An Investigation of Adverse Internal Control Reports and Changes in Discretionary Accruals

Mary Jane Lenard
Meredith College
U.S.A.

Pervaiz Alam
Kent State University
U.S.A.

Michael Pearson
Kent State University
U.S.A.

Abstract:
In light of the incidents of fraudulent financial reporting in the last few years, the U.S. Congress created the Public Company Accounting Oversight Board (PCAOB). One of the responsibilities of the PCAOB is to oversee the process of reporting by companies on the reliability of their internal control systems. Companies that find their internal controls lacking will likely examine the accuracy and completeness of their financial information. Controlling discretionary accruals can improve earnings informativeness and positively affect return on income (Subramanyam 1996; Tucker and Zarowin 2006). We use models developed in two previous studies (Tucker and Zarowin 2006, Geiger and North 2006) to determine if companies will change discretionary accruals based on the type of internal control report they received, in order to maintain the appearance of effective internal controls yet still provide informative value to external parties. We find significant differences in discretionary accruals between companies that received an adverse internal control report and those companies that received a good report. Further, companies that received a good report significantly increased their discretionary accruals the following year. We also find that companies that received an adverse report had significantly higher fraud characteristics than companies that received a good report.