Following Basu (1997) and Watts (2003a, 2003b), we define conservatism as the application of a higher standard of verification for favorable information, whereby accounting income reflects “bad news” on a more timely basis than “good news.” We operationalize accounting conservatism in a number of ways. Two tests of conditional 本文来自优.文,论-文·网原文请找腾讯324,9114 conservatism, based on Basu, are widely applied in empirical accounting research. First, we use a piecewise linear regression of earnings on contemporaneous stock returns to examine whether weak internal controls are associated with lower timeliness to reflect bad news. Second, we examine whether weak internal controls are negatively associated with the rate of the reversal of negative earnings changes. Finally, to overcome the potential limitations associated with the interpretations and assumptions underlying the approaches of Basu, we conduct additional tests of conditional conservatism as suggested by Ball and Shivakumar (2005, 2006), namely accrual-based conditional conservatism.
Using a sample of firms which disclosed at least one material weakness (MW) from January 2003 to November 2005, we find results that are generally consistent with our expectations.4 First, we find that firms with weak internal controls, as proxied by the existence of at least one MW, exhibit lower levels of accounting conservatism compared to control firms without such weaknesses. This result is in line with the expectation of regulators that weak internal controls result in a lower quality of financial reporting. Second, we find that firms that disclose and later remediate their MWs exhibit greater accounting conservatism than firms that continue to have these weaknesses. This finding suggests that the improvement in internal control quality result in more conservative accounting; this further strengthens the results on the relation between internal control quality and accounting conservatism. Finally, we find that our sample of
sms firms with MWs report more conservatively after the disclosure of these weaknesses, regardless of whether or not these weaknesses are remediated. This result suggests that the internal control reporting requirements have a disciplining effect on firms with weak internal controls, possibly because of the increasing litigation risk following the disclosure of MWs. Overall, our results provide empirical evidence that supports the benefits of the internal control reporting requirements of SOX against the widely documented costs of these requirements (SEC 2006).
First, it examines the implications of the internal control reporting requirements of SOX on the financial reporting quality of firms. This issue is timely and important given the controversies surrounding the internal control reporting requirements of SOX, such as the high costs of compliance. Given that accounting conservatism is universally demanded by stakeholders (Ball et al. 2000; Basu et al. 2001) and is an important feature of high quality financial reporting, examining the association between internal control quality and accounting conservatism can provide insights into the efficacy of the internal control reporting requirements. With regard to financial reporting, our results show that mandating firms to assess their internal controls and to disclose the ICWs discovered in the process can have a disciplining effect on firms to report more conservatively. The remediation of previously identified ICWs also makes firms more conservative in their financial reporting. Hence, the internal control reporting requirements of SOX provide benefits to market participants by ensuring that financial reporting is both more conservative and of a higher quality.
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