Internal Control Weaknesses and Evidence of Real Earnings Management

• In Event: Auditing I

Abstract

We examine the extent to which U.S. public firms that file internal control weakness reports with the Securities and Exchange Commission, as part of Section 404 of the Sarbanes-Oxley Act (SOX), exhibit higher levels of real activities management, compared to firms that do not file such reports. Section 404 of SOX requires that firms maintain adequate internal controls and that firm auditors provide an assessment of the internal controls that reveal relevant material control weaknesses. One of the consequences of the SOX Act is a perceived higher level of quality financial reporting which ultimately maps into a reduction in information risk. Using firm-level data for the period 2004-2010, we examine whether firms with internal control weaknesses exhibit evidence of real activities management. Our results indicate that firms with internal control weaknesses are prone to use real activities manipulation, beyond discretionary accruals, as a form of earnings management.

Authors

• Mary Jane Lenard, Meredith College

• Karin Ann Petruska, Youngstown State University

• Pervaiz Alam, Kent State University

• Bing Yu, Meredith College