Internal Control Weaknesses and Financial Reporting Fraud

Abstract

This study examines whether and how weak internal controls increase the risk of financial reporting fraud by top managers. Since top managers can override controls, there is a longstanding debate on whether control strength significantly affects fraud risk, yet little evidence on this issue. In fact, prior work suggests that control weaknesses are linked to lower quality accruals associated with errors, not intentional manipulation. We find a strong association between material weaknesses and future fraud revelation. We theorize this link could be attributable to weak controls a) giving managers greater opportunity to commit fraud or b) signaling a management characteristic that does not emphasize reporting quality and integrity. We find support consistent with weak controls giving managers the opportunity to commit fraud through entity-not process-level controls. This supports the PCAOB's assertion that entity-level controls reduce the risk of fraud and management override of controls.

Do the SEC Whistleblower Provisions of Dodd Frank Deter Aggressive Financial Reporting?

“…Doyle et al (2007a) also report significantly lower accrual quality for firms reporting ICWs. Chan, Farrell and Lee (2008) document a positive association between ICWs and restatements, and Donelson, Ege and McInnis (2016) find that firms that disclose material ICWs are significantly more likely to have a future fraud revelation, particularly for entity-level controls. This research supports an association between internal control quality strength and financial reporting quality.…”

The Value of Restatement to Fraud Prediction

“…Liou (2008) found an average time lag of around three years from the fraud to its detection. Therefore, We obtain the fraud data from 2009 to 2016, which is similar with the research (Donelson, Ege, & McInnis, 2017). For example, if a restatement occurred in 2013, the calculation of fraud sample would start from 2013 to 2016 which is released after the issuance of restatement.…”

Studies on Earnings Management and Financial Statement Fraud in Corporate Firms

“…This include accounting professionals to rationalize earnings management decision and incorporate corporate ethics and social responsibility in performing their duties (Shafer, 2015). Subsequently, weak controls will give managers the opportunity to commit fraud as earnings management is outweigh (Donelson, Ege, & McInnis, 2016;Zhang & Gao 2018). Ronen and Yaari (2007) classify earnings management as white (beneficial), gray (manipulation within boundaries) and black (misrepresentation and fraud).…”