A review of Doyle, J., W. Ge, and S. McVay, 2007, “Accruals Quality and Internal Control over Financial Reporting,” The Accounting Review 82 (5), 1141-1170.
I. Research question and its importance
This paper contributes to earning accrual quality literature. It empirically investigates the association between firm’s internal control environment and accrual quality, a proposition well suggested by early literature despite the lack of testable data. The authors leverage new data available since the disclosure under Section 302 and 404 of Sarbanes-Oxley Act in 2002 to test this longstanding hypothesis.
II. Method and findings
As this hypothesis becomes testable only after variation in internal control is disclosed after SOA, the authors use an observation of 705 firms that disclosed per new requirements from August 2002 to November 2005. They also separate firms by different reporting regimes (i.e., Section 302 versus 404) to estimate group-specific effects. First, they measure accrual quality by a modified measure of Dechow and Dichev (2002) by McNichols (2002) and Francis et al. (2005). They also adopt several other proxies and get consistent finding. Second, they document the variation in internal control by separating the sample into two groups: firms with material account- and company-specific weaknesses. This mutually exclusive categorization is deliberate upon authors’ criterions shown in Appendix A. Moreover, the authors also control innate firm characteristics pertaining to difficulty in accrual estimation as well as known determinants of material weakness for robustness. Finally, they correct for self-selection bias by Heckman (1979) two-stage process, Mills ratio approach and propensity score matching. As predicted, they find evidence that material weakness in firm’s internal control environment is associated with lower accrual quality (e.g., poorly estimated accrual). Specifically, they find company-specific (per authors’ definition) internal control weakness has more pronounced influence over accrual quality, indicating to the conjecture that company-specific control is less auditable compared to account-specific weakness. In addition, they also show differential effects when estimating separately for the observations that disclosed material weakness under Section 302 versus Section 404. Their finding shows the baseline effect is stronger for firms that disclosed material weakness under Section 302.
III. Limitation and future research
They authors acknowledge that sample bias exists because firms disclosed under SOX Section 404 are bigger and financially stronger, hence endanger its comparison with firms reporting under Section 302 regime. This requires a longer time horizon to test whether the intergroup variance is significant. Furthermore, as they categorize firms’ material weakness disclosures into account- and company-specific groups, this typology is very vague from reader’s perspective. Although they provide definition and explicit state that these measures are mutually exclusive, they do not provide test of validity for this set of constructs. Further research might extend this research with a more robust design. Finally, to extend this discussion into cross-country comparison, researchers might proxy by the business and legal environments in which internal control embeds to provides evidence to this research question.