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Using unique survey data from Great Place to Work® Institute, we investigate the association of intraorganizational trust (i.e., employees' trust in management) with three aspects of financial reporting: accruals quality, misstatements, and internal control quality. We find that trust is associated with better accrual quality, lower likelihood of financial statement misstatements, and lower likelihood of internal control material weakness disclosures. However, these effects are not uniform across all companies. Consistent with trust improving financial reporting quality through improved information production and information sharing, we find that trust is significantly associated with financial reporting quality in relatively decentralized firms, but not in firms that are relatively centralized. Our results are robust to several analyses that attempt to control for potential alternative explanations.

This study investigates the role that a firm's internal audit function (IAF) plays in the disclosure of material weaknesses reported under Section 404 of the Sarbanes-Oxley Act of 2002 (U.S. Congress 2002). Using data from 214 firms, we examine the relation between material weakness (MW) disclosures and various IAF attributes and activities. Our results indicate that MW disclosures are negatively associated with the education level of the IAF and the extent to which the IAF incorporates quality assurance techniques into fieldwork, audits activities related to financial reporting, and monitors the remediation of previously identified control problems. The timing of Section 404 work and the nature of follow-up monitoring suggests that these aspects of IAF quality help prevent MWs from occurring. We find that MW disclosures are positively associated with the IAF practice of grading audit engagements and external-internal auditor coordination, suggesting that these activities increase the effectiveness of Section 404 compliance processes.

We investigate whether ineffective internal control over financial reporting has implications for firm operations by examining the association between inventory-related material weaknesses in internal control over financial reporting and firms' inventory management. We find that firms with inventory-related material weaknesses have systematically lower inventory turnover ratios and are more likely to report inventory impairments relative to firms with effective internal control over financial reporting. We also find that inventory turnover rates increase for firms that remediate material weaknesses related to inventory tracking. Remediating firms also experience increases in sales, gross profit, and operating cash flows. Finally, we assess the generalizability of our findings by examining all material weaknesses in internal control over financial reporting, regardless of type, and provide evidence that firms' returns on assets are associated with both their existence and remediation. Collectively, our findings support the general hypothesis that internal control over financial reporting has an economically significant effect on firm operations.

This paper investigates the effect of internal control deficiencies and their remediation on accrual quality. We first document that firms reporting internal control deficiencies have lower quality accruals as measured by accrual noise and absolute abnormal accruals relative to firms not reporting internal control problems. Second, we find that firms that report internal control deficiencies have significantly larger positive and larger negative abnormal accruals relative to control firms. This finding suggests internal control weaknesses are more likely to lead to unintentional errors that add noise to accruals than intentional misstatements that bias earnings upward. Third, we document that firms whose auditors confirm remediation of previously reported internal control deficiencies exhibit an increase in accrual quality relative to firms that do not remediate their control problems. Finally, we find firms that receive different internal control audit opinions in successive years exhibit changes in accrual quality consistent with changes in internal control quality. Collectively, our cross-sectional and intertemporal change tests provide strong evidence that the quality of internal control affects the quality of accruals.

In 2001, the US moved to regulate internal control reporting by management and auditors. While some jurisdictions have followed the lead of the US, many others have not. An important question, therefore, is the relevance of internal control to stakeholders. The more specific issue of the benefits of US-style regulation of internal control reporting is also topical. We review studies on the determinants of internal control quality and its economic consequences for stakeholders including investors, creditors, managers, auditors and financial analysts. We extend previous reviews by focusing on US studies published since 2013 as well as all non-US studies investigating IC quality including countries regulating IC disclosure as well as unregulated settings and both developed and developing economies. In doing so, we identify research questions where evidence remains mixed and new directions in which there are research opportunities. Three main insights arise from our analysis. First, evidence on the economic consequences of internal control quality suggests that the quality of internal control can have a significant effect on decision making by users of financial information. Second, the results of research on the empirical association between ownership structure, certain board characteristics and internal control quality is generally mixed. Empirical evidence concerning the association between audit committee characteristics and internal control quality generally supports a positive and significant association. Finally, while studies in non-US jurisdictions are increasing, opportunities remain to explore the determinants and consequences of internal control in other jurisdictions. Our review provides evidence for policy makers of whether there are benefits from requiring management and auditors to report on internal control over financial reporting.

Using a sample of borrowing firms that disclosed internal control weaknesses (ICW) under Section 404 of the Sarbanes-Oxley Act, this study compares various features of loan contracts between firms with ICW and those without ICW. Our results show the following. First, the loan spread is higher for ICW firms than for non-ICW firms by about 28 basis points, after controlling for other known determinants of loan contract terms. Second, firms with more severe, company-level ICW pay significantly higher loan rates than those with less severe, account-level ICW. Third, lenders impose tighter nonprice terms on firms with ICW than on those without ICW. Fourth, fewer lenders are attracted to loan contracts involving firms with ICW. Finally, our within-firm analyses show that banks increase loan rates charged to ICW firms after their disclosure of internal control problems and that banks reduce loan rates after firms remediate previously reported ICW.

This study investigates the role of employment policies in reducing internal control ineffectiveness and financial restatements. We provide new evidence that employee treatment policies are an important predictor of ineffective internal control. We also find that employee-friendly policies significantly reduce the propensity for employee-related material weaknesses. These results suggest that greater employee benefits facilitate the acquisition, development, and motivation of the workforce and ameliorate the loss of valuable human capital, thereby mitigating employee failures to implement internal control tasks properly. Moreover, we document novel results that financial restatements, especially those caused by unintentional errors, are less likely to arise in firms that invest more in employee benefits. Collectively, our emphasis on the effect of employee treatment policies on the integrity of internal control and financial reporting distinguishes our paper from previous studies that focus on the role of top executives in accounting practices.

We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to \"audit around.\" We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

This study examines the extent to which audit clients successfully engage in internal control opinion shopping activities and whether audit market competition appears to facilitate those activities. Regulators have long been concerned about the impact of both audit market competition and opinion shopping on audit quality. We adopt the framework developed in Lennox (2000) to construct a proxy to measure the tendency that clients engage in internal control opinion shopping activities. Our empirical results suggest that clients are successful in shopping for clean internal control opinions. In addition, we find evidence that internal control opinion shopping occurs primarily in competitive audit markets. Finally, our results indicate that among auditor dismissal clients, opinion shopping is more likely to occur when dismissals are made relatively late during a reporting period and when audit market competition is high. Our findings have implications for the current policy debate regarding audit quality and audit market competition.

Internal controls influence information quality, thus affecting the ability of supply chain partners, who rely on collaborative systems of information sharing, to reliably contract. Using SOX-related internal control assessments as a proxy for internal control quality and U.S. GAAP-mandated major customer disclosures, we find that supplier internal control quality influences supply chain relationship duration. Specifically, our evidence demonstrates that: (1) poor internal control quality increases the likelihood of subsequent customer-supplier relationship termination; (2) timely control weakness remediation attenuates termination likelihood; and (3) weaknesses affecting customer contracting drive the effect of internal control quality on relationship termination. Our results control for supplier operational quality and performance, and are robust to propensity score matching techniques, controls for reverse causality, and alternative proxies for relationship termination and internal control quality. Overall, our findings are consistent with customers viewing strong supplier controls as important, albeit overlooked, contracting elements with significant implications for supply chain relationships.