Unlike Doyle et al. (2007a) and Ashbaugh-Skaife et al. (2008a), which examine the relation between internal control quality and accruals quality, we choose accounting conservatism as our measure of financial reporting quality. This is because Watts (2003a,2003b) argues that conservative accounting benefits the users of a firm’s accounting reports, by preventing managers from introducing bias and noise into contractual accounting measures in order to overpay themselves. Also, conservative accounting results in the early termination of negative NPV (Net Present Value) investments and mitigates the incentives of managers, in reporting accounting measures used in a contract, to undertake negative NPV project behavior. Therefore, the interests of stakeholders are better protected when managers practice conservative accounting than when they do not. In sum, accounting conservatism is an important feature of high quality financial reporting.
We first examine whether weak internal controls are associated with less conservative accounting. If such a relation exists, then the regulators’ emphasis on internal controls to prevent companies from using overly aggressive accounting practices is justified and would benefit stockholders. In addition, in order to allow stronger inferences to be made about the effects of internal control weaknesses (ICWs) on accounting conservatism, we conduct inter-temporal tests of the changes in the status of internal controls. We specifically examine whether firms that disclose, and later remediate, ICWs show greater accounting conservatism than firms that continue to have such weaknesses. Lastly, as Watts (2003a) contends that a demand for accounting conservatism arises from litigation, we expect the disclosure of ICWs under SOX to potentially increase the litigation risks of these firms (i.e., as a result of their overly aggressive accounting practices or less conservative accounting). Hence, we also examine whether firms with ICWs report more conservatively after the disclosure of these weaknesses. Such conservative reporting behavior will provide evidence that the reporting requirements have a disciplining effect on firms to report conservatively and will mitigate investors’ concerns that earnings and net assets are overstated.
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