THE IMPACT OF MANDATORY DISCLOSURES OF MATERIAL WEAKNESSES IN INTERNAL CONTROL BY THE SARBANES-OXLEY ACT OF

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1 THE IMPACT OF MANDATORY DISCLOSURES OF MATERIAL WEAKNESSES IN INTERNAL CONTROL BY THE SARBANES-OXLEY ACT OF 2002 Robert Bee, Deloitte & Touche LLP Eric Blazer, Millersville University ABSTRACT The current financial crisis has renewed calls for additional regulation of financial markets and criticisms of existing regulations including the 2002 Sarbanes-Oxley Act (SOX). This research focuses on the effectiveness of section 404 of SOX which requires firms to disclose material weaknesses in internal controls. The paper examines a sample of 155 companies disclosing material weakness in internal controls in the year 2004, and analyzes the relationship between material weakness disclosure and the likelihood of a firm restating its total assets. The findings of the research suggest that the disclosure of material weaknesses in a firm s internal control does not provide investors with useful information regarding a company s financial health. The overall results suggest that the costs of compliance may outweigh any benefits provided to potential investors, creditors, or other interest parties. The ongoing assessment and evaluation of the effectiveness of financial market regulation is essential to the health of our financial system and maintaining a healthy economy. INTRODUCTION The Sarbanes-Oxley Act (SOX) of July 2002 introduced new rules and procedures for both managers and auditors of publicly registered companies. One focus of SOX involves disclosures of the effectiveness of internal controls over financial reporting. Prior to SOX the only regulation addressing the maintenance and disclosure of internal controls was the Foreign Corrupt Practices Act (FCPA) of This act requires all companies whose securities are registered with the SEC to keep books, records, and accounts that accurately and fairly reflect transactions and dispositions of assets, and to devise a system of internal accounting controls. Under the FCPA firms were only required to disclose internal control deficiencies when filing a form 8-K (during a change of auditors) assuming the outgoing auditor actually identified a deficiency. 1 With the implementation of SOX, companies are now required to include a discussion of internal controls over financial reporting (ICOFR) in both 10-K and 10-Q filings. 2 Many companies complain about high compliance costs, a lack of guidance on how to comply with SOX requirements (including identifying internal control deficiencies and determining their level of significance), and on how the market will react to the new disclosure requirements. The complaints aimed at ICOFR disclosures arise from sections 302 and 404 of SOX, which require management (section 302) and the external auditors (section 404) to assess and report on the effectiveness of these controls. 3 If any control deficiencies are identified both the auditor and the company must determine whether the deficiencies are significant deficiencies or material weaknesses, of which only material weaknesses are required to be publicly reported. The Public Company Accounting Oversight Board (PCAOB) in Auditing Standard No. 2 defines both terms as follows: A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the company's ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company's annual or interim financial statements that is more than inconsequential will not be prevented or detected. A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the Northeastern Association of Business, Economics, and Technology Proceedings

2 annual or interim financial statements will not be prevented or detected. Many managers and auditors find these definitions are unreasonably vague. In a letter to the Secretary of the SEC (Nancy M. Morris) the Executive Director of the Chamber of Commerce (Michael J. Ryan) argues that managers and auditors need to have objective, quantitative benchmarks to guide their evaluation of material weaknesses. Ryan states that the indicators of a material weakness need to be more specific, and include illustrative examples to serve as guides while implementing and evaluating controls; otherwise costly over-testing, and overdocumentation will continue. 4 While a disclosure of ineffective internal controls does not result in sanctions or penalties from the SEC, the costs associated with disclosing a material weakness can be high. These costs include direct compliance costs and may lead to an increase in the firm s cost of capital. The confusion related to identifying and disclosing material weaknesses, as required by SOX, can result in excessive and unnecessary compliance and audit costs from, independent auditors, external consultants, additional internal audit and compliance functions, and the additional demands placed on management. 