Sarbanes Oxley Internal Control Requirements and Earnings Quality

Abstract

This study investigates whether the internal control requirements of Section 302 and Section 404 of the Sarbanes-Oxley Act of 2002 are related to improved earnings quality. Using unexpected total and current accruals as measures of earnings quality, I test the association of internal control weaknesses disclosed under both sections and unexpected accruals for the disclosure year. I find level that the absolute level of unexpected accruals increases in the year internal control weaknesses are disclosed. This is consistent with an increase in earnings quality and suggests that in the internal control weaknesses disclosure year, management reverses, voluntarily or at the auditor's request, prior accruals that were too large. Comparing Sections 302 and 404 disclosures, I find that the magnitude of unexpected accruals is larger for Section 302 disclosures, implying that the nature and significance of the problems might more severe for Section 302 disclosures. For companies reporting an effective internal control in their Section 404 report, I find a decrease in the magnitude of unexpected accruals in the year of their first report. This result suggests that because of Section 404 formal internal control assessment process, firms improved their internal control and/or auditor increased their audit effort, resulting in management booking smaller accruals for events and transactions occurring in that year. Overall, my results suggest that the Sarbanes-Oxley Act internal control requirements resulted in an improved earnings quality.

Keywords: Internal controls, Unexpected accruals, Earnings quality, Auditing, Sarbanes-Oxley Act

JEL Classification: M49, M41, M43, M45, G34, K22, G18, G38