Does SOX Section 404 Curb Material Misstatements?

Does SOX Section 404 Curb Material Misstatements? Mei Feng Assistant Professor of Accounting Katz School of Business, University of Pittsburgh mfeng@katz.pitt.edu Chan Li Assistant Professor of Accounting Katz School of Business, University of Pittsburgh chanli@katz.pitt.edu Preliminary Version Please do not quote without the authors permission. October 2010 Abstract: We examine whether and how SOX Section 404 serves one of its primary purposes -- curbing material misstatements. We document that compliance with SOX Section 404 enables firms to prevent and detect material misstatements in financial reports in a more timely manner. Moreover, among firms complying with Section 404, internal control quality is negatively associated with the likelihood of material misstatements, and internal control weaknesses in specific accounts are positively associated with misstatements in those accounts. Finally, we show that Section 404 curbs material misstatements by mitigating the influence of earnings manipulation incentives created by compensation contracts and debt covenants. Taken together, our findings suggest that SOX Section 404 reduces material misstatements.

Does SOX Section 404 Curb Material Misstatements? 1. Introduction The Sarbanes-Oxley Act (SOX), which was triggered by a series of high-profile corporate accounting scandals, aims to curb material misstatements resulting from violations of generally accepted accounting principles (GAAP). SOX Section 404 is particularly important in serving this purpose as it addresses internal controls, which is a process within a firm designed to provide reasonable assurance that the financial statements are prepared in accordance with GAAP (PCAOB, 2007). 1 While prior research has investigated various consequences of Section 404 (e.g., its impact on stock returns, earnings quality and cost of capital), surprisingly few studies examine whether Section 404 achieves one of its primary goals: reducing material misstatements. We investigate whether and how Section 404 helps companies prevent and more quickly detect material misstatements, proxied by restatements. 2 Examining this issue is critical because Section 404 has been very controversial among practitioners, legislators and regulators, and the empirical evidence on the benefits of Section 404 has been mixed. Specifically, corporate managers and financial information users (e.g., institutional investors, lenders and analysts) hold drastically different views regarding Section 404. In a recent survey conducted by the SEC, 52% of surveyed executives reported that they do not think compliance with Section 404 improves companies ability to prevent and detect accounting manipulations. In contrast, the majority of financial report users report that Section 404 increases their confidence in financial reports. Legislators and regulators also appear to be deeply divided over the benefits of Section 404. In October 2009, the SEC required all small firms to comply with Section 404(b) starting from the fiscal year ending on or after June 15, 2010, and stated that there would be no more extensions. The SEC expects Section 404 to continue to significantly improve investor confidence in the 1 Specifically, Section 404(a) requires managers to document, evaluate and disclose the effectiveness of internal control, and Section 404(b) requires auditors to attest to managers assessments. Additional details regarding Section 404 are provided in Section 2.1. 2 A restatement could be due not only to unintentional or intentional misstatements, but also to the adoption of a new accounting rule. We focus on the restatements caused by misstatements as they could be affected by Section 404. For further discussion see Section 4.1. 1

integrity of companies financial reports (SEC, 2009). However, in less than a year, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) in July 2010, which permanently exempts small firms from Section 404(b) requirements and directs the SEC to consider waiving requirements for more medium-sized firms. Regarding empirical evidence, Ashbaugh-Skaife et al. (2007 & 2008) document that an improvement in internal control quality is associated with better earnings quality and lower cost of capital. In contrast, Doyle et al. (2007a) and Ogneva et al. (2007) do not find that internal control quality disclosed under Section 404 is related to earnings quality or cost of capital. To shed light on the relation between Section 404 and material misstatements, we first investigate whether compliance with Section 404 helps firms detect material misstatements more quickly. We find that compared with firms not complying with Section 404 (non-accelerated filers), firms complying (accelerated filers) are more likely to detect material errors in their financial reports of 2002-2004 in the first compliance year (2004) instead of the subsequent years, indicating that compliance with Section 404 expedites the process of detecting and correcting misstatements. 3 We focus on financial reporting errors occurring before the first Section 404 report was filed (i.e. errors occurring in 2002, 2003 and the first three quarters of 2004) because compliance with Section 404 could affect accelerated filers financial reporting, potentially making the likelihood and the types of their financial reporting errors systematically different from those of non-accelerated filers. Of all misstatements that occurred in 2002-2004 and were announced in 2004-2007, accelerated filers detected 74% of them in 2004 and 26% in 2005-2007. In contrast, non-accelerated filers detected only 45% in 2004 and 55% in 2005-2007. Because there were financial, economic and political changes around the enactment of SOX, and because 3 The SEC defines accelerated filers as firms with a public float (the part of equity not held by management or large shareholders) greater than $75 million. Non-accelerated filers are firms with a public float less than $75 million. The SEC mandates that accelerated filers comply with Section 404(a) and 404(b) in the fiscal year ending on or after November 15, 2004, and non-accelerated filers comply with Section 404(a) in the fiscal year ending on or after December 15, 2007. Some firms with public float less than $75 million voluntarily comply with both Section 404(a) and (b) during our sample period. We treat these firms as accelerated filers in this study because we are interested in how the 404 compliance process helps firms detect and prevent misstatements. We conduct sensitivity tests for the voluntary adopters. Please see Sections 4.1 and 6.2 for detailed explanations and analyses. 2