5 Vague regulations may lead companies to be overly conservative, resulting in excessive investments on internal controls, and consequently reducing funds for operating activities and slowing creativity and innovation. 6 A 2004 Wall Street Journal article from stated companies disclosing material weaknesses could see declines in stock prices of 5 to 10 percent. Disclosures of material weaknesses could also make directors and officers insurance more restrictive and more costly. 7 On another level, investors are still on edge in the wake of major corporate accounting scandals associated with companies like Enron, WorldCom, Tyco, Xerox, and others in the early 2000 s. As a result, any public disclosure a company makes about potential accounting related problems may lead to an increased cost of capital. These costs may be unnecessary if the material weakness does not have an adverse impact on the firm s financial statements. Moody s Investors Service states that many reported material weaknesses do not rise to the level of serious concern from an analytical perspective. 8 Thus, it is possible that companies are punished by investors as a result of reporting material weaknesses, even if the disclosure does not result in a significant change to internal control procedures or the financial statements themselves. LITERATURE REVIEW Research on the reporting of material weaknesses can be separated in two categories, research before the passing of SOX and research performed after the passage of SOX section 404 and 302. Prior to SOX, material weaknesses were only disclosed in 8-K reports. Krishnan (2005) rated audit committees based on size, independence, and expertise, and found that for the years the frequency of reportable conditions (including material weaknesses) was negatively related to the quality of the audit committee. SOX has raised the profile of material weakness disclosures by requiring their inclusion in 10-K and 10-Q filings. Ge and McVay (2005) examined companies that reported at least one material weakness during the period August 2002 to November They explored five different firm characteristics, business complexity, firm experience, size, profitability, and auditor. They found the likelihood of reporting a material weakness is positively associated with business complexity, and negatively associated with firm size and profitability. Ge, McVay, and Doyle (2007) extended this analysis over a longer time period (2002 to 2005) with a larger sample. The study also included an expanded selection of firm characteristics such as firm size, age, financial health, financial reporting complexity, corporate governance, growth rates, and restructuring charges. They found that material weaknesses in internal control are more likely for smaller less profitable firms, that are growing rapidly, are more complex, or undergoing restructuring. Northeastern Association of Business, Economics, and Technology Proceedings

3 Leone (2005) finds share prices drop by up to 4% in the 60 day period following the disclosure of a material weakness. Neri Bukspan, the chief accountant at S&P observes that fewer than 10% of all companies disclosing a material weakness receive a subsequent downgrade. 9 DISCUSSION OF THE STUDY This study examines the impact of the SEC s mandatory disclosure requirements on publicly issued financial statements. Specifically it examines the relationship between a firm s disclosed weaknesses in internal controls and its concurrent and subsequent restatement (if any) of total assets and the firm s financial health, as measured by changes in its Altman Z-Score. A finding of a significant relationship between disclosed material weaknesses and restated assets or a firm s financial health would provide evidence to support the requirements of Section 302 and 404. On the other hand, if no significant relationship is found between disclosed material weaknesses and restated assets or a firm s financial health would bolster critics of Sections 302 and 404, who claim that compliance costs outweigh benefits to investors. Restatement of Assets Primary reasons for financial restatements include flawed judgments due to oversight or misuse of facts, fraud, or a misapplication of GAAP. These errors are usually caused by problems applying accounting rules, human or system errors, and fraudulent behavior. 