Auditor’s Industry Specialization and Earnings Management of Firms Reporting Internal Control Weaknesses Under SOX Section 404

Abstract

Prior studies document that firms having material weaknesses in internal control over financial reporting adjust more discretionary accruals in financial reporting process than other firms. This study examines the influence of industry-specialist audits on accrual management behavior of firms whose internal control is reported as ineffective by their external auditors pursuant to SOX Section 404. Previous research further shows that specialist auditors have greater industry-specific knowledge and expertise, and are more familiar with clients’ business. They constrain management’s propensity to misreport earnings and other financial information. In this study, we include auditor industry specialization as a proxy for the mitigating force on earnings management in an economic setting where incentive to manage earnings is deemed to be at an elevated level. The test results suggest that though firms with ineffective internal control (ICW) manage discretionary accruals at a greater level than firms with effective internal control (non-ICW), specialist auditors influence accrual management decision of the ICW firms and reduce the level of discretionary accrual adjustments. As a result, industry-specialist audits also substantially attenuate the difference in accrual management between ICW and non-ICW firms. We find consistent results for both the absolute and signed discretionary accruals for the sample ICW and non-ICW firms. Moreover, the supplemental tests for a sample of constant ICW and non-ICW firms produce similar results. Finally, our main results also hold for a reduced sample of the Big 4 client companies.

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Keywords: Discretionary accruals, internal control ineffectiveness/weakness, SOX Section 404, auditor’s industry specialization, earnings quality, Big 4 clients

JEL Classification: M41, M42