic difference in cost structure
across industries.23 The untabulated results from industry-level regressions are qualitatively
similar with those from the full-sample regressions. This finding suggests that the positive
association between ICW occurrence and SG&A cost stickiness is unaffected by the differ-
ence in cost structure across industries.
Second, we perform our regression analysis after controlling for firm fixed effects.
Although we control for various economic determinants of cost stickiness and ICW in
Table 3, we cannot rule out the possibility that some omitted variables might jointly
explain the degree of SG&A cost asymmetry and the incidence of ICW problems. The firm
fixed effect regression allows us to control for potential impacts on our results of time-
invariant firm-specific factors that are unobservable and thus omitted from the regression
(Lennox, Francis, & Wang, 2012). Moreover, the firm fixed effect regression is less sensi-
tive to the joint determination of SG&A cost stickiness and ICW occurrence (Larcker &
Rusticus, 2010; Lennox et al., 2012). Although not tabulated for brevity, we find that our
main results are robust to the inclusion of firm fixed effects. This finding alleviates a con-
cern over potential endogeneity that may arise from firm-level omitted variables that are
correlated with the incidence of ICW problems.
In sum, we find that SG&A cost asymmetry is more pronounced for ICW firms than for
non-ICW firms, which is consistent with the prediction in H1. The finding suggests that,
when the internal control system is not effective, managers tend to postpone their decisions
about whether to reduce committed resources in response to sales decrease.
Characteristics of ICW and SG&A Cost Asymmetry

We next investigate the impact of different types of ICW on SG&A cost asymmetry.
Specifically, we estimate Equation 4 to test the difference in SG&A cost stickiness between
ICW firms with internal information control problems and those with other control prob-
lems. Table 4 reports the results of OLS regressions for Equation 4. Column 1 shows the
effect of the two types of ICW problems on SG&A cost stickiness. The coefficients on the
three-way interaction terms with ICW_Info (b9) and with ICW_Others (b10) are both nega-
tive but only the former is statistically significant. The estimated value of b9 (= 20.305) is
significantly less (larger in absolute magnitude) than that of b10 (= 20.049; p \ .01). This
Table 4. Internal Information Control Problems and SG&A Cost Asymmetry.
(1) (2) (3)
Constant (b0) 0.029 5.32*** 20.002 20.30 0.043 3.80***

ICW_Info (b1) 0.014 1.88* 0.021 2.43** 0.018 2.36**
ICW_Others (b2) 20.007 20.83 20.002 20.25 20.006 20.97
GDP Growth (b3,2) 0.005 5.64*** 0.004 5.82***
Employee Intensity (b3,4) 20.008 24.62*** 20.004 21.81*
Firm Size (b3,5) 20.003 23.40***
Age (b3,6) 20.007 24.03***
Segments (b3,7) 0.001 0.35
Sales Growth (b3,8) 0.115 2.80***
Inventory (b3,9) 0.001 0.07
Loss (b3,10) 20.011 22.97***
Foreign Sales (b3,11) 20.009 22.85***
Sales Change (b4) + 0.566 21.68*** 0.697 14.88*** 0.372 5.45***
ICW_Info (b5) 0.033 0.72 20.024 20.44 0.001 0.00
ICW_Others (b6) 0.098 1.90* 0.054 1.20 0.092 2.02**
GDP Growth (b7,2) 20.009 21.46 20.002 20.46
Firm Size (b7,5) 0.045 6.12***
Age (b7,6) 20.015 21.47
Segments (b7,7) 20.031 21.63*
Sales Growth (b7,8) 20.122 23.20***
Inventory (b7,9) 20.095 21.16
Loss (b7,10) 20.007 20.29
Foreign Sales (b7,11) 0.070 2.49***
DecDummy (b8) 2 20.254 27.19*** 20.419 26.24*** 20.163 21.47
ICW_Info (b9) 2 20.305 23.41*** 20.268 22.42** 20.285 22.94***
ICW_Others (b10) 2 20.049 20.49 20.037 20.33 20.102 20.78
GDP Growth (b11,2) 2 0.010 1.02 0.003 0.42
Fixed Asset Intensity (b11,3) 2 0.025 1.18 0.026 1.85*
Firm Size (b11,5) 20.036 22.24**
Age (b11,6) 0.022 1.21
Segments (b11,7) 0.042 1.24
Sales Growth (b11,8) 0.256 1.51
Inventory (b11,9) 0.406 3.18***
(continued)
Kim et al. 19
(1) (2) (3)
Loss (b11,10) 20.106 23.32***

Foreign Sales (b11,11) 20.047 20.88
Adjusted R2 (%) 43.41 47.19 49.75
Note. This table reports the estimation results of SG&A cost asymmetry model in Equation 4 that includes two
ICW characteristics (ICW_Info and ICW_Others) representing the causes of ICW. ICW_Info equals 1 if a firm
reports ICW related to internal information problems, and 0 otherwise. ICW_Others equals 1 if a firm does not
report ICW related to internal information problems but reports other ICW problems, and 0 otherwise. See the
appendix for variable definitions. All reported t values are based on standard errors adjusted for heteroskedasticity
and firm and year clustering (Petersen, 2009). SG&A = selling, general, and administrative; ICW = internal control
weakness; GDP = gross domestic product.
result suggests that the significant effect of ICW on SG&A cost stickiness is more pro-
nounced in ICW firms with internal information problems than in those with other control
problems.
Columns 2 and 3 repeat the test in column 1 after including the main and interaction
terms of control variables. We find that the coefficients on the three-way interaction
terms with ICW_Info (b9) and ICW_Others (b10) are consistently negative but only the
former remains significant. This finding indicates that the positive association between
ICW and SG&A cost asymmetry is primarily attributable to internal information control
problems rather than to other control problems. The finding is also consistent with the
view that poor-quality internal information produced by the inadequate control system is
associated with the delayed adjustment of SG&A resources during the sales-decrease
periods.
Overall, the results in Table 4 further confirm that managers in ICW firms make less
timely downward adjustment of SG&A resources in response to sales decrease than those
in non-ICW firms, and show that the untimely resource adjustment is largely attributable
to the poor-quality internal information generated by the ineffective internal control
system.
Remediation of ICW and SG&A Cost Asymmetry

