Quality of internal control over financial reporting, corporate governance and credit ratings

International Journal of Disclosure and Governance

Volumn 6, Issue 2, 2009, Pages 127-149

  Elbannan, Mohamed A ^a  

^a NONE

Author keywords

Archival research; Corporate governance; Credit ratings; Internal controls; Sarbanes Oxley Act 2002

Indexed keywords

EID: 67650267463     PISSN: 17413591     EISSN: 17466539     Source Type: Journal    
DOI: 10.1057/jdg.2008.32     Document Type: Article

References (60)

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10. For listed firms that are classified as accelerated filers, Section 404 became effective for fiscal year-ends after 15 November 2004. However, even within this category, for listed firms with market capitalisation under $ 700 million, the SEC granted an additional 45 days to file the Section 404 reports if the fiscal year-end was on or before 28 February 2005. For non-accelerated filers and foreign listed firms, Section 404 is effective for fiscal year-ends on or after 15 July 2007.
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19. As noted in Ogneva et al 17, AS No. 2 states: · A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis (AS No. 2, para. 8). · A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the company's ability to initiate, authorise, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company's annual or interim financial statement that is more than inconsequential will not be prevented or detected (AS No. 2, para. 9). · A material weakness is a significant defi- ciency, or combination of significant defi- ciencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected (AS No. 2, para. 10).
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44. Duplicates include those instances where a parent and subsidiary both file with the SEC and report the same material weakness. In these cases, I include only the parent company; further, I found no instances where a parent and subsidiary reported different material weaknesses.
45. For example, Ashbaugh-Skaife et al 3 limit their analysis to Section 302 disclosures in the year prior to the effective date of Section 404.
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47. I also analyse the sample distribution on auditor type and audit opinion. Auditor type is frequently used as a proxy for audit quality in research studies, with Big Four firms expected to provide higher quality audits. Results show that of the 171 ICW companies, 84 per cent (144 firms) were audited by Big Four CPA firms compared to 55 per cent for all Compustat firms. Almost 96.5 per cent (165 firms) of all ICW firms, and all 105 ICW firms with material weaknesses, received either an unqualified or unqualified with additional language opinions compared to 76.6 per cent for all Compustat firms. Future research might examine whether auditor size and audit switches affect the probability of disclosing ICWs.
48. Regressions were run at three different times using different sets of independent variables: · Model A1: RATING= f (ICWs, firm characteristics). · Model A2: RATING= f (firm characteristics). · Model A3: RATING= f (ICWs) Model A1 is the full model that incorporates both ICW and firm characteristics control variables. However, to verify the robustness of the results, I repeat the analysis after omitting ICW (Model A2) and after omitting the control variables (Model A3). Upon omission of ICW from Model A1, the explanatory power of the modified model drops, but not substantially. Model A2, is also highly significant with a likelihood ratio - 2 of 281.57 and a generalized R 2 of 0.55. The highly significant likelihood ratio - 2 and the highly significant Wald - 2 indicate that ICW adds significant explanatory power over and above the control variables. The coefficients on the control variables have the expected sign and are signifi cant at the 0.01 level or better, except for CVNI, which is only marginally significant. Consistent with prior research (Horrigan; 49 Kaplan and Urwitz 50), I find that credit ratings are positively related to SIZE, ROA, INDUSTRY, SIZE and OPCASH, and negatively related to LEV, CVNI and LEVER. ICW is highly significant and is negatively related to credit ratings, as predicted. As for Model A3, which contains ICW as a single independent variable, the model is highly signifi cant with a likelihood ratio - 2 of 147.21 and a generalized R 2 of 0.36.
49. Horrigan, J. (1966) The determinants of longterm credit standing with financial ratios. Journal of Accounting Research 4 : 44-62.
50. Kaplan, R. and Urwitz, G. (1979) Statistical models of bond ratings: A methodological inquiry. Journal of Business 52 : 231-261.
51. Grinblatt, M. and Titman, S. (2002) Financial Markets and Corporate Strategy, 2nd edn., New York: McGrawHill-Irwin.
52. Past studies have also included the subordination status of bonds to research models to indicate if a bond issue is subordinated to other debt. A subordinated bond typically receives a lower rating than a non-subordinated bond. However, in this study, bonds of all sample firms were of senior status, so this variable was dropped from the analysis.
53. Recall that the SIZE variable is measured as the natural log of the 5-year average total assets of the firm.
54. Fisher, L. (1959) Determinants of risk premiums on corporate bonds. Journal of Political Economy 67 : 217-237.
55. West, R. R. (1970) An alternative approach to predicting corporate bond ratings. Journal of Accounting Research 8 : 118-125.
56. Ederington, L. (1985) Classification models and bond ratings. Financial Review 20 : 237-262.
57. Francis, J. , LaFond, R. , Olsson, P. and Schipper, K. (2005) The market pricing of accruals quality. Journal of Accountng and Economics 39 : 295-327.
58. Variable ICW by itself explains 36 per cent of the variation in firm credit rating scores (see note 9 above).
59. DeFond, M. and Jiambalvo, J. (1991) Incidence and circumstances of accounting errors. The Accounting Review 66 : 643-655.
60. In addition to analysing Model Y for the entire sample, I also test the relation within each of the two groups, ICW firms and non-ICW firms, separately. All three versions of Model Y are significant, albeit at different explanatory powers, measured by the adjusted R 2 (0.61, 0.50 and 0.45n, respectively). The results show an interesting conclusion: the relation between G-SCORE and RATING is positive for both groups, but is only significant for ICW firms. This may be due to rating agencies not placing governance on the top of the firm evaluation criteria if the firm exhibited no history of internal control deficiencies. Further, after including G-SCORE in the model, ROA, CVNI and LEVER in the sample group and INDUSTRY, LOSS and OPCASH in the control group entirely lose significance. In particular, the loss of significance for LEVER in the sample group is interesting because it is a primary driver for credit rating scores. This may be due to rating firms giving leverage a lower priority in well-governed firms, which increases the rating agency's confidence in the firm's stream of future cash fl ow. Additionally, the loss of significance for the set of variables representing firm risk (LOSS, OPCASH and CVNI) may suggest the lack of concern on the part of rating agencies for these measures when the firm being evaluated for credit worthiness has no internal control problems.