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Section 404(a) of the Sarbanes-Oxley Act of 2002 (SOX) requires the senior management of U.S. public companies to issue a report assessing the effectiveness of the company's internal control over financial reporting (ICFR). In addition, SOX section 404(b) requires the independent auditors of U.S. public companies to attest to the effectiveness of ICFR, although smaller public companies have been permanently exempted from this provision. Through these reporting requirements, regulators have sought to improve the quality of financial reporting and bolster investor confidence.
An entity's ICFR is considered ineffective if a material weakness is identified. The Public Company Accounting Oversight Board (PCAOB) defines a material weakness as "a deficiency, or a combination of deficiencies, in internal control over financial reporting, such mat mere is a reasonable possibility mat a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis" (Auditing Standard [AS] 5, An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements, Appendix A, A7, PCAOB, 2007).
Numerous studies have examined various issues related to material weakness reporting, such as the following:
* Characteristics of companies reporting material weaknesses (e.g., Weili Ge and Sarah E. McVay, "The Disclosure of Material Weaknesses in Internal Control After the Sarbanes-Oxley Act," Accounting Horizons, vol. 19, no. 3, pp. 137-158, 2005; Jeffrey T. Doyle, Weüi Ge, and Sarah E. McVay, 'Determinants of Weaknesses in Internal Control over Financial Reporting," Journal of Accounting and Economics, vol. 44, no. 1/2, pp. 193-223, 2007; Hollis Ashbaugh-Skaife, Daniel W. Collins, William R Kinney, Jr., and Ryan LaFond, "The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity," Journal of Accounting Research, vol. 41, no. 1, pp.1^13, 2009)
* Changes in corporate governance after reporting material weaknesses (e.g., Karla M. Johnstone, Chan Li, and Kathleen Hertz Rupley, "Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation," Contemporary Accounting Research, vol. 28, no. l,pp. 331-383, 2011)
* Capital market reactions to material weaknesses (e.g., Ashbaugh-Skaife 2009; Messod D. Beneish, Mary B. Billings, and Leslie D. Hodder, "Internal Control Weaknesses and Information Uncertainty," Accounting Review, vol. 83, no. 3, pp. 665-703, 2008; Jacqueline S. Hammersley, Linda A....