Do management reports on internal control over financial reporting improve financial reporting?by Thomas D. Dowdell, David N. Herda, Matthew A. Notbohm

Research in Accounting Regulation


Sociology and Political Science / Finance / Accounting



co g? atth x 605 93 Cen

Sarbanes–Oxley Act

Section 404

Management reports 404b ly, to (ICFR ment. We investigate the distinct effect of management reports on financial reporting gh-pr and sed gnificant increase all firms ts, similar l internal 1052-0457/ 2014 Elsevier Ltd. All rights reserved. ⇑ Corresponding author.

E-mail addresses: (T.D. Dowdell Jr.), david. (D.N. Herda), (M.A. Notbohm). 1 An accelerated filer is a company that (1) has a public float of at least $75 million, (2) has been subject to the SEC’s periodic reporting requirements for at least 12 months and has filed one annual report, and (3) is not eligible to use the SEC’s small business reporting forms.

Research in Accounting Regulation xxx (2014) xxx–xxx

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Research in Accounting Regulation journal homepage: www.elsevier .com/locate / racregassociated with improved reporting quality as evidenced by lower levels of signed discretionary accruals. However, audits. They conclude that the management report alone may provide sufficient identification of materialreporting (SEC, 2003).

Iliev (2010) provides evidence consistent with this, finding that the combination of Section 404 management evaluation and independent audits of internal control is

Kinney and Shepardson (2011) find a si in material weakness disclosures for sm initial Section 404a management repor increase for small firms undergoing initiaPlease cite this article in press as: Dowdell Jr., T. D., et al. Do management reports on internal control over financial reporting i financial reporting? Research in Accounting Regulation (2014), to the controlthe most contentious and expensive aspects of SOX is Section 404, which requires public companies and their auditors (if a larger company) to opine on the effectiveness of the company’s internal control over financial reporting (ICFR). Regulators posited that documenting and evaluating internal control would improve the quality of financial between Section 404 and better financial reporting quality.1

This is an important issue related to the question of whether companies should be required to have both a management report and an independent audit of ICFR.

Two recent papers provide evidence on the necessity of a management report and an independent audit of ICFR.Introduction

As a result of a sequence of hi scandals, most notably Enron

Sarbanes–Oxley Act (SOX) was pasquality. We find that management reports on ICFR improve reporting quality and demonstrate that there are financial reporting benefits from the management report requirement on its own without attestation.  2014 Elsevier Ltd. All rights reserved. ofile accounting

Worldcom, the in 2002. One of because accelerated filers (larger firms) were initially required to file amanagement report on ICFR (Section 404a) and have an external audit of ICFR (Section 404b) in 2004, it is unclear whether the management report, the auditor report, or their combination is responsible for the associationInternal control over financial reporting

Accrual quality report and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the attestation require-Research Report

Do management reports on internal reporting improve financial reportin

Thomas D. Dowdell Jr. a, David N. Herda a,⇑, M aCollege of Business, North Dakota State University, NDSU Dept. 2410, P.O. Bo bCollege of Business and Public Administration, University of North Dakota, 2 a r t i c l e i n f o

Article history:

Available online xxxx

Keywords: a b s t r a c t

Sections 404a and auditors, respective financial reportingntrol over financial ew A. Notbohmb 0, Fargo, ND 58108-6050, USA tennial Drive Stop 8097, Grand Forks, ND 58202-8097, USA of the Sarbanes–Oxley Act require management and external report on the adequacy of a company’s internal control over ). Larger public firms were first required to file a managementmprove weaknesses. In contrast, Bedard and Graham (2011) find that auditors detect about three-fourths of internal control deficiencies, suggesting that the internal control audit is important for detecting control deficiencies. However, neither of these two papers examine whether the management report requirement (without attestation) directly a management report on ICFR under Section 404a in 2007 management (McEnroe, 2007) and some archival research supports this contention (Cohen, Dey, & Lys, 2008; Lobo &

Zhou, 2006; Zhou, 2008). For example, Lobo and Zhou (2006) find a negative association between Section 302 certifications and signed discretionary accruals for their sample period of 2000–2003 and Cohen et al. (2008) find that absolute discretionary accruals declined after the passage of SOX in 2002.

Iliev (2010) more specifically examines Section 404’s effect (combined effect of the management and auditor

ICFR reports) by comparing firms of similar market capitalization that were subject to Section 404 (accelerated filers) 2 T.D. Dowdell Jr. et al. / Research in Accounting Regulation xxx (2014) xxx–xxxbut are exempt from the Section 404b attestation requirement.2 We compare changes in reporting quality measures across these groups to evaluate the independent effect of the management report requirement on financial reporting quality. By disentangling the effect of the management report itself (apart from ICFR audits) on reporting quality we contribute to the debate on the necessity of external audits of ICFR for smaller firms. External audits of ICFR are an expensive and controversial product of SOX. Examining whether a less costly aspect of the legislation (i.e., the management report) improves financial reporting on its own is a worthwhile endeavor. This investigation is particularly important in light of recent legislation providing for more exemptions from SOX Section 404 compliance.3