If the presence of ICW problems induces a high level of SG&A cost asymmetry, one can
expect to observe that this asymmetry is reduced when firms fix the reported ICW prob-
lems. As a validity check for our cross-sectional results in Tables 3 and 4, we now examine
whether the remediation of ICW problems leads to lowering the degree of SG&A cost asym-
metry, or equivalently, whether SG&A costs become less sticky after the remediation of
ICW. Specifically, we replace ICWi,t in Equation 3 by Remediationi,t, Non-Remediationi,t,
and New ICWi,t as follows:
DlogðSG&Ai, t Þ = b0 + b1 Remediationi, t + b2 Non-Remediationi, t + b3 New ICWi, t

+ b4, k SControlsi, t, k + b5 DlogðSalesi, t Þ + b6 Remediationi, t 3DlogðSalesi, t Þ
+ b7 Non-Remediationi, t 3 DlogðSalesi, t Þ + b8 New ICWi, t 3 DlogðSalesi, t Þ
+ b9, k SControlsi, t, k 3 DlogðSalesi, t Þ + b10 DecDummyi, t 3 DlogðSalesi, t Þ
+ b11 Remediationi, t 3 DecDummyi, t 3DlogðSalesi, t Þ
+ b12 Non-Remediationi, t 3 DecDummyi, t 3 DlogðSalesi, t Þ
+ b13 New ICWi, t 3 DecDummyi, t 3 DlogðSalesi, t Þ
+ b14, k SControlsi, t, k 3 DecDummyi, t 3 DlogðSalesi, t Þ
ð5Þ
where, for firm i and year t, Remediationi,t equals 1 if a firm received an adverse internal
control audit opinion under SOX 404 provisions in the previous year and then an unquali-
fied internal control audit opinion in the current year, and 0 otherwise. Non-Remediationi,t
equals 1 if a firm received an adverse SOX 404 audit opinion in both the previous and cur-
rent years, and 0 otherwise. New ICWi,t equals 1 if a firm received an unqualified SOX 404
audit opinion in the previous year and then an adverse SOX 404 opinion in the current
year, and 0 otherwise. Using Equation 5, we compare the degree of SG&A cost stickiness
among four groups: remediation firms (821 observations), nonremediation firms (411
observations), new ICW firms (1,340 observations), and non-ICW firms (21,911 observa-
tions that received an unqualified SOX 404 opinion in both the previous and current years).
If the remediation of ICW problems improves the internal information quality and, thus,
lowers the degree of cost asymmetry, we expect the coefficient b11 for remediation firms
to be significantly greater (i.e., less sticky costs) than the coefficient b12 for nonremedia-
tion firms and the coefficient b13 for new ICW firms.
Table 5 reports the results for Equation 5 with Remediation, Non-Remediation, and New
ICW as additional test variables. In column 1, the coefficient on Sales Change (b5) is sig-
nificantly positive and the coefficient on DecDummy 3 Sales Change (b10) is significantly
negative, which is consistent with the results in Tables 3 and 4. The coefficient on the
three-way interaction term with Remediation (b11) is significantly positive but the counter-
part with Non-Remediation (b12) is significantly negative. More important, the coefficient
b11 for remediation firms is significantly greater than the coefficient b12 for nonremedia-
tion firms (p \ .01). The results suggest that SG&A costs become less sticky for firms
with previously reported ICW problems being fixed in the current period than for firms
with previously reported ICW problems not being fixed. In contrast, the coefficient on the
three-way interaction with New ICW (b13) is negative and highly significant, which con-
firms our findings in Tables 3 and 4 that SG&A costs are stickier for ICW firms than for
non-ICW firms. Moreover, the coefficient b11 for remediation firms is significantly greater
than the coefficient b13 for new ICW firms (p \ .01), suggesting the significant decrease
in cost asymmetry following the remediation of ICW problems.
As shown in columns 2 and 3, the test results with various control variables added are
similar with those without them: The coefficient b11 for remediation firms is significantly
positive, whereas the coefficient b12 for nonremediation firms and the coefficient b13 for
new ICW firms are both significantly negative. Moreover, the coefficient b11 is signifi-
cantly greater than the coefficients b12 and b13 (ps \ .01 for all cases). Overall, the results
for overtime impact of ICW remediation on SG&A cost asymmetry show that the
Kim et al. 21
Table 5. Remediation of ICW and SG&A Cost Asymmetry.
(1) (2) (3)
Constant (b0) 0.027 6.23*** 20.001 20.33 0.043 5.70***

