ABSTRACT We study determinants of internal control reporting decisions under Section 404 of the Sarbanes‐Oxley Act (SOX 404) using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non‐audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.

ABSTRACT This study examines whether the volatility of interim estimates of the annual effective tax rate (ETR) provides ex ante information about the quality of firms' internal control environments. Recent research suggests that some firms selectively disclose internal control weaknesses (ICWs). Given the negative consequences associated with ICWs, it is important for capital market participants to be able to identify firms with ineffective internal controls in a timely manner. We find that firms with more volatile annual ETR estimates are more likely to report both tax‐ and nontax‐related ICWs in the current year. Our results also indicate that the volatility of annual ETR estimates declines following the remediation of tax‐related ICWs, but not following the remediation of nontax‐related ICWs. In addition, we find that ETR volatility in the current year is associated with the likelihood that a firm will report an ICW in the following year. Finally, we provide evidence that the volatility of annual ETR estimates is associated with the likelihood that a firm has an undisclosed ICW. In combination, our results suggest that the volatility of interim estimates of the annual ETR provides an ex ante signal of the likelihood that a firm's internal controls are ineffective.

Using the IPO setting, we test whether firms signal the quality of their investments in innovation activities by claiming R&D tax credits. We find the presence and amount of the R&D credit are each associated with lower information asymmetry and with higher investor demand at IPO. Conservatively, we estimate that sample firms realize additional IPO proceeds of 32–45 percent of their creditable R&D expenditures, indicating economically significant non-tax benefits associated with the R&D credit. We verify the R&D credit signal by showing its positive association with firms’ future patenting activity, patent citations, and post-IPO stock returns. Results from these tests are concentrated among firms limited in their ability to obtain tax benefits from R&D credits, consistent with the R&D credit providing nontax benefits as a signal of innovation investment quality.

ABSTRACT This study provides evidence that binary signals in audit reports are unable to fully communicate underlying risks that are inherently continuous in nature. Specifically, we find that companies whose audit reports signal an improvement in internal control effectiveness relative to the prior year are still more likely to subsequently restate the current year's financial statements than companies with no material weaknesses in either year. Similarly, companies deemed to no longer have substantial doubt of continuing as a going concern are still more likely to declare bankruptcy than companies with no going concern opinion in either year. Results in both settings suggest the presence of residual risk that cannot be communicated through a binary audit report, despite the fact that auditors recognize the risk, as evidenced by higher audit fees and longer audit report lags. Our findings are strongest when the reported improvement is more pronounced, and our results hold in matched samples. Our study provides empirical evidence that supports recent regulatory efforts to improve the content of the audit report and offers suggestions for future research.

ABSTRACT We examine various penalties that could serve as enforcement mechanisms for Sarbanes-Oxley (SOX) Section 404. We focus on firms with restatements, some of which had previously reported their control weaknesses as required and some of which acknowledged them only after announcing their restatement. We find no evidence that penalties are more likely for firms, managers, or auditors that fail to report existing control weaknesses. Instead, class action lawsuits, management turnover, and auditor turnover are all more likely in the wake of a restatement when control weaknesses had previously been reported. We find similar, although weaker, evidence for Securities and Exchange Commission (SEC) sanctions. These results are consistent with disclosure of control weaknesses making it difficult for management to plausibly claim later that they were unaware of the underlying conditions that led to restatements. The results also suggest that the public and private enforcement mechanisms surrounding SOX 404 are unlikely to provide strong incentives for compliance and offer a potential explanation for why most restatements are issued by firms that previously claimed to have effective internal controls.