Internal Control Weaknesses and Financial Reporting Fraud

• In Event: Fraud

Abstract

This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. Since top managers can override controls, there is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. In fact, prior work suggests that control weaknesses are linked to lower quality accruals associated with errors, not intentional manipulation. We find a strong association between material weaknesses and future fraud revelation. We theorize this link could be attributable to weak controls a) giving managers greater opportunity to commit fraud or b) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support consistent with weak controls giving managers the opportunity to commit fraud through entity- not process-level controls. This supports the PCAOB’s assertion that entity-level controls reduce the risk of fraud and management override of controls.

Authors

• Dain C. Donelson, The University of Texas at Austin

• Matthew Stephen Ege, University of Florida

• John M. McInnis, The University of Texas at Austin