Remediation (b1) 20.002 20.37 0.004 0.77 0.006 0.99
Non-Remediation (b2) 20.012 21.37 20.003 20.35 20.006 20.78
New ICW (b3) 0.017 3.51*** 0.023 4.83*** 0.019 4.12***
GDP Growth (b4,2) 0.004 7.51*** 0.004 7.13***
Fixed Asset Intensity (b4,3) 0.003 2.51*** 0.002 2.09**
Firm Size (b4,5) 20.003 23.97***
Age (b4,6) 20.007 24.55***
Segments (b4,7) 0.001 0.41
Sales Growth (b4,8) 0.113 22.29***
Inventory (b4,9) 20.001 20.12
Loss (b4,10) 20.010 23.71***
Foreign Sales (b4,11) 20.009 23.57***
Sales Change (b5) + 0.570 96.51*** 0.698 47.76*** 0.376 11.40***
Remediation (b6) 20.106 23.57*** 20.129 24.49*** 20.128 24.57***
Non-Remediation (b7) 0.089 2.07** 0.031 0.74 0.063 1.54
New ICW (b8) 0.027 1.32 20.026 21.30 0.003 0.13
GDP Growth (b9,2) 20.008 23.15*** 20.002 20.66
Firm Size (b9,5) 0.044 11.91***
Age (b9,6) 20.015 22.04**
Segments (b9,7) 20.031 23.60***
Sales Growth (b9,8) 20.121 221.28***
Inventory (b9,9) 20.086 21.97**
Loss (b9,10) 20.010 20.86
Foreign Sales (b9,11) 0.071 6.11***
DecDummy (b10) 2 20.261 222.82*** 20.421 216.84*** 20.191 23.01***
Remediation (b11) + 0.178 3.17*** 0.227 4.16*** 0.223 4.17***
Non-Remediation (b12) 2 20.202 22.17** 20.153 21.71* 20.214 22.43**
New ICW (b13) 2 20.149 23.61*** 20.116 22.87*** 20.148 23.70***
GDP Growth (b14,2) 2 0.007 1.64* 0.000 0.12*
Fixed Asset Intensity (b14,3) 2 0.026 3.37*** 0.027 3.41***
Employee Intensity (b14,4) 2 20.053 26.01*** 20.027 22.75***
Firm Size (b14,5) 20.035 24.85***
Age (b14,6) 0.024 1.70*
(continued)
(1) (2) (3)
Segments (b14,7) 0.034 1.98**

Sales Growth (b14,8) 0.225 7.05***
Inventory (b14,9) 0.374 4.55***
Loss (b14,10) 20.088 23.85***
Foreign Sales (b14,11) 20.031 21.31
Adjusted R2 (%) 43.33 47.11 49.61
Note. This table reports the estimation results of SG&A cost asymmetry model that includes an indicator for the
remediation of ICW (Remediation). Remediation equals 1 if the firm received an adverse SOX 404 opinion in the
previous year but an unqualified SOX 404 opinion in the current year, and 0 otherwise. Non-Remediation equals 1 if
the firm received an adverse SOX 404 opinion in both the previous and current years, and 0 otherwise. New ICW
equals 1 if the firm received an unqualified SOX 404 internal control audit opinion in the previous year but an
adverse SOX 404 opinion in the current year, and 0 otherwise. See the appendix for variable definitions. All
reported t values are based on standard errors adjusted for heteroskedasticity and firm and year clustering
(Petersen, 2009). SG&A = selling, general, and administrative; ICW = internal control weakness; GDP = gross
domestic product; SOX 404 = Section 404 of the Sarbanes–Oxley Act.
remediation of previously reported ICW problems accelerates the downward adjustment of

committed resources in response to sales decrease. This pre- and postremediation analysis
buttresses and enriches our results by reconfirming our cross-sectional findings in Tables 3
and 4 in a different but related setting.
Robustness Tests: Controlling for Endogeneity

To ensure that our findings are robust to the endogenous determination of internal control
quality, we employ a propensity score matching (PSM) test that addresses potential endo-
geneity that may arise from self-selection bias (Lennox et al., 2012; Tucker, 2010). We
first obtain the predicted likelihood (i.e., propensity score) of ICW incidence by estimating
a probit regression of an ICW indicator (ICW) on a set of ICW determinants identified by
Ashbaugh-Skaife et al. (2007) and Ashbaugh-Skaife, Collins, Kinney, and LaFond (2009):
firm size, firm age, the number of segments, sales growth, inventory holdings, a loss indi-
cator, a foreign sales indicator, and year and industry indicators.24 We measure all the
explanatory variables at the end of year t 2 1. Table 6, Panel A, presents the results of the
first-stage probit regression.
Using the predicted likelihood or propensity score of ICW incidence, we match each
ICW firm to a non-ICW control firm with a maximum 1% of allowable difference in pro-
pensity score.25 In doing so, we also require each ICW firm and its corresponding non-
ICW firm to operate in the same two-digit Standard Industrial Classification (SIC) industry
in each year. This PSM process controls for not only firm-level ICW determinants but also
industry-wide variation in SG&A cost asymmetry (Balakrishnan et al., 2014; Calleja,
Kim et al. 23
Table 6. Robustness Test: PSM Test.
Panel A: First-Stage Regression of ICW on Its Determinants.

Dependent variable = ICW
Predicted sign Coefficient t statistic
Constant (a0) 21.112 27.62***
Firm Size (a1) 2 20.264 214.91***
Age (a2) 2 20.073 22.01**
Segments (a3) + 0.084 1.96**
Sales Growth (a4) + 0.135 2.13**
Inventory (a5) + 0.349 1.75*
Loss (a6) + 0.711 13.37***
Foreign Sales (a7) + 0.183 3.19***
Year Dummies Yes
Industry Dummies Yes
Total observations 24,483
Likelihood ratio 6,068.82
Note. PSM = propensity score matching; ICW = internal control weakness.
Panel B: Mean Differences of the Determinants of ICW After PSM.
ICW Non-ICW
(N = 1,763) (N = 1,763) Difference (p)
Firm Size 2,502.20 2,129.30 372.90 (.30)
Age 2.68 2.68 0.00 (.76)
Segments 1.57 1.56 0.01 (.79)
Sales Growth 0.14 0.13 0.01 (.16)
Inventory 0.11 0.11 0.00 (.54)
Loss 0.40 0.37 0.03 (.19)
Foreign Sales 0.67 0.68 20.01 (.69)
Note. ICW = internal control weakness; PSM = propensity score matching.