accelerated filers could be fundamentally different from non-accelerated filers, we also perform a difference-in-difference test by comparing the changes in misstatement detection from 2001 to 2004 between accelerated filers and non-accelerated filers. After controlling for other factors affecting restatements, we find that the improvement in the timeliness of misstatement detection is significantly greater for accelerated filers than for non-accelerated filers, consistent with the argument that Section 404 helps firms detect material misstatements more quickly. Next, we examine whether Section 404 helps firms prevent material misstatements by comparing the incidence of misstatements in accelerated filers and non-accelerated filers as well as in firms with and without effective internal controls. We find that compared with non-accelerated filers, accelerated filers have significantly fewer misstatements after complying with Section 404 when controlling for other factors affecting misstatements. In a difference-in-difference test, we find that the reduction in misstatement rate from 2001 to 2004 is significantly higher for accelerated filers than for non-accelerated filers, consistent with the view that compliance with Section 404 helps firms reduce material misstatements. Specifically, we find that while the misstatement rate for accelerated filers decreased from 18% in 2001 to 13% in 2004, the misstatement rate for non-accelerated filers increased from 11% to 16% during the same period. Among accelerated filers, we also compare the likelihood of misstatements between firms with and without effective internal controls. If the internal control provisions contained in Section 404 reduce material misstatements, we expect that the reduction in misstatement rates to be greater for firms with effective internal controls because effective internal controls enable firms to capture and correct errors in financial reports more efficiently. Consistent with this assertion, we find that firms with effective internal controls are less likely to have misstatements than firms without effective controls. 4 In addition, our cross-sectional analyses show that material weaknesses in revenue/inventory are associated with misstatements in revenue/inventory accounts, while material weaknesses in areas other than revenue/inventory are associated with misstatements in non-revenue/inventory accounts. 4 Misstatements could trigger adverse auditor 404 opinions. To control for this, we eliminate the misstatements that are detected and announced before auditors issue the 404 reports for the misstating year. 3

Overall, our results suggest that internal controls, particularly effective ones, help reduce material misstatements. Finally, we examine how Section 404 curbs material misstatements by looking at the interaction between Section 404 and earnings manipulation incentives created by stock compensation and debt covenants. We find that these incentives appear to play a less important role in motivating firms to misstate their financial reports for accelerated filers and firms with effective internal controls than for non-accelerated filers and firms without effective controls, respectively. In fact, stock compensation and debt covenants, on average, appear to be associated with misstatements only for non-accelerated filers and firms without effective controls. These results indicate that internal controls curb material misstatements by mitigating the negative impact of earnings manipulation incentives created by stock compensation and debt covenants. We conduct several additional analyses to corroborate these findings. First, to limit the difference in size between accelerated and non-accelerated filers, we exclude firms with market capitalization greater than $250 million. We find that compared with non-accelerated filers, these small accelerated filers detect misstatements more quickly and are less likely to misstate their financial statements after compliance, consistent with the argument that Section 404 is useful in reducing material misstatements. Second, we compare firms with market capitalization less than $75 million but have voluntarily adopt edsection 404 (voluntary adoption firms) with non-accelerated filers. We find that, subsequent to adopting Section 404, voluntary adoption firms detect misstatements more quickly and are less likely to have misstatements than they were before the adoption of Section 404 and that this result extends to difference-in-difference analyses. Third, we find accelerated filers continue to have lower misstatement rates than non-accelerated filers in 2007 and 2008, when the latter group starts to comply with Section 404 (a) but not 404(b), again consistent with the argument that Section 404 (b) helps reduce misstatements. Fourth, to further control for the endogeneity of internal control material weaknesses, we model the material weakness and conduct a two-stage Heckman analysis. We continue to find evidence that firms with effective internal controls reduce accounting misstatements more than firms without 4

effective controls. Finally, we show that our results generally hold when we control for corporate governance. In summary, we find that compliance with Section 404 helps firms more quickly detect and reduce material misstatements in their financial reports. Among those firms complying with Section 404, misstatement rates decrease more for firms with effective internal controls than for firms without effective controls, consistent with the argument that the internal control provisions contained in Section 404, rather than other events associated with Section 404, lead to reductions in material misstatements. Moreover, internal controls, particularly effective ones, appear to mitigate the association between material misstatements and stock compensation contracts and debt covenants. Taken together, our results indicate that Section 404 does help curb material misstatements. Our study makes several contributions. First, we add to the heated debate on the benefits of Section 404 among practitioners, legislators, regulators and researchers. Contrary to corporate executives claims and consistent with financial report users beliefs, we find that Section 404 significantly helps firms prevent and detect material misstatements in a timely manner. This finding has direct implications for legislators and regulators. Many opponents of Section 404 have urged Congress to exempt medium-sized firms from Section 404. After passing the Act in July 2010, Congress called for studies examining the restatement rate for accelerated and non-accelerated filers, and directed the SEC to conduct more cost-benefit analyses on compliance with Section 404 for medium-sized firms. Our study responds to these calls and shows that Section 404 does serve one of its primary goals - reducing costly material misstatements - and that this benefit extends to small and medium-sized firms as well. SEC decision makers and other regulators will clearly benefit from such empirical evidence. Second, our paper extends the literature on Section 404. While several studies have shown that firms bear significant costs when complying with Section 404 (e.g., Krishnan et al. 2008), the evidence on the benefits of Section 404 has been mixed. For example, when examining the impact of Section 404 on accrual quality, Doyle et al. (2007a) find no significant association between accrual quality and internal control quality filed under Section 404, while Singer and You (2010) and Ashbaugh-Skaife et al. (2008) 5

