Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections

Contemporary Accounting Research, 2018

Posted: 19 Apr 2018

See all articles by Shijun Cheng

Shijun Cheng

Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University

Robert Felix

Catholic University of America (CUA) - Busch School of Business and Economics

Raffi Indjejikian

University of Michigan at Ann Arbor - Accounting

Date Written: April 2, 2018

Abstract

We find that firms are less likely to report an internal control material weakness (as mandated by the Sarbanes-Oxley Act) in a given year if one of their audit committee members is concurrently on the board of a firm that disclosed a material weakness within the prior three years. We find a similar spillover effect for financial restatement disclosures. The spillover from material weakness disclosures is evident only if a shared director has more experience with the disclosing firm or can channel more information about the disclosed material weakness. Our findings suggest that prior director experiences outside the firm influence the work of audit committees inside the firm. One rationale is that a director’s prior experience with an adverse disclosure helps diffuse important insights and serves as a catalyst for improvements in a firm’s internal control and financial reporting practices. An alternative explanation, which we cannot dismiss, holds that a director’s prior experience helps a firm to under-report material weaknesses and financial restatements without any attendant improvements in the underlying practices.

Keywords: Board Interlock, Audit Committee, Internal Controls, Material Weakness, Spillover, SOX

JEL Classification: G34, G39, M41, M49

Suggested Citation

Cheng, Shijun and Felix, Robert and Indjejikian, Raffi J., Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections (April 2, 2018). Contemporary Accounting Research, 2018, Available at SSRN: https://ssrn.com/abstract=3154534

Shijun Cheng

Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University ( email )

211 West Huaihai Road
Shanghai, 200030
China

Robert Felix (Contact Author)

Catholic University of America (CUA) - Busch School of Business and Economics ( email )

620 Michigan Avenue, NE
Washington, DC 20064
United States

Raffi J. Indjejikian

University of Michigan at Ann Arbor - Accounting ( email )

701 Tappan Street
Ann Arbor, MI 48109-1234
United States

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