Failed Remediation of Material Weaknesses: The Role of Incentives and Remediation Actions

• In Event: Internal Controls

Abstract

Prior research provides evidence of many economic benefits associated with the remediation of material weaknesses. However there is anecdotal evidence suggesting that not all remediation efforts adequately strengthen internal controls. I define a failed remediation as a case where a remediated company-year is subsequently restated. I examine whether incentives to disclose remediation and whether the timing of remediation disclosure and extent of remediation actions employed are associated with the likelihood of a failed remediation. I find that 18.5% of remediated company years fail to adequately strengthen internal controls, with higher failure rates for companies under pressure to restore financial reporting credibility, under financial distress, and for companies that rush to disclose remediation, and lower failure rates for companies that take a holistic approach to strengthening internal controls. Overall, these results indicate that incentives play a role in whether disclosed remediation adequately improves underlying control problems and that remediation disclosures provide information that is useful in assessing the likelihood of a failed remediation.

Author

• Andrew John Imdieke, University of Notre Dame