document an improvement in accrual quality when firms comply with Section 404 or remediate internal control material weaknesses. One reason for the mixed results is that accruals quality, estimated based on accrual expectation models, are subject to significant measurement errors (e.g., Dechow et al. 1995; McNichols, 2002). Moreover, while accrual quality reflects earnings management both within GAAP and outside of GAAP, our measure, restatement, captures earnings manipulations outside of GAAP, which SOX was triggered by and aims to curb. We document consistent and economically significant evidence that Section 404 reduces material misstatements, which we see as its key benefit. Third, our paper also contributes to the restatement literature by identifying a mechanism that can reduce costly restatements. Prior studies document that equity compensation contracts and debt covenants are associated with restatements. In response to this finding, corporate boards have reduced equity compensation in order to decrease the likelihood of restatements. However, reducing equity compensation can be costly, as equity compensation plays an important role in aligning the interests of managers and shareholders. Our paper shows that instead of decreasing equity incentives, firms could reduce restatements by establishing effective internal controls over financial reporting. 2. Institutional Background and Literature Review 2.1 Institutional Background A string of high-profile corporate scandals around 2001, such as Enron, Worldcom, Xerox, Waste Management, and Tyco, caused huge losses to investors and eroded investors confidence in the stock market. Enacted amid the scandals, the Sarbanes-Oxley Act (SOX) mandates far-reaching reforms in business practices, such as requiring more disclosure on internal controls, requesting more oversight of the audit industry, and imposing greater penalties for managerial misconduct. One primary goal of these reforms is to curtail earnings manipulation and accounting fraud resulting from violations of generally accepted accounting principles (GAAP). According to the SEC Commissioner Paul Atkins, by codifying the responsibilities of corporate executives, corporate directors, lawyers, and accountants and creating a broad oversight regime for auditors of public companies, SOX attempts to provide fundamental mechanisms to prevent the misdeeds that led to investor losses. (Atkins 2003) 6

The internal control reforms required by Sections 302 and 404 are at the core of the SOX legislation (Coates, 2007). 5 Internal control over financial reporting (ICFR) is defined as a process to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP (PCAOB, 2007, AS No. 5) (emphasis added). Thus, one main purpose of ICFR is to provide reasonable assurance regarding the within GAAP financial reporting. In an effort to ensure that ICFR serves this purpose, Section 404 requires managers to establish, evaluate and disclose the effectiveness of the ICFR (404(a)), and requires auditors to attest to and report on the effectiveness of the ICFR (404(b)). A company s ICFR cannot be considered effective if one or more material weaknesses exist, where material weakness is defined as reasonably possible that a material misstatement of the company s annual or interim financial statements will not be prevented or detected on a timely basis (PCAOB, 2007, p. 434) (emphasis added). The focus on material misstatement in the definition of material weakness reflects the overall goal of SOX, to curb accounting misstatements. Consistent with this, the SEC has stated repeatedly that strong internal controls are vital to averting and detecting financial reporting failure (e.g. Nicolaisen, 2004; SEC release 33-8238, 2003). For example, Chairman of PCAOB William McDonough pointed out good internal control is one of the most effective deterrents to fraud, and therefore we expect our standards to help protect investors from the kinds of financial reporting scandals that the Sarbanes-Oxley Act seeks to prevent. Therefore, if Section 404 serves its purpose, it should reduce material misstatements. Since SOX was enacted, Section 404 has been very controversial among practitioners, legislators, regulators and researchers. As a result, the SEC set different compliance schedules for large and small firms. Large firms started to comply with Section 404 requirements in the fiscal year ending on or after 5 Section 302 took effect in August of 2002 and applies to all SEC registrants. Section 302 requires that CEOs and CFOs certify the effectiveness of internal control over financial reporting and disclose any material changes in internal control in the quarterly and annual financial statements. We focus on Section 404 reports, although material weaknesses are also disclosed under Section 302. The disclosure rules under Section 302 are more ambiguous (see Ashbaugh-Skaife et al., 2007) and require a less rigorous assessment of internal controls. For example, a Glass Lewis & Company report states that 94% of the firms reporting ineffective internal controls under Section 404 had not disclosed a material weakness in internal control in the previous quarter under SOX 302 (Townsend and Grothe, 2005) 7