(continued)
Steliaros, & Thomas, 2006; Subramaniam & Weidenmier, 2003). The PSM process results
in a total of 3,526 firm–year observations: 1,763 observations from ICW firms and 1,763
from non-ICW firms.
Panel B of Table 6 presents the univariate comparison between ICW firms and non-
ICW firms after PSM. In the PSM sample, none of the seven ICW determinants in the
first-stage regression exhibits a significant difference between the two groups. The results
contrast to those in Panel B of Table 2 in which five out of seven ICW determinants have
significant differences between ICW firms and non-ICW firms before PSM. Therefore, the
covariate balance test confirms the effectiveness of our PSM process.
Using this PSM sample, we reestimate Equation 3. As shown in Panel C of Table 6, the
PSM results are qualitatively identical with our main regression results reported earlier in
Table 3. Whereas the coefficient on Sales Change (b3) is significantly positive, the coeffi-
cient on DecDummy 3 Sales Change (b6) is significantly negative. More important, the
coefficient on the three-way interaction with ICW (b7) remains negative and significant.
Table 6 (continued)
Panel C: Second-Stage SG&A Cost Asymmetry Regressions With the Propensity Score–Matched
Sample.
(1) (2) (3)
Constant (b0) 0.035 2.72*** 0.021 1.46 0.049 1.90*

ICW (b1) 0.009 1.36 0.013 1.94** 0.010 1.46
GDP Growth (b2,2) 0.004 2.43** 0.004 2.50***
Employee Intensity (b2,4) 20.004 21.06 0.001 0.31
Firm Size (b2,5) 20.002 20.88
Age (b2,6) 20.006 21.18
Segments (b2,7) 0.005 0.96
Sales Growth (b2,8) 0.166 9.38***
Inventory (b2,9) 0.005 0.18
Loss (b2,10) 0.003 0.40
Foreign Sales (b2,11) 20.013 21.66*
Sales Change (b3) + 0.608 25.94*** 0.796 16.15*** 0.589 5.02***
ICW (b4) 0.011 0.35 20.017 20.52 20.005 20.16
GDP Growth (b5,2) 20.019 22.66*** 20.004 20.52
Fixed Asset Intensity (b5,3) 20.023 21.87** 20.031 22.42**
Firm Size (b5,5) 0.046 3.70***
Age (b5,6) 20.048 22.00**
Segments (b5,7) 20.064 22.50***
Sales Growth (b5,8) 20.223 25.88***
Inventory (b5,9) 20.359 23.26
Loss (b5,10) 20.016 20.50*
Foreign Sales (b5,11) 0.062 1.82***
DecDummy (b6) 2 20.329 27.70*** 20.587 27.00*** 20.541 22.48***
ICW (b7) 2 20.150 22.53*** 20.121 21.96** 20.160 22.59***
Successive Decrease (b8,1) + 0.201 3.31*** 0.119 1.86*
GDP Growth (b8,2) 2 0.019 1.64* 0.006 0.51
Fixed Asset Intensity (b8,3) 2 0.015 0.59 0.025 0.91
Firm Size (b8,5) 20.033 21.45
Age (b8,6) 0.062 1.37
Segments (b8,7) 0.119 2.35**
Sales Growth (b8,8) 0.118 0.89
(continued)
Kim et al. 25
Table 6 (continued)
(1) (2) (3)
Inventory (b8,9) 0.650 2.98***

Loss (b8,10) 20.018 20.27
Foreign Sales (b8,11) 20.130 21.89*
Adjusted R2 (%) 39.91 43.56 46.66
Note. This table shows the results of the PSM analysis. Panel A reports the first-stage probit regression of the
indicator of ICW on its determinants. Panel B compares the means of explanatory variables in the first-stage
probit regression between ICW firms and non-ICW firms after PSM. Panel C reports the second-stage SG&A cost
asymmetry regressions. All reported t values are based on standard errors adjusted for heteroskedasticity and firm
and year clustering (Petersen, 2009). See the appendix for variable definitions. PSM = propensity score matching;
SG&A = selling, general, and administrative; ICW = internal control weakness; GDP = gross domestic product.
The results from the PSM test suggest that our primary findings are unlikely to be driven
by potential endogeneity associated with the incidence of ICW problems.
Robustness Tests: Firm-Specific Measure of SG&A Cost Asymmetry

Thus far, we have estimated the degree of SG&A cost stickiness using Anderson et al.’s
(2003) asymmetric cost behavior model. To check whether our results are sensitive to the
measurement of SG&A cost stickiness, we employ the firm-specific measure of SG&A
cost asymmetry developed by Weiss (2010). Weiss defines the SG&A cost asymmetry for
firm i in quarter q (SG&A_Asymmetryi,q) as the difference in the cost function slope
between the two most recent quarters from quarter q 2 3 to quarter q, such that sales
decrease in one quarter and sales increase in the other.

