Analysis of Material Weaknesses in Internal Control ...



Analysis of Material Weaknesses in Internal Control Disclosures After the Sarbanes-Oxley Act

DESCRIPTION OF PROJECT

Purpose: The proposed research will examine the type and frequency of material weaknesses in internal control over financial reporting disclosed by publicly held corporations in the U.S. pursuant to the Sarbanes-Oxley Act. The results should be useful to those with an interest in financial statements, including users, preparers (i.e. company management), external auditors, and accounting regulators.

Statement of Problem: The Sarbanes-Oxley Act, passed in July 2002, requires top management in publicly traded companies to maintain and regularly evaluate the effectiveness of internal control over financial. Each annual report that a publicly held company filed with the Securities and Exchange Commission (SEC) must include an assessment report by management of effectiveness of internal control and disclose any material weakness. A material weakness in internal control is defined as "a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected" (PCAOB, 2004). If a material weakness in internal control is identified, management is prohibited from concluding that the internal control is effective. The company's independent auditor is also required to attest to and report on the assessment by management. Such audit report also must be included in the annual report filed with the SEC. The identification of material weaknesses internal control has several implications for those interested in financial reporting. For the company's management, they are required to take action to improve the effectiveness of the company's internal control. The question is whether the management actually takes action to correct the weaknesses or if such weaknesses continue to exist. Also, the company's independent auditor will need to decide on the appropriate responses when such weaknesses exist or continue to exist. Since material misstatements may not be prevented or detected in the presence of such a material weakness, the reliability (or quality) of financial statements will suffer. As a result, users of financial statements may make the wrong investment decisions. Therefore, the findings from this proposed research should be informative to those interested in the quality of financial reports.

Method of lnquiry: First, I will search and review prior auditing research to better understand the issues related to internal control over financial report. Next, I will identify cases of material weaknesses in internal control that publicly held companies have disclosed in their annual report on SEC Form 10-K. I will then use a classification scheme similar to that of Ge and McVay (Accounting Horizon, September 2005) to determine the types and frequency of internal control deficiencies. I will also examine whether any material weakness disclosed is corrected or if it persists. I will also analyze if the types of internal control weaknesses are related to the type of auditors, industry type, and some financial characteristics of the companies. Data analysis software, such as SAS, will be used to analyze the data on internal control weaknesses.

Project Results: I will write a paper to summarize the research methodology and findings. The expected findings may include some internal weaknesses will persist. Also, I expect that the type and frequency of internal control deficiencies are related to auditor type and financial characteristics of the companies. Finally, the frequency of internal control deficiencies is also expected to be related to the type of industry in which a company operates.

TIMETABLE:

Jan. 2, to Jan. 20, 2007: Literature search and review (20 hrs)

Jan. 21 to Mar. 20, 2007: Data collection (45 hrs)

Mar. 21 to April 20, 2007: Data analyses (20 hrs)

April 21 to May 31, 2007: Draft paper (25 hrs)

June 1 to June 15, 2007: Edit and finalize paper (10 hrs)

RELATIONSHIP OF RESEARCH TO MY FACULTY SPONSOR:

My faculty sponsor teaches courses in auditing and financial reporting and he has been conducting research studies on issues in financial reporting quality. This research project will provide both of us with insights about compliance by companies with the requirements of the Sarbanes-Oxley Act. Specifically, both of us will gain knowledge about the types and circumstances of material weaknesses in internal control disclosed in the annual reports. Professor Lin will assist me in proper design and execution of the research project. Such assistance will include providing information about sources of and/or access to research database on disclosure of material weakness in internal control. Professor Lin will explain to me and show the proper data analysis method to use in this project. He will also provide comments and suggestions to improve my draft paper.

EDUCATIONAL OBJECTIVES:

This project will help me better understand issues related to financial reporting quality. And for personal growth, I will be able to further enhance my communication and research skills that will benefit me for both of my academic career as well as a professional in accounting. I would like to apply my classroom experience/learning to this research project. What I will learn from planning and carrying out this project will enhance my understanding of issues related to financial reporting in general and to internal control in particular. In addition, from my internship experience with Cargill, Inc. in the summer of 2006, I have learned the importance of internal control not only to financial reporting but also to the efficient operations of a business. Also, I have accepted a second internship with Cargill. I could foresee some of the internal audit tasks that Cargill may ask me to perform. The knowledge I will gain from doing this research about importance as well as potential weaknesses in internal control will better prepare me for this upcoming internship and future career in accounting as well.

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