The Timing of Internal Control Weaknesses and Financial Reporting Quality

Abstract

This study investigates how prior- and current-period internal control quality signal financial reporting quality. Consistent with prior research, we find that firms with internal control weaknesses (ICWs) have higher misstatement risk. However, the level of misstatement risk depends on ICW timing. Specifically, firms with repeat ICWs have lower misstatement risk than firms with first-time ICWs, and firms with repeat ICWs that spillover from the prior-annual to current-quarterly periods drive these findings. For firms that remediate prior-period ICWs, those with current-quarter ICWs have higher misstatement risk than firms without prior-period ICWs, but firms with prior-annual ICWs have similar misstatement risk to firms without prior-period ICWs. Taken together, our study indicates that the time-series relation between ICWs and misstatements is more nuanced than suggested by the academic literature.

Keywords: internal control weaknesses, restatements, internal control weakness remediation, financial reporting quality

JEL Classification: M41, M42, M48