Why Did Management and Auditors Fail to Identify Ineffective Internal Controls in Their Initial SOX 404 Reviews?

Review of Accounting and Finance, Vol. 7, No. 4, pp. 338-354, 2008

Pace University Accounting Research Paper No. 2007/01

Posted: 11 Jan 2007 Last revised: 4 Sep 2019

See all articles by Kam C. Chan

Kam C. Chan

Pace University

Picheng Lee

Pace University - Department of Accounting

Gim-Seong Seow

University of Connecticut - Department of Accounting

Date Written: January 9, 2007

Abstract

With the current debate focusing on providing relief to firms subject to Section 404 of Sarbanes-Oxley Act, the SEC and the PCAOB are jointly developing regulatory and auditing guidelines to simplify and increase the efficiency of the Section 404 review process. To shed light on this ongoing debate, this study examines the economic factors that affect a firms' probability to amend their initial internal control report from effective internal controls to one with internal control weaknesses. For fiscal year 2004, 400 sample firms reported that they have ineffective internal controls under Section 404. Of the 400 firms, 56 firms have previously reported that they have effective internal controls per Section 404, but subsequently filed amendments to their initial reports. In effect, these 56 firms disclose that they have internal control weaknesses that were not detected earlier. Using logistic regression on the sample firms, the empirical results show that firm size, the use of a Big 4 auditor, and the ratio of nonaudit to total fees, are positively associated, while the number of internal control weaknesses reported and the number of audit committee meetings are negatively associated with the probability to file an amended internal control report. Our results suggest that operational complexity, the auditor-client relationship, the extent of internal control weaknesses, and audit committee activities influence the likelihood for a firm to file such amendments.

Keywords: Sarbanes-Oxley Act, Section 404, Internal control weaknesses, Audit committee

JEL Classification: G34, G38, M41, M49

Suggested Citation

Chan, Kam C. and Lee, Picheng and Seow, Gim-Seong, Why Did Management and Auditors Fail to Identify Ineffective Internal Controls in Their Initial SOX 404 Reviews? (January 9, 2007). Review of Accounting and Finance, Vol. 7, No. 4, pp. 338-354, 2008 ; Pace University Accounting Research Paper No. 2007/01. Available at SSRN: https://ssrn.com/abstract=956178

Kam C. Chan (Contact Author)

Pace University ( email )

Lubin School of Business
Pleasantville, NY 10570
United States

Picheng Lee

Pace University - Department of Accounting ( email )

1 Pace Plaza
New York, NY 10038-1502
United States

Gim-Seong Seow

University of Connecticut - Department of Accounting ( email )

School of Business
Storrs, CT 06269-2041
United States
203-486-3019 (Phone)
203-486-4838 (Fax)

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