10 When a company identifies these errors they will often restate prior year(s) financial documents to correct the identified error. Sections 302 and 404 of SOX were designed to help management and auditors uncover these types of accounting errors. In this study Compustat data is used to calculate the average percentage change in a firm s restated assets for a two year period ( ) prior to and two year period ( ) subsequent to the disclosure of a material weakness. The average restated total assets for companies disclosing a material weakness are compared to the change for a control group. The difference between the two groups is used to evaluate the relationship between material weaknesses disclosures and the likelihood subsequent financial document restatements. Altman Z-Score The Altman Z-Score combines liquidity, profitability, and bankruptcy ratios into one metric for assessing a company s financial health. Jayadev (2006) finds the Z-score successfully predicted 72% of corporate bankruptcies two years prior to filing for Chapter 7. The Z-score combines the following five ratios: Ratio 1: Working Capital / Total Assets Ratio 2: Retained Earnings / Total Assets Ratio 3: Earnings Before Income Tax / Total Assets Ratio 4: Market Value of Equity / Total Liabilities Ratio 5: Sales / Total Assets The coefficient weights as determined by Altman as follows: Z-Score = (1.2 * R1) + (1.4 * R2) + (3.3 * R3) + (0.6 * R4) + (1.0 * R5) A company s Z-Score places it in one of three risk categories. A Z-Score of less than 1.8 indicates likelihood of bankruptcy, and a Z-score greater than 3.0 indicates a healthy financial position, suggesting the firm is unlikely to file for bankruptcy. A score between 1.8 and 3.0 lies in the gray area. This study compares average Z-Scores for the two years prior ( ) and the two years after ( ) disclosing a material weakness, with the average Z-Scores for the same periods using restated financial statements. A significant difference between the original Z-Scores and Z-Scores based on restated data would indicate that the original financial statements may have been misleading to investors. If there is no significant difference between Z-Scores it would suggest that material weakness disclosures, in accordance with current legislation, do not provide meaningful information to investors. SAMPLE The sample group obtained for this study is based on an initial set of 478 companies disclosing various levels of internal control deficiencies in This Northeastern Association of Business, Economics, and Technology Proceedings

4 set was retrieved through Compliance Week, a service dedicated to SOX related compliance issues. This initial data set was screened against Compustat s North American database, and 147 companies were excluded because of unavailable financial data. This reduced the sample size to 331 companies. Since Compliance Week reports all internal control disclosures, and not just material weakness disclosures, each SEC filing was examined to ensure only disclosures of material weaknesses in internal controls were included. This screening eliminated an additional 176 companies, leaving a final set of 155 companies for analysis. Of the 155 companies only 74 restated assets during , with an average over-statement of $18.7 million or.48 percent. During the post-disclosure period ( ) only 16 companies restated their assets, with an average understatement of $0.8 million or.06 percent. The control group was created by screening the Compustat database for companies with the traits of firms likely to disclose a material weakness in The screen was performed using three main determinants identified by Ge (2007). Ge examined traits of 779 companies disclosing material weaknesses from 2002 to 2005, and found that firms disclosing material weaknesses tend to be smaller, less profitable, and more complex. Ge used market capitalization as a proxy for firm size, and found a significant negative relationship between firm size and the likelihood of disclosing a material weakness. Income before extraordinary items over a two year period was used to measure profitability, and a significant negative relationship was found between profitability and the likelihood of disclosing a material weakness. The number of business segments reported for the company was used as a proxy for firm complexity, and Ge found a significant positive relationship between complexity and the likelihood of disclosing a material weakness. Ge found that firms are more likely to disclose a material weakness if; their market capitalization is less than $181 million, they are less profitable, and they operate with 3 or more business segments. To build a control set the Compustat database was screened to eliminate companies that did not match these criteria in the year This created a control set of 270 companies that did not disclose material weaknesses, but had characteristics of firms likely to disclose a material weakness. Of the 270 companies 45 restated assets during , with an average overstatement of assets of $.06 million or.47 percent. During companies restated assets, with an average understatement of $.03 million or.21 percent. The following table outlines the descriptive statistics sample and control groups. Sample Group (n=155) Mean Median Standard