Internal Control Weaknesses and Financial Reporting Fraud

Posted: 14 Jun 2014 Last revised: 30 Sep 2016

See all articles by Dain C. Donelson

Dain C. Donelson

University of Texas at Austin - Red McCombs School of Business

Matthew Ege

Texas A&M University - Department of Accounting

John M. McInnis

University of Texas at Austin - Department of Accounting

Date Written: September 1, 2016

Abstract

This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. There is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. Further, there is no evidence on the mechanism linking control strength to fraud risk. We find a strong association between material weaknesses and future fraud revelation. We theorize this link could be attributable to weak controls a) giving managers greater opportunity to commit fraud or b) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support for the opportunity explanation, but not through specific accounts linked to control weaknesses. Instead, consistent with the PCAOB’s assertion, weaknesses in entity-wide controls, not process-level controls, are associated with a higher risk of reporting fraud.

Keywords: internal control weaknesses, Sarbanes-Oxley Act (SOX), fraud, PCAOB

JEL Classification: M41

Suggested Citation

Donelson, Dain C. and Ege, Matthew and McInnis, John M., Internal Control Weaknesses and Financial Reporting Fraud (September 1, 2016). Auditing: A Journal of Practice & Theory, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2449287 or http://dx.doi.org/10.2139/ssrn.2449287

Dain C. Donelson

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States
512-232-3733 (Phone)

Matthew Ege (Contact Author)

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States

John M. McInnis

University of Texas at Austin - Department of Accounting ( email )

Austin, TX 78712
United States
512-232-6791 (Phone)

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