A Comparison of Regulatory Regimes

In our paper Corporate Governance and Internal Control over Financial Reporting: A Comparison of Regulatory Regimes which was recently accepted for publication in the Accounting Review, we investigate the association of audit committee and board characteristics with the effectiveness of internal controls over financial reporting (ICFR). We measure this association using data on internal controls from two provisions of the Sarbanes-Oxley Act (Sections 302 and 404) that differ in the requirement that controls be tested by the company’s management and external auditor.

We proceed in two steps. First, we study whether internal control quality, measured as material weaknesses (MW) disclosure, is associated with governance characteristics; i.e. audit committee financial expertise, and board and audit committee structure and activity. Second, we investigate whether the link between governance characteristics and internal control quality holds in both Sections 302 and 404 regulatory regimes. We use an automated data extraction and parsing routine that builds a database of audit committee qualifications from background information available from AuditAnalytics. This method produces a sample of 5,480 firm-year observations with complete data on fiscal years ending between November 2004 to May 2006 (including 19,673 audit committee members), enabling us to address our second research question by studying the governance/MW association among smaller companies that are subject to Section 302 (but not Section 404) as well as larger companies subject to both regulatory regimes.

We find a clear difference in the association of corporate governance quality with MW disclosure between these regulatory regimes. We find that more accounting and supervisory financial expertise on the audit committee is associated with lower likelihood of MW disclosure under Section 404, but not under Section 302. For members with accounting qualifications, this association is evident regardless of whether the individuals are publicly designated as “Section 407 financial experts.” However, among members with supervisory qualifications, we find a significant association only for individuals not publicly designated. In supplemental analysis, we also find that only accounting financial experts are associated with lower likelihood of disclosing MW related to account-specific control problems, while only supervisory financial experts are associated with lower likelihood of disclosing MW related to more management-oriented issues of personnel and information technology. These results are consistent across contemporaneous and lag specifications, are not sensitive to controlling for selection bias, and are robust to several alternative variable specifications.

Overall, our findings suggest that in regulatory environments without requirements of mandatory testing and independent auditor attestation that are required under Section 404, corporate governance quality has no observable association with ICFR disclosure. The full paper is available for download here.