Error Market Cap* Profitability* Total Assets* # of Segments # of Firms with Restatements % of Firm with Restatements 47% 10% Average Restatement* Average % Restatement 0.48% 0.06% * millions Control Group (n=270) Mean Median Standard Error Market Cap* Profitability* Total Assets* # of Segments # of Firms with Restatements % of Firm with Restatements 17% 9% Average Restatement* Average % Restatement 0.47% 0.21% * millions METHODOLOGY / RESULTS Paired two sample t-tests are used first to evaluate the likelihood that a material weakness disclosure will lead to a subsequent restatement of total assets. This is done by comparing pre and post disclosure period total restated assets between the sample and control group. To evaluate whether restated financial Northeastern Association of Business, Economics, and Technology Proceedings

5 statements associated with material weakness disclosures provide useful information to current or potential investors, pre and post disclosure period Z- Scores are calculated and compared. The results of these tests are used to evaluate the overall effectiveness of current material weakness disclosure regulations. If Compustat was unable to return complete data for a firm, it was removed from its group (either the sample group or control group). The number of observations listed in the each tables indicates the number of companies in that group for which full data was available. Average Restated Assets To control for differences in firm size between the control and test group, Total Restated Assets as a percentage of Total Assets were compared for each two-year period. The following hypotheses were tested: H0: Average Restated Assets are not significantly different. H1: Average Restated Assets are significantly different First, F-tests were performed to determine whether the sample and control groups had equal or unequal variances. The variances for both the pre and post disclosure periods are significantly different, and t- tests assuming unequal variances were performed (Prior Years) Results: The means for the test group (.0047) and the control group (.0046) indicate that neither group made restatements of a substantial nature in their financial statements for the two years prior to The p- value of.988, is much greater than the accepted level of significance (.05) which suggests that disclosing a material weakness in internal controls does not significantly increase the likelihood of making a restatement for the two years prior to the disclosure. The t-test results appear below: t-test: Percentage Restated Total Assets ( ) Sample Control Mean Variance Observations t-stat P(T<=t) two tail t Critical two-tail (Subsequent Years) Results The small means for the test group (.0006) and the control group (-.002) indicate that neither group made restatements of a substantial nature in the two years after The p-value of.24 is much greater than the accepted level of significance (.05), which suggests that disclosing a material weakness in internal controls does not significantly increase the likelihood of making a restatement for the two years subsequent to the disclosure. The t-test results appear below: t-test: Percentage Restated Total Assets ( ) Sample Control Mean Variance Observations t-stat P(T<=t) two tail t Critical two-tail Altman Z-Score A paired two sample t-test was used to evaluate the difference between Z-Scores calculated using initial financial statements and Z-Scores calculated using restated (if any) financial statements for companies in Northeastern Association of Business, Economics, and Technology Proceedings

6 the sample group. The following hypotheses were tested: H0: Average Z-Scores are not significantly different H1: Average Z-Scores are significantly different (Prior Years) Results: The average Z-Score calculated using initially reported financial statements is while the mean Z-Score for the same companies using restated information (if any was reported) is This decrease in Z-Score indicates that initially reported financial statements on average overstate a company s Z-Score, but a p-value of.321 indicates that the difference is not statistically significant. This indicates that disclosing a material weakness in internal controls does not result in a significantly greater likelihood of making a financially meaningful financial restatement. The t-test results appear below: t-test: Altman Z-Score Sample Group ( ) Original Restated Mean Variance Observations t-stat P(T<=t) two tail t Critical two-tail (Subsequent Years) Results The mean Z-Score using originally reported financial information was while the mean Z-Score for the same companies using their restated information (if any was reported) is Since the P-Value is just below the significance level of.05 this may indicate that originally reported information was overstating the Z-Score and that