DSG&A DSG&A
SG&A Asymmetryi, q = log log , u,
u 2 fq, q 1, q 2, q 3g
DSales i, u DSales i, u
where u is the most recent of the last four quarters with a decrease in sales and u is the
most recent of the last four quarters with an increase in sales. We obtain
SG&A_Asymmetryi,t by taking the mean of SG&A_Asymmetryi,q values for firm i and in
year t.26 SG&A_Asymmetryi,t is an inverse measure of firm-level SG&A cost stickiness.
That is, a lower value of SG&A_Asymmetryi,t represents a higher degree of SG&A cost
stickiness.
Table 7 shows the results for the effect of ICW on firm-specific SG&A cost asymme-
try.27 Column 1 presents the coefficient estimates from OLS regressions of
SG&A_Asymmetryi,t on ICWi,t and control variables. The coefficient on ICW (b1) is nega-
tive and significant at the 10% level. This result is consistent with our H1, suggesting that
SG&A cost stickiness is more pronounced for ICW firms than for non-ICW firms.
Table 7. Robustness Test: Firm-Specific Measure of SG&A Cost Asymmetry.
Dependent variable = Dependent variable =

Predicted SG&A_Asymmetryi,t Predicted DSG&A_Asymmetryi,t
sign (1) sign (2)
Constant (b0) 20.308* Constant (b0) 0.035

(–1.80) (1.19)
ICW (b1) 2 20.108* DICW (b1) 2 20.274***
(–1.68) (–2.81)
Successive Decrease (b2) + 0.140*** DSuccessive Decrease (b2) + 0.120
(2.59) (1.41)
GDP Growth (b3) 2 20.005 DGDP Growth (b3) 2 0.009
(–0.71) (0.73)
Fixed Asset Intensity (b4) 2 20.001 DFixed Asset Intensity (b4) 2 20.097
(–0.02) (–0.32)
Employee Intensity (b5) 2 20.007 DEmployee Intensity (b5) 2 20.424
(–0.24) (–1.36)
Firm Size (b6) 0.013 DFirm Size (b6) 20.434**
(1.20) (–2.26)
Age (b7) 0.077* DAge (b7) 20.431*
(1.84) (–1.92)
Segments (b8) 20.020 DSegments (b8) 20.099
(–0.65) (–1.23)
Sales Growth (b9) 0.202* DSales Growth (b9) 20.234
(1.82) (–0.95)
Inventory (b10) 20.458** DInventory (b10) 0.737
(–2.46) (0.64)
Loss (b11) 20.019 DLoss (b11) 20.068
(–0.29) (–0.74)
Foreign Sales (b12) 20.004 DForeign Sales (b12) 0.265*
(–0.06) (1.81)
Year Dummies Yes Year Dummies Yes
Industry Dummies Yes Industry Dummies Yes
Total observations 5,115 Total observations 2,068
Adjusted R2 (%) .10 Adjusted R2 (%) .41
Note. This table shows the relation between ICW and firm-level SG&A cost asymmetry. Column 1 reports the
regression of firm-level SG&A cost asymmetry (SG&A_Asymmetryi,t) on the indicator of ICW (ICWi,t) and control
variables. Column 2 reports the regression of the change in firm-level SG&A cost asymmetry (DSG&A_Asymmetryi,t)
on the indicator for the change of ICW (DICWi,t) and control variables. We estimate the firm-specific measure of
SG&A cost asymmetry (SG&A_Asymmetryi,t) following Weiss (2010). A lower value of SG&A_Asymmetryi,t represents
a higher degree of SG&A cost stickiness. DICWi,t equals 1 if a firm receives an unqualified SOX 404 internal control
audit opinion in year t 2 1 but an adverse SOX 404 opinion in year t, –1 if a firm receives an adverse SOX 404
opinion in year t 2 1 but an unqualified SOX 404 opinion in year t, and 0 otherwise. All other variables are as
previously defined in the appendix. All reported t values in parentheses are based on standard errors adjusted
for heteroskedasticity and firm and year clustering (Petersen, 2009). SG&A = selling, general, and administrative; ICW =
internal control weakness; GDP = gross domestic product; SOX 404 = Section 404 of the Sarbanes–Oxley Act.
Column 2 of Table 7 displays the results from OLS regressions of DSG&A_Asymmetryi,t

