Hambisa Belina

SUMMARY: Prior research shows that many of the companies that disclose material weaknesses in internal control (MWs) do not disclose such weaknesses in earlier quarterly 10-Q filings for the same year—i.e., the year-end MW disclosures are “surprise” disclosures. We find that shareholders at accelerated filers with surprise MW disclosures are more likely to vote against auditor ratification (by a factor of about 1.4 times) than at companies with “no-surprise” MW disclosures. These findings suggest that shareholders may at least partly blame auditors and hold them responsible for the surprise MW disclosures. Internal control disclosures necessarily involve professional judgment, but the results indicate that for shareholders, earlier disclosure of such problems is preferable to waiting until the year-end (and perhaps hoping that the problems will be resolved).

SUMMARY: SOX Section 404(b) continues to be of interest to legislators and regulators. Prior studies show that in the initial implementation years of SOX 404, the majority of material weakness (MW) disclosures were “surprise” MWs—i.e., disclosed at year-end, but not in prior quarterly filings (Hermanson and Ye 2009; Munsif, Raghunandan, and Rama 2013). We show that during the years 2010–2019, 74 (72) percent of MW disclosures by accelerated (non-accelerated) filers were surprise disclosures. Additionally, surprise MWs are more likely to be associated with internal control issues that involve year-end adjustments and/or documentation, procedure, or policy issues. “Early-warning” MWs are more likely due to systemic internal control problems, like segregation of duties. Our findings suggest a role for auditors and substantive audit tests in the disclosure of certain types of MWs. Increased auditor emphasis on interim substantive tests may reduce the likelihood of surprise MWs.