disclosing a material weakness in internal controls could significantly increase the likelihood of presenting unreliable information to investors two years after disclosing a material weakness. While this difference of Z-Scores is significant at a statistical level, there is not likely an economic difference between the two groups of a significant level. This is because the average Z-Score for both groups is so far below the lowest Z-Score threshold that the difference between them is not likely significant enough to provide any substantial information to investors. The t-test results appear below: t-test: Altman Z-Score Sample Group ( ) Original Restated Mean Variance Observations t-stat P(T<=t) two tail t Critical two-tail CONCLUSIONS The Sarbanes-Oxley Act of 2002 introduced mandatory public disclosures of material weaknesses in internal control over financial reporting for all SEC registered companies. The SEC s definition of material weaknesses focuses on whether or not an error could have been material thus many organizations are forced to make disclosures of ineffective controls leading to public reports of material weaknesses under subjective terms. This means companies with unqualified financial statements may still be required to disclose a material weakness in their internal controls. Any material weakness in internal controls leads to an adverse opinion on the overall effectiveness of internal controls. This may leave investors, creditors, and others with the impression that an organization s financial statements are not reliable, even though the Northeastern Association of Business, Economics, and Technology Proceedings

7 opinion on the financial statements is likely unqualified. This paper examined the relationship between the disclosure of material weaknesses in internal controls, and concurrent and subsequent restatement of assets and changes in a firm s financial health as measured by its Z-score. Concurrent and subsequent asset restatements were compared for firms disclosing material weaknesses with a control group. No significant difference was observed between total assets as originally reported and restated total assets. This suggests that the disclosure of material weaknesses does not provide investors with any new or useful information that rational investment decisions would rely on. Since the results of this analysis suggest that there may be no useful information supplied by this disclosure, it implies that the cost incurred by a company to discover and disclose this information outweighs the benefit it provides to interested parties. To assess the impact of restated assets on measures of financial health, Z-scores were calculated prior to and subsequent to restatements (if any) for firms disclosing material weaknesses. No statistical difference was found between original and restated Z-scores for the two-year period prior to the disclosure, but a weak statistical difference was observed during the period subsequent to the disclosure. However, it is unlikely that the difference is economically significant as the average restated Z- score decreased from to -1.92, which are both so far below the lowest Z-Score threshold of 1.8 (which indicates a poor financial position) that the difference between them is not likely significant enough to provide any substantial economic information to investors. Sections 302 and 404 of the Sarbanes-Oxley Act (along with other requirements as well) have led to strained relationships between companies and their external auditors. While in the past management and external auditors worked together to ensure financial statements were presented in accordance with GAAP, it seems the external auditors now stand back and simply evaluate the decisions of management and assess penalties. Because of the subjective nature of the definition of a material weakness auditors are probably over-cautious with their examinations, leading to the conclusion that an otherwise immaterial item could potentially have been material, causing classifications of ineffective internal controls. The results of this study suggest that this may happen with some degree of regularity. These decisions greatly impact the cost of the audit, and the costs of compliance with Sarbanes-Oxley. It is likely that the costs of compliance incurred by a company, both internally and externally, outweighs the benefits provided to those interested in their financial documents. Further research could examine how much these costs outweigh the benefit provided to investors, or the impact these increased compliance costs have on a private companies decision of whether or not to go public. Using the tests performed in this study it is apparent that the disclosure of a material weakness in internal controls in accordance with current legislations is not significantly related to a decrease in