on DICWi,t and changes in control variables from year t 2 1 to year t. The use of the
change specification helps us alleviate concerns about potential problems arising from cor-
related omitted variables and endogeneity (Bradshaw, Bushee, & Miller, 2006). The
Kim et al. 27
coefficient on DICW (b1) is negative and highly significant at the 1% level. This result sug-
gests that the change in firm-level SG&A cost stickiness is inversely associated with the
change in internal control quality. The significant effect of the deteriorating internal control
quality on increasing the level of SG&A cost asymmetry lends further support for the view
that managers in ICW firms make less timely downward adjustment of committed
resources in response to sales decrease because they rely on poor-quality internal manage-
rial reports generated under ineffective internal controls.
Conclusion
Previous research on internal control effectiveness over financial reporting has focused
mainly on the internal control problems from the perspective of external users of account-
ing information such as investors and creditors, and has paid less attention to the economic
consequences of internal control problems from the perspective of internal users. As a
result, little is known about the impact of ICW on the cost side of business operation. Our
study attempts to fill this void by investigating the relation between a firm’s internal con-
trol quality and the extent of SG&A cost stickiness or asymmetry. We are motivated to
study the impact of ICW on managers’ resource allocation decisions in relation to SG&A
expenditures because, first, managers can exercise more discretion over SG&A costs than
other costs (e.g., cost of goods sold) in making resource commitment decisions and,
second, SG&A costs account, on average, for about 26% of total sales, and thus, are a sig-
nificant factor determining corporate earnings. To the best of our knowledge, our study is
the first to examine whether and how internal control quality is linked to the degree of
SG&A cost asymmetry.
Our results, using a sample of firms with SOX 404 disclosures, reveal the following.
First, we find that SG&A cost asymmetry is greater for ICW firms than for non-ICW
firms. ICW firms exhibit only a 0.19% decrease in SG&A costs per 1% decrease in sales
revenue, whereas non-ICW firms exhibit a 0.31% decrease in SG&A costs per 1% decrease
in sales revenue. We also find that the stickier SG&A costs in ICW firms are primarily
attributable to internal information control problems rather than to other control problems.
The above findings are in line with the view that managers in ICW firms make less timely
decisions on the adjustment of SG&A resources because they use poor-quality internal
managerial reports generated under ineffective internal controls. In addition, we find that
the effect of ICW on SG&A cost asymmetry weakens significantly after firms remediate
previously reported ICW. Our results are robust to controlling for the potential influence of
omitted variables, applying the propensity score–matched sample test, and using an alterna-
tive firm-specific measure of SG&A cost asymmetry.
In conclusion, our results suggest that internal control quality is an important factor that
determines the behavior of SG&A costs. We also document a hitherto unrecognized benefit
of SOX 404 by showing that effective internal controls and/or remediation of previously
reported ICW problems reduce the degree of SG&A cost asymmetry by facilitating timely
adjustment of committed resources. Overall, our results are consistent with the prediction
of the real options theory, in that, poor-quality internal information associated with ICW
incents managers to postpone downward adjustments of SG&A resources until the informa-
tion uncertainty is resolved to a certain extent. Given the scarcity of empirical evidence on
the relation between internal information quality and cost management efficiency from the
internal user’s perspective, we recommend further research on the issue.
Appendix Variable Definitions.
Variable Definition
ICWi,t An indicator variable that equals 1 if the auditor concludes a firm’s internal
control over financial reporting is not effective under SOX 404, and 0
otherwise. The data on SOX 404 disclosures are from the Audit Analytics
database.
ICW_Infoi,t An indicator variable that equals 1 if a firm reports ICW related to internal
information problems, and 0 otherwise.
ICW_Othersi,t An indicator variable that equals 1 if a firm does not report ICW related to
internal information problems but reports other ICW problems, and 0
otherwise.
Remediationi,t An indicator variable that equals 1 if a firm receives an adverse SOX 404
opinion in year t 2 1 but an unqualified SOX 404 opinion in year t, and 0
otherwise.
Non-Remediationi,t An indicator variable that equals 1 if a firm receives an adverse SOX 404
opinion in both year t 2 1 and year t, and 0 otherwise.
New ICWi,t An indicator variable that equals 1 if a firm receives an unqualified SOX 404
opinion in year t 2 1 but an adverse SOX 404 opinion in year t, and 0
otherwise.
SG&A_Asymmetryi,t A firm-level variable of SG&A cost asymmetry that is a mean of
SG&A_Asymmetryi,q values for firm i and in year t. SG&A_Asymmetryi,q is the
difference in the cost function slope between the two most recent quarters
from quarter q 2 3 to quarter q, such that sales decrease in one quarter and
sales increase in the other (Weiss, 2010).