November 15, 2004. The compliance date for small firms has been extended multiple times. Small firms had to comply with Section 404 (a) starting from the fiscal year ending on or after December 15, 2007, but they were exempted from Section 404 (b) compliance by the Act in July 2010. 6 Company managers and financial information users view the benefits and costs of Section 404 very differently, as reflected in the SEC s recent survey study on SOX Section 404. 7 Specifically, a majority of company executives surveyed (63%) perceive the costs to be greater than the benefits, even after the adoption of the PCAOB Auditing Standard No. 5 (AS No. 5). 51% of the executives think the quality of their companies financial reporting did not improve, and 52% of the executives think their companies ability to prevent and detect fraud did not improve. Almost 30% of the respondents even think that complying with Section 404 reduces the efficiency of the operating and financial reporting process. Many executives argue that since their firms already have many controls in place, Section 404 compliance is a redundant exercise that comes at a very high cost. While managers generally think that Section 404 compliance adds little value to their firms financial reporting process, financial report users perceive matters differently. In the same survey, lenders, analysts, credit rating agencies, and other investors generally regard Section 404 disclosures as having a positive impact on their confidence in companies financial reports, and believe that independent audit of ICFR provides an incremental benefit to management s own assessment. Legislators and regulators are also deeply divided over Section 404. On one hand, some regulators and organizations believe that Section 404 helps protect investors from accounting scandals; therefore, they strongly support it. For example, the AICPA, the Center for Audit Quality (CAQ), the CFA Institute, and the Council of Institutional Investors have all written letters to Congress opposing any attempt to amend and weaken Section 404. The SEC and the PCAOB, as well as other organizations, such as the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and CAQ, stand firm on Section 404 and have expended considerable effort to improve both the effectiveness and 6 Accelerated filers were initially expected to comply with the auditor attestation requirement in annual reports filed on or after June 15, 2004. 7 http://www.sec.gov/news/studies/2009/sox-404_study.pdf 8

efficiency of ICFR reporting. 8 In the final rule extending the compliance date for filing 404 (b) for nonaccelerated filers, the SEC notes that all steps necessary to implement the requirements of Section 404 of SOX have been completed, and the SEC does not expect to further defer the obligation of non-accelerated filers to comply with Section 404(b) (SEC release No. 34-60813, 2009). On the other hand, Congress passed the Act in July 2010. The Act includes an amendment to SOX Section 404 that permanently exempts non-accelerated filers from the requirements of SOX Section 404(b). In addition, Congress directs the Comptroller General of the United States to carry out a study on the impact of the amendment to SOX Section 404, including an analysis of whether issuers that are exempt from SOX Section 404(b) have fewer or more restatements of published accounting statements than issuers that are required to comply with SOX Section 404(b). Because many opponents of Section 404 argue that the exemption should include companies with public floats of at least $150 million, Congress also directs the SEC to conduct a study to determine how the SEC could reduce the burden of complying with SOX Section 404(b) for companies whose market capitalization is between $75,000,000 and $250,000,000, while maintaining investor protections for such companies. In summary, while Section 404 is expected to play a critical role in curbing accounting misstatements, regulators, companies, and practitioners have diverging beliefs about the section s requirements. Our study tries to provide comprehensive empirical evidence on whether and how Section 404 serves one of its main purposes: helping companies prevent and detect financial statement manipulations. Our study also responds to the Congressional call for research examining financial restatements by accelerated and non-accelerated filers. 2.2 Literature Review Our study is related to three streams of literature: the effect of SOX Section 404, the impact of internal control quality, and the underlying causes of material misstatements. 8 Among the steps taken, the SEC approved issuance by the PCAOB of AS No. 5, which replaced AS No. 2. In addition, the SEC issued interpretive guidance to assist management in complying with the ICFR evaluation and disclosure requirements, and the PCAOB created a task force and developed additional guidance in applying the requirements of the auditing standard in audits of smaller companies. 9

2.2.1 Section 404 The first line of literature examines various costs and benefits of Section 404. Regarding the costs, Krishnan et al. (2008) show that for a sample of firms that voluntarily disclose Section 404 cost information from January 2003 to September 2005, the average total compliance cost is $2.2 million, representing 3% of total sales. In addition, Zhang (2007) and Iliev (2010) document that non-accelerated filers have higher abnormal returns around announcements of delays in Section 404 implementation, suggesting that investors interpret the delays as positive news. Regarding the benefits of Section 404, Singer and You (2010) find that compared with non-accelerated filers, accelerated filers improve their earnings quality more around the adoption of Section 404, where the earnings quality is measured by variables such as absolute abnormal accruals and the asymmetry between slightly meeting and slightly missing analysts forecasts. Qian et al. (2010) report that after the adoption of Section 404, accelerated filers enjoy more economic benefits than non-accelerated filers, including reduced CEO compensation and financial slack, and improved access to public debt. No studies, however, have focused on whether the adoption of Section 404 reduces earnings manipulations outside of GAAP. Examining this issue is important for at least two reasons. First, SOX, which was enacted in response to a number of high-profile corporate scandals, aims to prevent corporations from manipulating earnings outside of GAAP. Second, the underlying causes of within GAAP earnings management and outside of GAAP earnings manipulations may differ (due, in part, to litigation risk and top management s incentives). For example, Jiang et al. (2010) document that the equity incentives of CFOs, but not CEOs, are significantly associated with discretionary accruals and the likelihood of beating analyst forecasts, more likely reflecting within-gaap earnings management. In contrast, Feng et al. (2010) show that CEOs, rather than CFOs, play a key role in accounting manipulations outside of GAAP. As a result, the findings in Singer and You (2010) may not be generalizable to outside GAAP manipulations. 2.2.2 Internal Control Quality 10

