In the 15 years since the Sarbanes-Oxley Act was passed to deter the kind of fraud committed by Enron and other companies, Section 404(b) continues to garner criticism for its requirement that external auditors assess companies’ internal controls over financial reporting.
A new study published in the American Accounting Association’s “Auditing: A Journal of Practice & Theory” likely will fuel more debate on the merits of Section 404(b).
The 26-page report, Internal Control Weaknesses and Financial Reporting Fraud, makes the case that Section 404(b) serves as an early warning system for corporate fraud. The study finds that "a statistically and economically significant association between material weaknesses [in internal controls] and the future revelation of fraud... driven entirely by instances where the internal control issue reflects a general opportunity to commit fraud."
Indeed, the incidence of fraud disclosures at companies that previously were found to have material weaknesses is 80 percent to 90 percent more than at other firms. And of the 127 fraud cases that the study identifies, material weaknesses in internal controls were cited in almost 30 percent of them.
Chief executive officers were named in 111 of the 127 fraud cases, and chief financial officers in 108.
"Although material-weakness reports mostly reflect accounting errors and portend revelations of fraud only infrequently, the fact that they precede almost 30 percent of the instances where fraud does, in fact, come to light should lead investors, regulators, and legislators to take notice," said Matthew Ege of Texas A&M University, who conducted the study with Dain Donelson and John McInnis of the University of Texas in Austin.
“We find a strong association between material weaknesses and future fraud revelation,” they write in the study. “We theorize that this link could be attributable to weak controls (1) giving managers greater opportunity to commit fraud, or (2) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support for the opportunity explanation, but not through specific accounts linked to control weaknesses.”
In fact, skeptics have indicated that top managers could override the best of internal controls. Some have said that devious managers would want strong controls because it would reduce the likelihood of anyone finding the fraud, which would benefit the managers more than fraudsters elsewhere in the company.
That’s been the contention of the Public Company Accounting Oversight Board, which believes that entity-wide controls — not process-level controls — are tied to a greater risk of reporting fraud, the study states.
While the researchers acknowledge that the study doesn’t address the completeness of Section 404(b) reporting in the identification of companies with weak controls, the findings indicate that control opinions citing material weaknesses provide a “meaningful signal of increased fraud risk.”
The authors write that their findings indicate that an auditor’s adverse internal control opinion is a red flag that points to managers who are committing unrevealed fraud. Further, fraud or litigation prediction models should control for internal control weaknesses. And Section 404(b)’s early fraud warning potential may prompt regulators and policymakers to consider how to improve the accuracy of material weakness disclosures.
The authors based their study on about 14,000 auditor internal-control opinions for large and medium-size corporations, and they analyzed the relationship between reports of material weaknesses and incidents of company fraud within a three-year period. Fraud was revealed by reviewing settled securities class-action lawsuits for violations of generally accepted accounting principles and federal enforcement actions by the Securities and Exchange Commission or Department of Justice.
Further research could explore whether auditor expertise or other characteristics could mitigate the connection between material weaknesses and discovery of future fraud, the authors concluded.
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.