SG&A Asymmetryi, q = log DSG&A
DSales i, u log DSG&A
DSales i,
u
, u,
u 2 fq, q 1, q 2, q 3g
where u is the most recent of the last four quarters with a decrease in sales
and u is the most recent of the last four quarters with an increase in sales.
SG&A_Asymmetryi,t is an inverse measure of firm-level SG&A cost stickiness.
Thus, a lower value of SG&A_Asymmetryi,t represents a higher degree of
SG&A cost stickiness.
SG&Ai,t SG&A costs in year t.
Salesi,t Sales revenue in year t.
DecDummyi,t An indicator variable that equals 1 if sales revenue in year t is less than sales
revenue in t 2 1, and 0 otherwise.
Successive Decreasei,t An indicator variable that equals 1 if sales revenue in year t21 is less than
sales revenue in t 2 2, and 0 otherwise.
GDP Growthi,t One-year percentage growth in GDPs.
Fixed Asset Intensityi,t Total property, plant, and equipment scaled by total assets.
Employee Intensityi,t Number of employees divided by sales revenue ($mil.). Following Anderson,
Banker, and Janakiraman (2003), we use the natural log of employee intensity
in all regressions.
Firm Sizei,t Natural log of total assets in year t.
Agei,t Natural log of firm age in year t.
Segmentsi,t Number of reported business segments in year t.
Sales Growthi,t One-year percentage growth rate in sales revenue from year t 2 1 to year t.
Inventoryi,t The ratio of inventory to total assets in year t.
Lossi,t An indicator variable that equals 1 if net income in year t is negative and 0
otherwise.
Foreign Salesi,t An indicator variable that equals 1 if a firm reports foreign sales in year t and 0
otherwise.
Note. SOX = Sarbanes–Oxley Act; SG&A = selling, general, and administrative; ICW = internal control weakness;
GDP = gross domestic product.
Kim et al. 29
Acknowledgment
We thank Bharat Sarath (editor); Kannan Raghunandan (associate editor); an anonymous referee; Jim
Cannon; Ivo Jansen; Kyonghee Kim; Natalia Kochetova-Kozloski; Feng Liu; Sarah McVay; Gord
Richardson; Liu Zheng; seminar participants at City University of Hong Kong, Fudan University,
Hong Kong Baptist University, Old Dominion University, University of Macau, University of
Massachusetts Boston, University of South Florida, University of Waterloo, and Xiamen University;
and conference participants at the 2012 AAA Annual Meeting, the 2012 AAA Mid-Atlantic Meeting,
the 2013 CAAA Annual Conference, and the 2013 Korean Accounting Association Summer
International Conference.
Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/
or publication of this article.
Funding
The author(s) received no financial support for the research, authorship, and/or publication of this
article.
ORCID iD
Jay Junghun Lee https://orcid.org/0000-0003-0653-0486
Notes
1. Downsizing costs or downward resource adjustment costs include costs of removing slack
resources (e.g., costs of firing employees) and restoring resources (e.g., costs of hiring and train-
ing employees) when demand bounces back.
2. Economists define investments as the act of incurring an immediate cost in the expectation of
future rewards. Dixit and Pindyck (1994) argue that
somewhat less obviously, a firm that shuts down a loss-making plant is also investing: the
payment it must make to extract itself from contractual commitments, including severance
payments to labor, are the initial expenditure, and the prospective reward is the reduction in
future losses. (p. 3)
We thus view all downward resource adjustments as investments because they involve upfront
cost commitments in the face of uncertainty to reap prospective rewards such as the reduction of
future costs (Dixit & Pindyck, 1994).
3. The uncertainty includes demand uncertainty about future sales and cost uncertainty about future
costs. Cost uncertainty also affects adjustment costs such as hiring and training costs when
demand restores.
4. Following Gallemore and Labro (2015), we define internal information quality in terms of the
accessibility, usefulness, reliability, accuracy, quantity, and signal-to-noise ratio of the data and
knowledge collected, generated, and consumed within an organization.
5. First-mover advantages can arise from various factors such as learning curve effects, customer
loyalty, patent protection, and preemption of scarce resources (Lieberman & Montgomery,
1988).
6. Two recent studies provide evidence that ineffective internal control over financial reporting has
a negative impact on firm operations. Feng, Li, McVay, and Skaife (2015) show that firms with
inventory-related internal control weaknesses (ICWs) have lower inventory turnover ratios and
higher risk of inventory impairments than non-ICW firms. Cheng, Goh, and Kim (2018) further
show that ICW firms have lower operating efficiency, derived from the frontier analysis, than
non-ICW firms. However, neither of the two studies investigates the effect of ICW on selling,
general, and administrative (SG&A) spending decisions or cost management.
7. For example, dismissing existing employees (downward adjustment) is costlier than hiring new
employees (upward adjustment). Downward adjustment costs include not only explicit costs such
as severance pay for fired workers and search and training costs for new employees who will
replace dismissed workers but also implicit costs such as a loss of morale and productivity
among remaining workers (Anderson, Banker, & Janakiraman, 2003; Banker & Byzalov, 2014).
Therefore, the cost of retaining excessive labor is often smaller than the cost of reducing labor,
especially in the case of temporary sales fall.
8. Similarly, in the cross-country setting, Calleja, Steliaros, and Thomas (2006); Banker and
Byzalov (2014); Banker et al. (2013); and Cannon, Hu, Lee, and Yang (2018) document that
firms in countries with strong shareholder (labor) protection exhibit a lower (higher) degree of
SG&A stickiness than those with weak shareholder (labor) protection.
9. Masli, Peters, Richardson, and Sanchez (2010) document improved financial reporting quality
resulting from implementation of internal control monitoring technology. Choi et al. (2013) find
that firms with greater investment in internal control personnel are less likely to report ICW.
10. We use the reason keys available in Audit Analytics to categorize ICW problems. This method
provides at least two advantages over a manual classification method. First, it improves the
objectivity and transparency of the classification scheme by removing the potential influence of
researchers’ judgment. Second, it reduces the time and cost of manual classifications not only for
this study but also for future research.
11. We do not focus on internal control problems related to SG&A expense for two related reasons.
First, following Anderson et al. (2003) and subsequent studies, we use SG&A cost asymmetry to
examine the managers’ deliberate decisions on resource adjustment in response to demand fluc-
tuation. The internal control problems related to SG&A expense are less likely to affect manag-
ers’ assessment of the permanence of the demand changes than the internal information
problems on internal reporting systems that generate the forecasts of future demand. Second,
only a small number of our sample firms report SG&A-related internal control problems and the
problems are mainly related to account-specific issues such as the recording errors in SG&A
expense. Therefore, SG&A-related problems may add measurement errors to SG&A cost asym-
metry as a proxy for managerial decisions on resource adjustment, but are less likely to influence
such managerial decisions directly.
12. For instance, in an attempt to remediate material weakness (described in Section 2), 3D Systems
Corp. disclosed in the 2006 10-K filing that
we expanded the number of ‘‘super users’’ and provided additional training for employees
who operate and interface with our ERP system, including training in placing and processing
orders, inventory accounting practices and the functions and features of our new ERP system;
created specific reports in our ERP system tailored to our business and the controls necessary
to promote accurate data entry and processing and timely compilation and reporting of our
financial records; Troubleshot our ERP system to identify any missing, incomplete, corrupt or
otherwise insufficient data necessary to properly record, process and fill orders.
This example illustrates that if a firm lacks the personnel with sufficient accounting and informa-
tion technology expertise, its internal reporting quality may be limited by incomplete accounting
records and its internal reporting system is less likely to provide timely and accurate information
for managerial decision making.
13. Note that Dlog(SG&Ai,t) = log(SG&Ai,t) 2 log(SG&Ai,t21) = log(SG&Ai,t /SG&Ai,t21).
Kim et al. 31
14. Equation 3 includes two-way interaction terms ICWi,t 3 Dlog(Salesi,t) and SControlsi,t,k 3
Dlog(Salesi,t) to capture the potential effects of ICW and control variables on SG&A spending
decisions during the sales expansion period, respectively. We further augment Equation 3 with
the main effects of ICWi,t and SControlsi,t,k to prevent interaction terms merely reflecting the
omitted main effects.
15. All our inferences are unaltered when we use two-digit primary Standard Industrial
Classification (SIC) codes as an alternative industry classification.
16. We perform two additional tests to examine the potential effect of extreme observations. First,
we estimate Cook’s (1977) distance in all regressions and confirm that there is no remaining out-
lier in our winsorized sample. Second, we estimate quantile regressions, which are robust to the
influence of outliers, and find that our results remain qualitatively similar.
17. As shown in Table 1, Panel A, 598 unique firms report ICW at least once during our sample
period and 3,586 unique firms do not report any ICW for the same period. When we classify
firm–year observations, we allow a firm to move between ICW firm–years and non-ICW firm–
years over time.
18. Our results are robust when we exclude firms in the utilities and financial industries (SIC 4000-
4949 and 6000-6999, respectively).
19. Annual sales revenue decreased for two consecutive years for 11.4% of the observations includ-
ing 12.2% of ICW firms and 11.3% of non-ICW firms (i.e., DecDummyi,t = 1 and Successive
Decreasei,t = 1).
20. Alternatively, a higher ratio of SG&A costs to sales revenue in ICW firms may reflect the differ-
ence in cost structure between ICW firms and non-ICW firms. We purge the potential effect of
cost structure by controlling for fixed asset intensity, employee intensity, industry fixed effects,
and various economic determinants of ICW in our tests.
21. The insignificant coefficient on ICW 3 Sales Change (b4) is consistent with our argument that
first-mover advantages in the product market weaken managerial incentives to delay their deci-
sions to add resources in the presence of information uncertainty.
22. The coefficients on the three-way interaction terms with GDP Growth and Fixed Asset
Intensity are insignificant because our regression Equation 3 also includes the main effects of
those control variables and their two-way interaction terms. When we drop the main and two-
way interaction terms of control variables to make the regression model consistent with those
in Anderson et al. (2003) and Chen, Lu, and Sougiannis (2012), we find that the coefficients
on the three-way interaction variables with GDP Growth and Fixed Asset Intensity become sig-
nificantly negative.
23. Alternatively, we perform the Fama–MacBeth regressions in which we estimate the mean coeffi-
cients and t statistics based on the standard errors of annual coefficients. Our inferences are
unchanged in the Fama–MacBeth regressions.
24. Table 2 includes the descriptive statistics for the ICW determinants. Variable definitions are
detailed in the appendix.
25. Our results are robust to applying 0.1% of allowable difference in propensity score.
26. Because Weiss (2010) defines SG&A_Asymmetryi,q in each quarter, we annualize it to obtain our
firm-specific SG&A cost asymmetry measure, SG&A_Asymmetryi,t. The results in Table 7 are
robust when we use the median of SG&A_Asymmetryi,q values to define SG&A_Asymmetryi,t.
27. The sample size decreases substantially to 5,115 observations in column 1 of Table 7 because
the measurement of firm-level SG&A_Asymmetryi,t requires sales revenues and SG&A expenses
over the past four quarters including both sales-increase and sales-decrease quarters. The sample
size drops further to 2,068 observations in column 2 because the change variable
DSG&A_Asymmetryi,t requires nonmissing values of SG&A_Asymmetry for two consecutive
years.
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Internal Control Weakness and The Asymmetrical Behavior of Selling, General, and Administrative Costs