When implementing Section 404, firms assess and report the internal control quality as either effective or ineffective. Prior studies examine the impact of internal control quality in various settings such as accrual quality (Bedard, 2006; Doyle et al., 2007a; Ashbaugh-Skaife et al., 2008), stock prices and cost of equity capital (e.g., Ashbaugh-Skaife et al., 2009; Beneish et al., 2008; Hammersley et al., 2008; Ogneva et al., 2007), and audit cost (e.g., Ettredge et al., 2006, 2010; Hogan and Wilkins, 2008; Hoitash et al., 2008; Raghunandan and Rama, 2006). These studies generally find mixed results on the consequences of ineffective internal controls. Examining accrual quality, Doyle et al. (2007a) find no relation, on average, between accrual quality and material weaknesses filed under Section 404. However, Ashbaugh-Skaife et al. (2008) document evidence of improvements in accrual quality following remediation of material weaknesses for firms disclosing weaknesses. This mixed evidence on the relation between internal control and accrual quality could be due to the low power of the accrual quality measures. Prior research suggests that the accruals estimated based on accrual expectation models are subject to significant measurement error and thus are likely to incorrectly characterize a firm as having poor earnings quality (Dechow et al., 1995; McNichols, 2002; Hribar and Collins, 2002; Hribar and Nichols, 2007; Ball and Shivakumar, 2008). Restatements are a more direct measure of a company s errors in financial reporting (Palmrose and Scholz, 2004), resulting in higher-power tests about the potential impact of Section 404. 2.2.3 Material Misstatements Previous research has shown that a material misstatement can result in various negative consequences to the firm and the top management, such as declined stock price, increased cost of capital, increased litigation risk, and higher top management turnovers. Palmrose et al. (2004) investigate the market reaction to restatement announcements and document significant negative market-adjusted abnormal returns of -9.2% on average over a 2-day event window (days 0 and 1). According to a report published by the General Accounting Office in 2002, recent accounting restatements have caused a market capitalization loss of around $100 billion and diminished public confidence in the capital markets. Hibar and Jenkins (2004) find that in the month immediately following a restatement, firms experience an 11

average of 7 to19 percent increases in the cost of equity capital. Research on litigation indicates that restatements increase the risk of securities class action lawsuits (Jones and Weingram, 1996), and certain types of restatements increase both the likelihood and severity of lawsuits (Palmrose and Scholz, 2004). Restating companies also experience higher top manager (board chair, CEO, and/or president) turnover and director turnover, compared to matched, non-restatement companies (Srinivasan, 2005; Desai et al., 2006). Researchers and regulators have blamed stock-based compensation, especially the stock option component, for prompting managers to manipulate financial statements. Consistent with this argument, the former Chairman of the Federal Reserve Board, Alan Greenspan, argues that too many corporate executives artificially inflate reported earnings in order to increase the stock compensation. Several papers also document that stock-based compensation is positively associated with the likelihood of restatements (e.g., Burns and Kedia, 2006; Efendi et al., 2007). Given that equity incentive compensation appears to motivate managers to manipulate the financial statements, which is highly costly to shareholders, corporate boards have reduced the incentive compensation of executives since the passage of the SOX (e.g., Cohen et al., 2010). While this reduction will decrease managers incentives to manage earnings, it may result in misalignment with managers and shareholders interests. Specifically, Jensen and Meckling (1976) argue that managers compensation should be linked with shareholders wealth in order to resolve conflicts of interest between managers and shareholders. Smith and Stulz (1985) show that stock options can be used to reduce the effects of managerial risk aversion. Therefore, reducing equity incentives may increase agency costs, such as moral hazard and avoidance of risky projects. Like compensation incentives, avoiding debt covenants violations also provides an incentive for firms to misstate their earnings. For example, Dechow et al. (1996) find that earnings manipulation firms are more likely to violate debt covenants during and after the manipulation period than control firms. In addition, restatement firms have higher leverage and interest coverage ratios than matched control firms (Richardson et al., 2003; Burns and Kedia, 2006; Efendi et al.; 2007). 12

