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Abstract:
We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to audit around. We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

earnings quality, accruals quality, internal control, material weaknesses

Abstract:
We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to "audit around." We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

Accruals quality, earnings quality, internal control

Abstract:
We examine determinants of weaknesses in internal control for 779 firms disclosing material weaknesses from August 2002 to August 2005. We find that these firms tend to be smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. Firms with more serious entity-wide control problems are smaller, younger and weaker financially, while firms with less severe, account-specific problems are healthy financially but have complex, diversified, and rapidly changing operations. Finally, we find that the determinants also vary based on the specific reason for the material weakness, consistent with each firm facing their own unique set of internal control challenges.

Internal Control, Material Weakness, Sarbanes-Oxley

Abstract:
We examine determinants of internal control deficiencies using a sample of 779 firms disclosing material weaknesses from August 2002 to August 2005. We find that material weaknesses in internal control are more likely for firms that are smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. We next investigate whether these determinants differ based on whether the problem is at the transaction-level or is a more serious company-level problem. We find that firms with more serious entity-wide control problems are smaller, younger and weaker financially, while firms with account-specific problems tend to be healthy financially, but have complex, diversified, and rapidly changing operations. We also provide evidence that the determinants vary based on the specific reason for the material weakness. For example, firm size and age are strong determinants of staffing issues, consistent with each firm facing their own unique set of internal control challenges.

Internal Control; Material Weakness; Sarbanes-Oxley

Abstract:
This paper presents a sales forecasting model and tests the model on a sample of firms in the retail industry. The model distinguishes between sales growth due to an increase in the number of sales-generating units (e.g. opening new stores) and growth due to an increase in the sales rate at the existing units (e.g. the comparable store growth rate). The model accommodates different trends in the sales rates, allowing new stores to earn more or less than existing stores, perhaps because new stores are different sizes than existing stores or may take either a long time to reach maturity or alternatively enjoy an early "fad" status. We show how to use the historical series of sales, stores and comparable store growth rates to estimate the sales rates on new stores and on existing stores. The model uses only a few years of firm-specific, publicly available information, yet generates in-sample forecast errors of less than two percent of sales, generates out-of-sample forecast errors that are comparable to analyst revenue forecasts, and when used with analyst forecasts, adds significant incremental information.

Revenue, forecasting, retail, financial statement analysis

Abstract:
We examine the relation between internal control quality and the accuracy of management guidance. Consistent with managers in firms with ineffective internal controls relying on erroneous internal management reports when forming guidance, we document less accurate guidance among firms reporting ineffective internal controls. This relation extends to a change analysis, and the impact of ineffective internal controls on forecast accuracy is three times larger when the weakness relates to revenues or cost of goods sold — inputs particularly relevant to forecasting earnings. We conclude that internal control quality has an economically significant effect on internal management reports and thus decisions based on these figures.

Management Guidance, Management Forecast Accuracy, Internal Control over Financial Reporting

Abstract:
Quantifying managerial ability is an essential component in the consideration of many important research questions, such as those examining investment choice, executive compensation, and corporate governance. To date, researchers have used ad hoc and noisy ability proxies, such as stock price performance and media mentions. We develop a comprehensive managerial efficiency score and show that this measure is significantly associated with important attributes of managerial talent, such as stock price performance, executive compensation and investment opportunities, but outperforms these measures in explaining stock price reactions to managerial turnovers, where the price reactions reflect the market’s assessment of the outgoing manager’s ability. Such a measure opens the door to an abundance of previously difficult-to-pursue research questions. For example, we illustrate the use of our measure in the setting of the implications of equity financing. We document that the negative association with future abnormal returns documented in prior research is mitigated by managerial ability.

Managerial ability, data envelopment analysis

Abstract:
We empirically examine the effects of intensified scrutiny over non-GAAP reporting on the quality of non-GAAP earnings exclusions. We find that, on average, exclusions are of higher quality (i.e., more transitory) following intervention by the Securities and Exchange Commission (SEC) into non-GAAP reporting. We further find that firms that stopped releasing non-GAAP earnings numbers after the SEC intervention had lower quality exclusions in the pre-intervention period. These results are consistent with the SEC's objectives of improving the quality of non-GAAP earnings figures. However, when we decompose total exclusions into special items and other exclusions, we find evidence that the quality of special items has decreased in the post-intervention period, which suggests that managers adapted to the new disclosure environment by shifting more recurring expenses into special items. This suggests that there may be unintended consequences arising from the heightened scrutiny over non-GAAP reporting.

Non-GAAP Earnings, Street Earnings, Pro Forma Earnings, Regulation G, Sarbanes-Oxley

Abstract:
We empirically examine the effects of intensified scrutiny over non-GAAP reporting on the quality of non-GAAP earnings exclusions. We find that, on average, exclusions are of higher quality (i.e., more transitory) following intervention by the Securities and Exchange Commission (SEC) into non-GAAP reporting. We further find that firms that stopped releasing non-GAAP earnings numbers after the SEC intervention had lower quality exclusions in the pre-intervention period. These results are consistent with the SEC's objectives of improving the quality of non-GAAP earnings figures. However, when we decompose total exclusions into special items and other exclusions, we find evidence that the quality of special items has decreased in the post-intervention period, which suggests that managers adapted to the new disclosure environment by shifting more recurring expenses into special items. This suggests that there may be unintended consequences arising from the heightened scrutiny over non-GAAP reporting.

