Earnings Management of Firms Reporting Material Internal Control Weaknesses Under Section 404 of the Sarbanes-Oxley Act

35 Pages Posted: 26 Dec 2007

See all articles by Kam C. Chan

Kam C. Chan

Pace University

Barbara R. Farrell

Pace University - Lubin School of Business

Picheng Lee

Pace University - Department of Accounting

Abstract

The main objectives of the Sarbanes-Oxley Act of 2002 are to improve the accuracy and reliability of corporate disclosure. Under Section 404 of the Sarbanes-Oxley Act, the external auditor has to report an assessment of the firm's internal controls and attest to management's assessment of those firm's internal controls. Material weaknesses in internal controls must be disclosed in the auditor and management reports. The objective of this study is to examine if firms reporting material internal control weaknesses under Section 404 have more earnings management compared to other firms. The results provide mild evidence that there are more positive and absolute discretionary accruals for firms reporting material internal control weaknesses than for other firms. Since the findings of ineffective internal controls by auditors under Section 404 may cause firms to improve their internal controls, Section 404 has the potential benefits of reducing the opportunity of intentional and unintentional accounting errors and of improving the quality of reported earnings.

Keywords: earnings management, internal control weakness, Sarbanes-Oxley, Section 404

JEL Classification: G34, M41, M45, M49, G38

Suggested Citation

Chan, Kam C. and Farrell, Barbara R. and Lee, Picheng, Earnings Management of Firms Reporting Material Internal Control Weaknesses Under Section 404 of the Sarbanes-Oxley Act. Auditing: A Journal of Practice & Theory, Forthcoming; Pace University Accounting Research Paper No. 2007/05. Available at SSRN: https://ssrn.com/abstract=1078522

Kam C. Chan (Contact Author)

Pace University ( email )

Lubin School of Business
Pleasantville, NY 10570
United States

Barbara R. Farrell

Pace University - Lubin School of Business ( email )

861 Bedford Road
Goldstein Center
Pleasantville, NY 10570
United States

Picheng Lee

Pace University - Department of Accounting ( email )

1 Pace Plaza
New York, NY 10038-1502
United States

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