While prior research has examined various incentives associated with material misstatements, no study has investigated whether internal controls mitigate the influence of these incentives on material misstatements. Investigating this is important as it helps prevent costly accounting misstatements without sacrificing those incentives. 3. Hypothesis Development 3.1 Misstatement detection For a restatement to exist, a material error must occur in the accounting reporting process, and the error must not initially be detected by the company s internal control systems or by the external auditors (Kinney and McDaniel, 1989). Because internal control over financial reporting (ICFR) is intended to provide reasonable assurance that the preparation of financial statements is in accordance with GAAP (PCAOB, AS No. 5, 2007), the objective of companies ICFR is to prevent errors from occurring in the financial reporting processes; if errors have already occurred, the control systems should be able to detect them before the financial reports are issued. Before Section 404, a company s internal controls are considered in the context of planning the audit but are not required to be reported publicly, except in response to the SEC s Form 8-K requirements related to a change in auditor. Section 404 has changed this one-time evaluation to an ongoing requirement (Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers, 2004). Specifically, accelerated filers need to document, test and evaluate their ICFR, and auditors need to report on the management assessment of the effectiveness of the ICFR. As companies build the evaluation of ICFR into their everyday processes, internal control problems are likely to be identified more quickly, and the financial reporting errors due to such control deficiencies will be detected. Thus, we expect that accelerated filers, which comply with Section 404, detect material misstatement more quickly than nonaccelerated filers which do not comply with Section 404. Our first hypothesis is stated as follows: H1: Accelerated filers detect material misstatements more quickly than non-accelerated filers. 13

We use fiscal year 2004 as the first compliance year. 9 To test this hypothesis, we first examine the association between filer status and the timeliness of misstatement announcements in 2004. We then conduct a difference-in-difference test by examining how filer status is associated with changes in the timeliness of misstatement announcements from 2001 (pre-sox) to 2004. 3.2 Misstatement prevention As we mentioned earlier, one of the objectives of a company s ICFR is to prevent financial reporting errors from happening. If the internal control systems are effective, both intentional and unintentional errors will be greatly reduced (DeFond and Jiambalvo, 1991). An effective internal control process is comprehensive and involves people at all levels throughout a company, including those in a variety of operating roles, those who keep accounting records, those who prepare and disseminate policies, those who monitor systems and those serving on the top management team and the board of directors (Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers, 2004). Regarding unintentional material misstatements, a sound internal control system is likely to reduce procedural, estimation and system errors. Regarding intentional material misstatements, internal control systems help prevent managers from overturning the accounting department numbers by segregating duties, evaluating the tone at the top, and establishing whistle blower programs. In addition, because Section 404 creates an ongoing evaluation requirement, companies will learn from their evaluation process and remediate identified deficiencies on an ongoing basis, which will also result in fewer financial reporting misstatements. Moreover, among firms complying with Section 404, we expect internal control quality to influence the extent to which misstatements are reduced. Specifically, material weaknesses in internal controls could preclude certain errors in financial reports from being detected and corrected, and thus increase the likelihood of misstatements. Drawing on the above arguments, we form our second hypothesis. 9 We recognize that fiscal year 2005 is the first Section 404 adoption year for accelerated filers with fiscal year ending in June to October 2005. To make our tests consistent, i.e., based on fiscal years, we choose 2004 as the first adoption year. Excluding June to October fiscal year ending firms from the first year adoption sample potentially biases against our findings. 14

H2a: Accelerated filers are less likely to have material misstatements after complying with Section 404 than non-accelerated filers. H2b: Among accelerated filers, firms with effective internal controls are less likely to have material misstatements than firms with internal control material weaknesses. To test H2a, we first examine the association between the likelihood of misstatements and filer status during 2004 to 2007. We next compare the change in misstatements from 2001 to 2004 between accelerated filers and non-accelerated filers. To test H2b, we conduct two tests. First, we examine the association between the likelihood of restatements and internal control quality. Second, we partition the material weaknesses by type concentrating on weaknesses affecting sales or inventory, which we expect to be more likely to result in misstatements on revenue and inventory. 3.3 The mitigation role of internal control systems A stream of research suggests that fraud is more likely to occur when someone has an incentive to commit fraud, when weak controls or oversight provide an opportunity for the person to commit fraud, and when the person can rationalize the fraudulent behavior (e.g. Cressey, 1973; Loebbecke et al., 1989). This three-pronged framework, commonly known as the "fraud triangle," has long been a useful tool for CPAs seeking to understand and manage risk of material earnings manipulation. The framework has been formally adopted by the auditing profession as part of SAS 99 (AICPA, 2002). Importantly, each of these three factors is a necessary but not a sufficient condition for earnings manipulation. Hence, material misstatement risk assessments should consider the interaction of these factors (Loebbecke et al., 1989). For instance, incentive and rationalization can draw a person toward earnings manipulations. However, there also must be an opportunity opening the door to manipulation. As we discussed earlier, prior studies find that executive compensation and avoiding debt covenants violations provide two incentives for managers to materially misstate earnings (e.g. Dechow et al., 1996; Burns and Kedia, 2006; Efendi et al., 2007). Because reducing those incentives could be costly for shareholders and creditors, the greatest chance to prevent material earnings manipulation lies in reducing or minimizing the opportunity to do so. This is typically done by implementing a good system of internal controls. By building the documentation 15

