Articlegreen2014

Internal Control Weaknesses and Financial Reporting Fraud

Dain C. Donelson · Matthew S. Ege · John M. McInnis

238 citations0/0 files storedAuditing A Journal of Practice & Theory

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Auditing, Earnings Management, Governance Accounting and Organizational Management Corporate Governance and Financial Management

Abstract

SUMMARY This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. There is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. Further, there is no evidence on the mechanism linking control strength to fraud risk. We find a strong association between material weaknesses and future fraud revelation. 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. Instead, consistent with the PCAOB's assertion, weaknesses in entity-wide controls, not process-level controls, are associated with a higher risk of reporting fraud. JEL Classifications: M41.

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References

2002The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors 2001Forecasting Bankruptcy More Accurately: A Simple Hazard Model 2010Who Blows the Whistle on Corporate Fraud?2011Predicting Material Accounting Misstatements*2007Determinants of weaknesses in internal control over financial reporting 2007Accruals Quality and Internal Control over Financial Reporting 2008The Cost to Firms of Cooking the Books 2008The Importance of Distinguishing Errors from Irregularities in Restatement Research: The Case of Restatements and CEO/CFO Turnover

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