Non-GAAP Earnings, Street Earnings, Pro Forma Earnings, Regulation G, Sarbanes-Oxley

Abstract:
We conduct a comprehensive analysis of the possible misuses of special items. In addition to including unusual or infrequent charges in special items, managers can also misclassify future core expenses (e.g., depreciation expense as an asset write-off), current core expenses (e.g., everyday severance fees as restructuring), or past core expenses (e.g., unrecognized bad debt expense as an asset write-off) as "special." We first document evidence consistent with each of these earnings management mechanisms, individually and jointly, and then partition special items into low and high quality based on whether they appear to be due to the shifting of core expenses from the past, present and/or future. We find that once we partition special items by their relative quality, high quality special items are not associated with future cash flows, while low quality special items are, at times, associated with negative future cash flows.

Special items, earnings quality, managerial opportunism, future operating performance

Abstract:
We examine the association between board independence and the characteristics of Street Earnings. Our findings suggest that companies with less independent boards are more likely to exclude recurring items from Street Earnings. Specifically, we find exclusions from Street Earnings have a greater association with future earnings and cash flows when boards contain proportionally fewer independent directors. We also find analysts act as intermediaries; they are more likely to reinstate earnings components excluded by managers with less independent boards. Consistent with the association between board independence and the permanence of Street Exclusions reflecting opportunism rather than the economics of the firm, we find that the association declines following Regulation G, and that managers appear to use exclusions to meet earnings targets prior to selling their shares more often in firms with fewer independent board members. Overall, our results suggest that board independence is positively associated with the quality of Street Earnings.

Street Earnings, Board Independence, Voluntary Disclosure, Earnings Quality

Abstract:
We examine the economic consequences of changes in the financial statement presentation of discontinued operations. Recent reporting requirements under SFAS 144 broadened the classification of discontinued operations beyond the divestiture of lines of business to include divestitures that can be distinguished operationally and for financial reporting purposes from the company's ongoing operations. We document a significant increase in the frequency of discontinued operations following the rule change, and find that discontinued operations are less associated with economic factors in the post SFAS 144 period. We then show that the persistence of income from discontinued operations increases dramatically, while the persistence of continuing income is essentially unchanged. In contrast to the FASB's intention of SFAS 144 resulting in the classification of more homogenous transactions within discontinued operations, our results suggest that the broader scope of the rule has resulted in transactions being classified as discontinued operations that would be better characterized as income from continuing operations. Our findings illustrate the importance of financial statement presentation on the properties of earnings. We conclude that the change in the presentation of discontinued operations had the unanticipated result of lowering the quality of earnings from continuing operations.

Discontinued operations, financial reporting, SFAS 144

Abstract:
In McVay (2006), I present evidence of managers classifying core operating expenses as special, in the year of the special item, to increase core earnings (which is the focus of both investors and analysts). The analysis requires a model of expected core earnings, and I discuss the limitations of this model at length in the original paper. Barua and Cready (2008) build upon these stated limitations and claim that the evidence of classification shifting is a byproduct of the expectations model. In this reply, I argue against this claim. I first present evidence of classification shifting for a subset of firms without using a model of expected core earnings. I next critique each of the authors' empirical tests, and then replicate their main analysis and show that their results are not consistent with model bias. I conclude my reply by summarizing the improvements to the classification shifting model made by subsequent researchers.

Classification Shifting, Model Bias

Abstract:
We examine the relation between internal control quality and the accuracy of management guidance. Consistent with managers in firms with ineffective internal controls relying on erroneous internal management reports when forming guidance, we document less accurate guidance among firms reporting ineffective internal controls. This relation extends to a change analysis, and the impact of ineffective internal controls on forecast accuracy is three times larger when the weakness relates to revenues or cost of goods sold - inputs particularly relevant to forecasting earnings. We conclude that internal control quality has an economically significant effect on internal management reports and thus decisions based on these figures.

Management Guidance, Management Forecast Accuracy, Internal Control over Financial Reporting

Abstract:
We examine stock sales as a managerial incentive to help explain the discontinuity around the analyst forecast benchmark. We find that the likelihood of just meeting versus just missing the analyst forecast is strongly associated with subsequent managerial stock sales. Moreover, we provide evidence that managers manage earnings prior to just meeting the threshold and selling their shares. Finally, the relation between just meeting and subsequently selling shares does not hold for non-manager insiders, who arguably cannot affect the earnings outcome, and is weaker in the presence of an independent board, suggesting that good corporate governance mitigates this strategic behavior.

analyst forecasts, earnings, managerial compensation, insider trading, corporate governance

Abstract:
This paper examines the classification of items within the income statement as an earnings management tool. Evidence is consistent with managers opportunistically shifting expenses from core expenses (cost of goods sold and selling, general, and administrative expenses) to special items. This vertical movement of expenses does not change bottom-line earnings, but overstates core earnings. In addition, it appears that managers use this earnings management tool to meet the analyst forecast earnings benchmark, as special items tend to be excluded from both pro forma and analyst earnings definitions.

Earnings Management, Earnings Components, Special Items, Analyst Forecasts

Abstract:
This paper focuses on a sample of 261 companies that have disclosed at least one material weakness in internal control in their SEC filings after the effective date of the Sarbanes-Oxley Act of 2002. Based on the descriptive material weakness disclosures provided by management, we find that poor internal control is usually related to an insufficient commitment of resources for accounting controls. Material weaknesses in internal control tend to be related to deficient revenue recognition policies, lack of segregation of duties, deficiencies in the period-end reporting process and accounting policies, and inappropriate account reconciliation. The most common account-specific material weaknesses occur in the current accrual accounts, such as the accounts receivable and inventory accounts. Material weakness disclosures by management also frequently describe internal control problems in complex accounts, such as the derivative and income tax accounts. In our statistical analysis, we find that disclosing a material weakness is positively associated with business complexity (e.g., multiple segments and foreign currency), negatively associated with firm size (e.g., market capitalization), and negatively associated with firm profitability (e.g., return on assets).

internal control, material weakness, Sarbanes-Oxley