and evaluation of internal controls into companies everyday processes, Section 404 compliance is likely to alleviate the impact of compensation and debt covenant incentives on material misstatements. In addition, we expect that material weaknesses in internal controls are likely to hinder the alleviating role of internal control. Our third and fourth hypotheses are thus stated as follows: H3a: Managerial compensation incentives are less likely to motivate managers to materially misstate earnings in accelerated filers than in non-accelerated filers. H3b: Managerial compensation incentives are less likely to motivate managers to materially misstate earnings in firms with effective internal controls than in firms with internal control material weaknesses. H4a: Debt covenant concerns are less likely to motivate managers to materially misstate earnings in accelerated filers than in non-accelerated filers. H4b: Debt covenant concerns are less likely to motivate managers to materially misstate earnings in firms with effective internal controls than in firms with internal control material weaknesses. 4. Sample Selection, Main Variable Definitions and Descriptive Statistics 4.1 Sample Selection We collect our data from Audit Analytics (Section 404 reports and restatement) and Compustat (financial information). 10 We begin with all 132,861 firm-year observations covered by Audit Analytics for fiscal years 2000 through 2007. 11 We then require them to be covered by Compustat, which results in 66,878 observations. After excluding 10,982 firm-year observations that do not have necessary financial data from Compustat, our final sample contains 55,896 firm years. Among them, 4458 (7.2%) announced restatements between 01/01/2000 and 12/31/2009. Because accelerated filers are required to have Section 404 auditor reports after fiscal year end of November 15, 2004, we define firms having Section 404 auditor reports as accelerated filers, and firms without Section 404 auditor reports as non-accelerated 10 Audit Analytics does not consider a company s adoption of a new accounting rule as a restatement. Only instances of accounting errors or fraud are included in its restatement dataset. 11 Our sample stops at fiscal year 2007 because there is, on average, a lag of two and a half years between the misstatement and its subsequent detection and announcement through a restatement. 16

filers. 12 If firms are accelerated filers from 2004, we treat them as accelerated filers before 2004 for our test of H1. In our sample, 26,188 (46.9%) firm-year observations are accelerated filers, while 29,708 (53.1%) firm-year observations are non-accelerated filers. Among accelerated filers, 1,820 (9.6%) observations have adverse Section 404 auditor opinions, which indicate a material weakness in the internal controls over financial reporting. Further sample attrition processes will be discussed in each analysis. 4.2 Main Variable Definitions We create four indictor variables in order to test our hypotheses: RESTATE, MISSTATE, ACCELERATE, and ICMW. RESTATE i,t is equal to one if firm i announces a restatement from 270 days before to 90 days after the end of fiscal year t. Assume, for example, that on February 1, 2005, a December fiscal-year-end firm announces to restate its financial reports for fiscal years 2002 and 2003. RESTATE 2004 is then equal to one. We use this window because some misstatements are found by auditors in the financial reporting auditing or ICFR evaluation process. MISSTATE i,t is equal to one if there are material misstatements in the financial reports of firm i at year t, regardless of when the firm announces the restatements. In the above example, both MISSTATE 2002 and MISSTATE 2003 are equal to one. ACCELERATE i,t is equal to one if firm i complies with both Section 404(a) and 404(b) in year t, and zero otherwise. ICMW i,t is equal to one if firm i receives an adverse 404 opinion for year t, and zero if the firm receives a clean 404 opinion for year t. 4.3 Descriptive Statistics Our data covers restatement announcements from fiscal year 2000 to 2007. Overall, 7.2% firms in our sample announced restatements. Table 1 reports the restatement announcement rate (RESTATE) for accelerated vs. non-accelerated filers. In our sample period, non-accelerated filers are generally more likely to announce restatements than accelerated filers except in years 2002-2004, when SOX was passed 12 We do not use $75 million public float as the cut-off between accelerated and non-accelerated filers because our purpose is to examine whether preparing Section 404 reports helps firms identify material misstatements. Even some small firms with less than $75 million public float voluntarily disclose 404 auditor reports, and they still engage in the same internal control evaluation process as large firms. Thus, we also consider them to be accelerated filers. 17

