GB791 Unit 9 Literature Synthesis Example

Three Studies, Three Answers: A Unit 9 Literature Synthesis on Material Weaknesses and the Cost of Equity

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Purdue University Global

GB791: Advanced Topics in Accounting

Unit 9 Literature Synthesis

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[Date]

The synthesis concerns real published studies; the organization by explanation and the conclusions drawn are the candidate's.

Why the Question Matters

The Sarbanes-Oxley Act of 2002 introduced two disclosure requirements about internal control. Section 302 required chief executives and chief financial officers to certify each quarter that they had evaluated their company's disclosure controls and to disclose material weaknesses they found. Section 404 required management to assess internal control over financial reporting annually and, for larger companies, required the auditor to attest to that assessment, beginning with fiscal years ending after November 15, 2004. Both were costly, and their defenders argued that the cost was justified because better internal control reduces information risk and therefore the return investors require. If that argument is right, firms disclosing weaknesses should face a higher cost of equity, and remediating them should lower it.

The Three Core Studies

Ogneva et al. (2007) studied firms that disclosed material weaknesses in their first Section 404 reports. Using implied cost of equity estimated from analyst forecasts, they found that weakness firms had a higher cost of equity before controls, but that the difference was no longer significant once they controlled for firm characteristics associated with weaknesses and for bias in analysts' forecasts.

Beneish et al. (2008) distinguished between the two disclosure regimes. They found that firms disclosing weaknesses under Section 302, in the period before audited Section 404 reports, experienced negative stock price reactions and an increase in cost of capital, while firms disclosing under Section 404 experienced little market reaction and no significant change.

Ashbaugh-Skaife et al. (2009) studied firms disclosing internal control deficiencies, including those reported before Section 404 took effect, and found that they had higher idiosyncratic risk, higher systematic risk and a higher cost of equity than firms without deficiencies. They also found that firms whose auditors later confirmed that the deficiencies had been remediated experienced a decline in cost of equity.

Explanation One: Which Disclosures Were Studied

The studies did not examine the same disclosures. Beneish et al. (2008) made this the center of their design, and their results suggest the regime matters. Section 302 disclosures were made by management, without auditor attestation, often by smaller firms and often unexpectedly. Section 404 disclosures came in the first round of mandatory audited reports, when many weaknesses were anticipated: firms had disclosed problems earlier, analysts had discussed them and the market expected a large number of adverse reports. A disclosure that the market already expects carries less news.

Ogneva et al. (2007) studied Section 404 disclosures and found no significant effect, consistent with that explanation. Ashbaugh-Skaife et al. (2009) included disclosures made before audited reports existed, many of them under Section 302, and found significant effects. On this reading, two of the three studies agree once the disclosure regime is held constant: news about weaknesses moved the cost of equity when it was news.

Explanation Two: How the Cost of Equity Was Measured

None of the studies observed the cost of equity directly, since it is the return investors expect and cannot be read from prices. Each estimated it from analysts' forecasts of earnings and the current share price, solving for the discount rate that equates them. These implied estimates are sensitive to errors in the forecasts. If analysts' forecasts for weakness firms are systematically optimistic, the implied cost of equity will be biased upward for those firms, creating an apparent effect that reflects forecast error rather than investors' required returns.

Ogneva et al. (2007) controlled for forecast bias explicitly, and that control contributed to the disappearance of the effect in their results. The other studies used different estimation approaches and controls. Part of the disagreement may therefore come from measurement: the effect is sensitive to how analysts' errors are handled.

Explanation Three: What Firm Risk Was Controlled For

Firms that disclose weaknesses are not a random sample. Doyle et al. (2007) found that companies reporting weaknesses were, on average, smaller and younger, in weaker financial health, more complicated in structure, and more often growing quickly or reorganizing. Each of those characteristics is associated with higher risk, and a higher cost of equity, regardless of internal control. A study that compares weakness firms with other firms without controlling for these characteristics will attribute to the weakness a cost of equity that reflects the kind of firm that has weaknesses.

The studies differed in how fully they controlled for these traits. Ogneva et al. (2007) included an extensive set, and their effect disappeared. Ashbaugh-Skaife et al. (2009) controlled for many characteristics as well but still found an effect, and their remediation result is especially useful here: when the same firms remediated their weaknesses, their cost of equity fell. A change within the same firm is harder to attribute to fixed firm characteristics, since those characteristics did not change when the weakness was fixed. That design choice is what gives their study the most weight in this synthesis.

The remediation result does what a cross-sectional comparison cannot: it watches the same firms before and after the weakness is fixed.

What the Literature Jointly Supports

Taken together, the three studies support a qualified conclusion. Disclosures of internal control weaknesses were associated with a higher cost of equity when they came as news, in the early, unaudited regime, and the remediation evidence suggests the association reflects information risk rather than only firm characteristics. In the first round of audited Section 404 reports, where weaknesses were widely expected, there is little evidence of an effect. Much of the cross-sectional difference between weakness firms and other firms reflects the characteristics that make weaknesses more likely.

The literature does not support either strong claim made in the policy debate: that Section 404 lowered the cost of equity across firms enough to justify its cost, or that internal control disclosures had no effect on investors. The evidence is consistent with internal control information mattering when it is new and specific.

What Remains Open

Two questions remain. First, the studies cover the early years of the regime, and it is not clear whether the effects persist now that internal control reporting is routine. Second, all three rely on implied cost of equity estimates, so their agreement and disagreement share a common measurement weakness. A study using a different measure of required returns, or examining a later setting where weakness disclosures are again unexpected, would test whether the synthesis holds.

References

Ashbaugh-Skaife, H., Collins, D. W., Kinney, W. R., Jr., & LaFond, R. (2009). The effect of SOX internal control deficiencies on firm risk and cost of equity. Journal of Accounting Research, 47(1), 1-43. https://doi.org/10.1111/j.1475-679X.2008.00315.x

Beneish, M. D., Billings, M. B., & Hodder, L. D. (2008). Internal control weaknesses and information uncertainty. The Accounting Review, 83(3), 665-703. https://doi.org/10.2308/accr.2008.83.3.665

Doyle, J., Ge, W., & McVay, S. (2007). Determinants of weaknesses in internal control over financial reporting. Journal of Accounting and Economics, 44(1-2), 193-223. https://doi.org/10.1016/j.jacceco.2006.10.003

Ogneva, M., Subramanyam, K. R., & Raghunandan, K. (2007). Internal control weakness and cost of equity: Evidence from SOX Section 404 disclosures. The Accounting Review, 82(5), 1255-1297. https://doi.org/10.2308/accr.2007.82.5.1255