Fair Value Measurements and Material Weaknesses: A Root Cause Analysis

• In Event: Continental Breakfast - Research and Education Forum
  In Roundtable Session: Table 1: Internal Controls over Financial Reporting

Abstract

U.S. and international regulators and standard setters have recently criticized companies and audit firms alike for failing to appropriately establish and audit internal controls over volatile fair value measurements (FVMs), calling for a root cause analysis of FVM-related inspection deficiencies. In this study, we examine the extent to which the uncertainty underlying FVMs impacts the likelihood of reporting a material control weakness, as well as settings in which this relation may be reduced. Using observations from 2008-2012, we find that companies with FVM portfolios more heavily concentrated in Level 2 and Level 3 FVMs are significantly more likely to report material weaknesses. More importantly, we find that this relation is not present in larger companies, those audited by industry expert audit firms, or those audited by FVM-specific expert audit firms. Further, larger companies audited by an industry expert audit firm have a lower likelihood of reporting a material weakness as FVM portfolios are more concentrated in Level 2 FVMs. These results suggest that despite the inherent uncertainty of Level 2 and Level 3 FVMs, and in contrast to concerns voiced in recent research, company- and auditor-specific characteristics can significantly impact companies’ abilities to create an effective internal control structure around FVMs.

Authors

• Nathan Hatch Cannon, Texas State University - San Marcos

• Brant Erich Christensen, Texas A&M University

• Thomas C. Omer, University of Nebraska–Lincoln

• David A. Wood, Brigham Young University