(2002) and Section 404 was implemented (2004). The difference between accelerated and nonaccelerated filers peaks in 2004, when accelerated filers announce about 50% more restatements than non-accelerated filers. Figure 1 depicts the trend. The change in the difference between accelerated filers and non-accelerated filers around SOX is consistent with the argument that the restatement rate is affected by SOX Section 404. Accelerated filers are likely to start to prepare for the 404 report in late 2002, and fully work on the documentation and testing of ICFR in 2004. During the process of evaluating their ICFR, accelerated filers are likely to identify errors in prior financial reports, which leads to restatements. In years subsequent to 2004, accelerated filers have ICFR in place, and thus are less likely to have errors in their financial reports and to announce restatement in the future. 13 Therefore, the restatement rate for accelerated filers drops significantly after 2004. -------------- Insert Table 1 and Figure 1 here ---------- 5. Empirical Models and Results 5.1 Test of H1: Timely detection of material misstatement Our H1 hypothesizes that accelerated filers can detect material misstatements more quickly than non-accelerated filers. In other words, conditional on having material misstatements in financial reports, accelerated filers are more likely to announce restatements in the years immediately following the misstatement year and less likely to announce restatements in later years than non-accelerated filers. To test H1, we focus on the misstatements that occurred in 2002 to 2004 and were announced in 2004, 14 the first compliance year of Section 404. As Table 1 shows, the restatement announcement rates for accelerated filers significantly decrease after 2004. Moreover, the type of misstatements could also differ for accelerated and non-accelerated filers after the initial year of Section 404 compliance. For example, the errors in non-accelerated filers financial reports could be easier to detect than those in accelerated 13 We will examine the timely detection of previous misstatement in the test of H1 and the prevention of future misstatement in the test of H2. Both are reported in the next section. 14 The mean and the median of the difference between the firms misstatement starting time and the restatement disclosure time in our restatement sample is 779 days and the median is 880 days, which is about two and a half years. As a result, we examine the restatement disclosures in 2004 for misstatements that occurred in the prior two years (2002-2003) and in the first three quarters of 2004. 18

filers financial reports, as the errors of accelerated filers initially escape the detection of the ICFR. In contrast, the misstatements of accelerated and non-accelerated filers are less likely to differ systematically in years 2002 and 2003. Table 2, Panel A reports, for each year from 2004 to 2007, the percentage of firms that announce to restate the financial statements of 2002, 2003 and the first three quarters of 2004. Compared with nonaccelerated filers, accelerated filers are significantly more likely to restate their financial reports of the prior three years in 2004, but are less likely to restate the reports in 2005 and 2006. Among all misstatements in 2002-2004 that are restated in 2004-2007, accelerated filers detect and announce 74% in 2004 and 26% in the remaining three years, while non-accelerated filers detect and announce only 45% in 2004. These results are consistent with our argument in H1 that accelerated filers are more likely to detect errors in a timely manner in the first year of Section 404 reports. Figure 2 depicts the difference between accelerated and non-accelerated filers from 2004 to 2007. One alternative explanation for our finding is that accelerated filers have more resources, so they can always discover misstatements more quickly than non-accelerated filers. To mitigate this concern, we also do a difference-in-difference analysis. As we did for 2004, we calculate for 2001 the percentages of accelerated and non-accelerated filers restating their financial statements of 1999, 2000 and the first three quarters of 2001. We then compare the change in restatement rate from 2001 to 2004 for accelerated and non-accelerated filers. We choose 2001, the latest year before the passage of SOX, as our comparison year to avoid any confounding effect caused by the passage of SOX. As Table 2 Panel B shows, 12 percent of accelerated filers restate their prior three years financial statements in 2004, which is more than three times the percentage in 2001, 3.4%. Although the restatement rate also increases from 5.4% to 7.8% for non-accelerated filers, the magnitude of the change is much smaller. 15 Overall, the restatement rate for accelerated filers increases by 8.8%, which is significantly greater than the rate increase for nonaccelerated filers, 3.2%, with a p-value of less than 0.001. These findings indicate that the high 15 0.088 and 0.030 are slightly different from the difference between 2004 and 2001 (0.120-0.034 = 0.086, 0.078-0.054 = 0.024), because we require both 2001 and 2004 data in the difference-in-difference test. 19

restatement rate in 2004 for accelerated filers is likely to be driven by their compliance with Section 404 rather than the difference between accelerated and non-accelerated filers. -------------- Insert Table 2 and Figure 2 here ---------- Accelerated and non-accelerated filers can be systematically different in various aspects, such as company size, financial performance, organizational changes, complexity, future financing, auditors and firm age. These factors could also be related to financial restatements (e.g. Kinney and McDaniel 1989; DeFond and Jiambalvo 1991; Turner and Sennetti 2001; Efendi et al. 2007). To control for the differences, we estimate the following logistic regression: where: RESTATE = b 0 + b 1 ACCELERATE + b 2 LNAT + b 3 ROA + b 4 LEVERAGE + b 5 LOSS + b 6 BKMK + b 7 RESTRUCT + b 8 MA + b 9 FOREIGN + b 10 SEGNUM + b 11 SI + b 12 FINANCING + b 13 BIGN + b 14 AGE (1) ACCELERATE = an indicator variable that is equal to one if a firm complies with Section 404 reports, and 0 otherwise. LNAT ROA LEVERAGE LOSS BKMK RESTRUCT MA FOREIGN SEGNUM SI FINANCING = the natural logarithm of total assets. = net income / total assets. = total long-term debt / total assets. = the percentage of number of years reporting negative net income in the prior three years. = book to market ratio. = an indicator variable that is equal to one if a firm recognized restructuring charges, and 0 otherwise. = an indicator variable that is equal to one if a firm undertook a large merger or acquisition, and 0 otherwise = an indicator variable that is equal to one if a firm has foreign transactions, and 0 otherwise. = the natural logarithm of the total number of geographic and operating segments. = the absolute value of special items / total assets. = an indicator variable that is equal to one if a firm issues new equity or new debt in the following year, and 0 otherwise. 20