Earnings Management and Instances of Material Weaknesses Reported Under Sections 302 and 404

Abstract

Sections 302 and 404 of the 2002 Sarbanes-Oxley Act require firms to disclose material weaknesses (MWs) in internal controls. We investigate the association of single and multiple instances of MWs with earnings management. Multiple instances are positively associated with earnings management for Section 302 and 404 firms, whereas single instances have no such association for either firm type. Thus, MWs that are not remediated within one quarter or year tend to be positively associated with earnings management and, in particular, with income- decreasing earnings management. Multiple instances of MWs for such firms can therefore provide critical information for auditors and investors.

Keywords: Internal control weakness, material weakness, earnings management, Sarbanes-Oxley Act, multiple disclosures

JEL Classification: G30, G39, M41, M42, M49