We examine determinants of weaknesses in internal control for 779 firms disclosing material weaknesses from August 2002 to 2005. We find that these firms tend to be smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. Firms with more serious entity-wide control problems are smaller, younger and weaker financially, while firms with less severe, account-specific problems are healthy financially but have complex, diversified, and rapidly changing operations. Finally, we find that the determinants also vary based on the specific reason for the material weakness, consistent with each firm facing their own unique set of internal control challenges.

We quantify measurable benefits and costs of exempting firms from auditor oversight of internal control effectiveness disclosures. We measure the benefit of exemption as an aggregate 388 million in audit fee savings from 2007–2014. The costs stem from internal control misreporting: an aggregate 719 million of lower operating performance due to non-remediation and a $935 million delay in aggregate market value decline due to the failure to disclose ineffective internal controls. The audit fee savings benefit shareholders of all exempt firms, whereas the costs are borne by shareholders of only a fraction of exempt firms (the internal control misreporters).

Researchers have used various measures as indications of “earnings quality” including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because “quality” is contingent on the decision context. We also point out that the “quality” of earnings is a function of the firm’s fundamental performance. The contribution of a firm’s fundamental performance to its earnings quality is suggested as one area for future work.

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 paper examines why CFOs become involved in material accounting manipulations. We find that while CFOs bear substantial legal costs when involved in accounting manipulations, these CFOs have similar equity incentives to the CFOs of matched non-manipulation firms. In contrast, CEOs of manipulation firms have higher equity incentives and more power than CEOs of matched firms. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives. AAER content analysis reinforces this conclusion.

This paper examines how chief executive officers’ (CEOs’) prosocial tendency influences corporate policies and firm value. We use individuals’ involvement with charitable organizations as a proxy for prosocial tendency. We find that, compared to firms with non-prosocial CEOs, firms with prosocial CEOs have lower executive subordinate turnover, implement more employee-friendly policies, experience higher customer satisfaction, and engage in more socially responsible activities. We also find that firms with prosocial CEOs have higher value and lower risk, partly due to the corporate policies adopted by prosocial CEOs. These results are corroborated when we compare changes in corporate policies and firm value around different types of CEO turnovers: a prosocial CEO replacing a non-prosocial CEO versus other types. Our results thus suggest that prosocial CEOs are more likely to make corporate decisions that benefit others and increase firm value.

ABSTRACT We examine whether the strength of internal control over financial reporting (internal control) reduces the expropriation of resources from the firm by managers and controlling shareholders. Although we have ample evidence from prior literature that internal controls reduce errors in financial reports, it is less clear that they can curb resource extraction, because management may fail to enforce these controls. Exploiting the setting of China, where we have a rich internal control data set and established measures of resource extraction, we provide evidence consistent with internal controls curbing resource extraction on average. In particular, we document a negative association between internal control strength and resource extraction. We also find that the association between internal control strength and resource extraction is weaker in settings where we expect management to have fewer incentives to enforce these controls: within state‐owned firms and within non‐state‐owned firms that have a powerful controlling shareholder. We interpret these results as suggesting that internal controls must both exist and be enforced by management for the controls to safeguard assets. Although the analyses are conducted using Chinese data, we expect the spirit of our findings to generalize to other settings—management can “window dress” internal control procedures while still engaging in undesirable behavior.