Relationship between Management Ownership and Probability of Material Weakness: An Investigation of Incentive and Entrenchment Effects.

• In Event: Equity Incentive, Financial Reporting, and Fair Value Accounting

Abstract

The purpose of this study is to examine whether the percentage of managerial shareholdings affect the probability of material weakness and if so, do we see the difference in the behaviors of accelerated and non-accelerated filers, using incentive and entrenchment aspects of agency theory. We use probability of material weakness as a proxy for agency costs. We further examine if the higher probability of material weakness translates into earnings management. The logit regression analysis with a fixed firm effect indicates that a relationship exists between management ownership and the probability of material weakness. The results mostly do not support the theoretical predictions. For all SOX 302 filers, all SOX 302 accelerated filers, and SOX 404 filers, we find that probability of material weakness increases as the managerial shareholdings equal or are greater than 25%, that is, in the large shareholding area. Agency costs, as proxied by probability of material weakness, increase after the management is fully entrenched. In case of SOX 302 non-accelerated filers, the results partially support the incentive effect and contradict the entrenchment effect predictions. The probability of material weakness decreases in the medium ownership areas (as incentive effect predicts) but increases in small and large ownership areas. The entrenchment effect predictions are not supported in any region for our sample. The results for the earnings management indicate that if managerial shareholdings are below 5% then the those are negatively correlated with the earnings management. This result does not support incentive effects. The policy implications for the auditors are also discussed.

Authors

• Shin Hyoung Kwon, Penn State University - Erie

• Ashutosh V Deshmukh, Penn State University - Erie