financial health, so the adverse opinions on internal controls may be unnecessarily, and adversely, impacting the opinions of those interested in a company s financial statements. These results suggest that some sort of reform or revised definition of what constitutes a material weakness in internal controls by the SEC, along with guidance from the SEC for both management and external auditors on how to interpret and enforce a new definition, could reduce compliance costs and improve the quality of information provided to investors. Until then many SEC registered corporations may be susceptible to unnecessary costs; both monetarily and to their reputation. ENDNOTES 1 SEC Disclosure Amendments to Regulation S-K, form 8-K and Schedule 14-A Regarding Changes in Accountants and Potential Opinion Shopping Situations. SEC Release No Agami, Abdel M Reporting on Internal Control Over Financial Reporting. The CPA Northeastern Association of Business, Economics, and Technology Proceedings

8 Journal Online Vol. LXXVI, No. 11. Available at ntials/ p32.htm Available is_2004_jan_13/ai_ at 3 SEC Certification of Disclosure in Companies Quarterly and Annual Reports, Final Rule (August 29), Washington D.C. Available at 4 Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2 An Audit of Internal Contorl over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Available at d/auditing_standard_2.pdf 5 Ibid. 6 Ryan, Michael J File Number PCAOB ; File Number S U.S. Chamber of Commerce. Available at tv2gj5le66fkygopkfknsaooj2ysvmuibopjci5lrxtuwe 53zlp26vxjdrq6xzllal2wt4ywttsm65ul6bc/SOXAS 5Mgmt pdf 7 Ibid. 8 Ibid. 9 Leone, Marie. November 18, Where Material Weaknesses Really Matter. CFO.com. Available at 5?f=singlepage 10 Doss, M., and G. Jonas Section 404 Reports on Internal Control: Impact on Ratings Will Depend on Nature of Material Weaknesses Reported. October. New York, NY: Moody s Investors Service, Global Credit Research. 11 Ibid. 12 Business Editors/Legal Writers. January 13, Huron Consulting Group Reveals Leading Causes of Financial Restatements in Business Wire. 13 Ibid. WORKS REFERENCED Agami, Abdel M Reporting on Internal Control Over Financial Reporting. The CPA Journal Online Vol. LXXVI, No. 11. Available at ials/ p32.htm Business Editors/Legal Writers. January 13, Huron Consulting Group Reveals Leading Causes of Financial Restatements in Business Wire. Available at is_2004_jan_13/ai_ Doss, M., and G. Jonas Section 404 Reports on Internal Control: Impact on Ratings Will Depend on Nature of Material Weaknesses Reported. October. New York, NY: Moody s Investors Service, Global Credit Research. Doyle, J., et al., Determinants of Weaknesses in Internal Control Over Financial Reporting. Journal of Accounting and Economics (2007), doi: /j.jacceco The Foreign Corrupt Practices Act. 12 U.S.C. 78dd-1. Available at fraud/docs/statue.html Ge, Weili, McVay, Sarah The Disclosure of Material Weaknesses in Internal Control After the Sarbanes-Oxley Act. Accounting Horizons 19, Jayadev, M Predictive Power of Financial Risk Factors: An Empirical Analysis of Default Companies. Vikalpa: The Journal for Decision Makers 31 (3), Krishnan, J Audit committee quality and internal control: An empirical analysis. The Accounting Review 80 (2): Northeastern Association of Business, Economics, and Technology Proceedings

9 Leone, Marie. July 21, How Markets Punish Material Weaknesses. CFO.com. Available at Leone, Marie. November 18, Where Material Weaknesses Really Matter. CFO.com. Available at f=singlepage McClure, Ben Z Marks the End. Investopedia.com. Available at / asp Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2 An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Available at Auditing_Standard_2.pdf SEC Certification of Disclosure in Companies Quarterly and Annual Reports, Final Rule (August 29), Washington D.C. Available at SEC Disclosure Amendments to Regulation S-K, form 8-K and Schedule 14-A Regarding Changes in Accountants and Potential Opinion Shopping Situations. SEC Release No Wackerly, Dennis D. and W. Mendenhall. Mathematical Statistics with Applications, Sixth Edition. Pacific Grove: Duxbury Thomson Learning, 2002 Ryan, Michael J File Number PCAOB ; File Number S U.S. Chamber of Commerce. Available at rdonlyres/ezleeiwvtv2gj5le66fkygopkfknsaooj2ysvm uibopjci5lrxtuwe53zlp26vxjdrq6xzllal2wt4ywttsm65 ul6bc/soxas5mgmt pdf Robert Bee is a graduate of Millersville University of Pennsylvania. He received a Bachelors of Science in Business Administration with an option in Accounting. He is Audit Assistant with Deloitte & Touche LLP in Pittsburgh. Eric L. Blazer, CPA, is an Associate Professor of Finance and Accounting at Millersville University of Pennsylvania. He received a PhD in Finance and a Masters in Accounting from Virginia Tech. Northeastern Association of Business, Economics, and Technology Proceedings