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and Administrative Costs

Jeong-Bon Kim1, Jay Junghun Lee2 , and Jong Chool Park3

decisions to adjust SG&A costs downward in response to sales decrease. Moreover, we

DlogðSG&Ai, t Þ = a0 + a1 DlogðSalesi, t Þ + a2 DecDummyi, t 3DlogðSalesi, t Þ + ei, t ð1Þ

DlogðSG&Ai, t Þ = b0 + b1 ICWi, t + b2, k SControlsi, t, k + b3 DlogðSalesi, t Þ

DlogðSG&Ai, t Þ = b0 + b1 ICW Infoi, t + b2 ICW Othersi, t + b3, k SControlsi, t, k

Sample and Data

Table 1. Sample Distribution.

Panel A: Sample Distribution by the Type of ICW.

Note. ICW = internal control weakness.

Panel B: Sample Distribution by Industry.

Sample with ineffective Sample with effective

Fama–French industry Number Percent Number Percent Number Percent

Table 2. Descriptive Statistics.

Panel A: Summary Statistics for the Full Sample (N = 24,483).

Panel B: Summary Statistics for Subsamples Partitioned by ICW.

Full sample Sample with ICW

Variable Mean Mean Mean Mean

Table 3. ICW and SG&A Cost Asymmetry.

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Constant (b0) 0.029 5.30*** 20.001 20.21 0.044 3.78***

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Loss (b8,10) 20.093 22.73***

Characteristics of ICW and SG&A Cost Asymmetry

Table 4. Internal Information Control Problems and SG&A Cost Asymmetry.

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Constant (b0) 0.029 5.32*** 20.002 20.30 0.043 3.80***

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Loss (b11,10) 20.106 23.32***

Remediation of ICW and SG&A Cost Asymmetry

DlogðSG&Ai, t Þ = b0 + b1 Remediationi, t + b2 Non-Remediationi, t + b3 New ICWi, t

Table 5. Remediation of ICW and SG&A Cost Asymmetry.

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Constant (b0) 0.027 6.23*** 20.001 20.33 0.043 5.70***

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Segments (b14,7) 0.034 1.98**

remediation of previously reported ICW problems accelerates the downward adjustment of

Robustness Tests: Controlling for Endogeneity

Table 6. Robustness Test: PSM Test.

Panel A: First-Stage Regression of ICW on Its Determinants.

Note. PSM = propensity score matching; ICW = internal control weakness.

Panel B: Mean Differences of the Determinants of ICW After PSM.

Note. ICW = internal control weakness; PSM = propensity score matching.

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Predicted sign Coefficient t statistic Coefficient t statistic Coefficient t statistic

Constant (b0) 0.035 2.72*** 0.021 1.46 0.049 1.90*

Dependent variable = Dlog(SG&Ai,t)

(1) (2) (3)

Constant (b0) 0.029 5.30* 20.001 20.21 0.044 3.78*

Constant (b0) 0.029 5.32* 20.002 20.30 0.043 3.80*

Constant (b0) 0.027 6.23* 20.001 20.33 0.043 5.70*