Dynamics of Deterioration in Internal Control Reported under SOX 404

41 Pages Posted: 9 Mar 2019

See all articles by Chunhua Chen

Chunhua Chen

Shanghai Lixin University of Accounting and Finance

Tianze Li

University of Manitoba - Department of Accounting and Finance

Ruiqing Shao

Shanghai Lixin University of Commerce

Steven Xiaofan Zheng

University of Manitoba - Asper School of Business

Date Written: December 8, 2018

Abstract

We examine why many firms disclose internal control weaknesses (ICW) under section 404 of Sarbanes-Oxley Act after previously reporting effective internal control (IC). We find that about half of the cross-sectional ICW determinant variables either do not change significantly from Year T-1 to Year T or change in a direction that is not expected to cause IC deterioration. The reported deterioration in IC can be attributed to increases in audit fee, management turnover, restatement, financial distress, firm size, and decrease in financial activities. Consistent with an agency hypothesis that managers try to manipulate the IC process when firm performance declines, the reported deterioration in IC is also associated with poor stock returns in the year before disclosure. ICW disclosure is more likely when poor stock return is combined with higher sensitivity of executive compensation to stock price change.

Keywords: Sarbanes-Oxley Act; Internal Control Weakness; Deterioration; Restatement; Agency Problem; Benchmark Adjusted Returns; Executive Compensation

JEL Classification: G12, G14, G30

Suggested Citation

Chen, Chunhua and Li, Tianze and Shao, Ruiqing and Zheng, Steven Xiaofan, Dynamics of Deterioration in Internal Control Reported under SOX 404 (December 8, 2018). International Review of Economics & Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3337042

Chunhua Chen (Contact Author)

Shanghai Lixin University of Accounting and Finance ( email )

Tianze Li

University of Manitoba - Department of Accounting and Finance ( email )

Faculty of Management
Winnipeg, MB R3T 5V4
Canada

Ruiqing Shao

Shanghai Lixin University of Commerce ( email )

2800 Wenxiang Road
Shanghai
China

Steven Xiaofan Zheng

University of Manitoba - Asper School of Business ( email )

Department of Accounting and Finance
Winnipeg, Manitoba R3T 5V4
Canada
204-474-7933 (Phone)

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