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Accounting Resources Directly Impact Internal Control Competencies

1/10/2005 --

New study shows that poor internal control is usually associated with inadequate accounting resources.

ANN ARBOR, Mich. – In the wake of the Enron and WorldCom financial scandals of 2002, the Sarbanes-Oxley Act (SOX) was enacted to protect company shareholders and the general public from accounting errors and fraudulent practices.

A new study by Weili Ge, a doctoral candidate in accounting at the Stephen M. Ross School of Business at the University of Michigan, and colleague Sarah McVay, a professor at New York University's Stern School of Business, examines disclosure of material weaknesses in internal control following this landmark legislation.

Their findings are based on a sample of 145 companies that have disclosed such material weaknesses in their 10-K filings. These annual reports, which include information on company history, organization, financial performance and data, officers, competition and executive compensation, are required by the Securities and Exchange Commission within 90 days of the close of the normal fiscal year.

"Since the Sarbanes-Oxley 404 on internal control is effective from November 2004, our paper is the first paper that provides empirical evidence on the internal control issue after the SOX," Ge and McVay said.

The study found that poor internal control is usually associated with inadequate accounting resources. Further, material weaknesses in internal control tend to be related to improper revenue recognition, lack of segregation of duties within a company, deficiencies in the period-end reporting process and accounting policies, and inappropriate account reconciliation.

Ge and McVay say that account-specific material weaknesses in internal control are the most pervasive in the current accrual accounts, supporting the notion that these accounts are less reliable than the average balance sheet account. In addition, complex accounts, such as derivatives and income tax, also tend to have internal control problems.

The researchers also found that disclosing a material weakness is positively associated with complexity (measured by the number of reported operating segments), but negatively associated with experience (measured by firm age) and profitability (measured by earnings).

"Interestingly, we find that being audited by a large audit firm is positively associated with the reporting of a material weakness," Ge and McVay said. "It is possible that large audit firms were more diligent about searching for and reporting material weaknesses in our sample period."

Written by Nancy Davis

For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847