Voluntary Reporting on Internal Control Systems and Governance Characteristics: An Analysis of Large U.S. Companies

Abstract

It has been hotly debated for decades in the U.S. whether management should be required to report on internal controls over financial reporting, and whether independent auditors should be required to attest to such reports. It was only recently that the U.S. Congress was provoked by high profile corporate failures in the country to pass the Sarbanes-Oxley Act of 2002 (SOX) (1) to mandate management report on internal control systems (U.S. House of Representatives, 2002). However, in spite of the absence of mandatory reporting requirements on internal control systems, several companies did voluntarily include a report on internal control systems in their annual reports. (2) Given that reporting on internal control systems entails both out-of-pocket and indirect costs, one wonders why some companies voluntarily chose to do so before SOX made it a mandatory requirement. This article seeks to investigate this issue using 2001 data of a sample of Fortune 500 companies as the unit of analysis. While there has been considerable research on the determinants and capital market effects of voluntary disclosure (see, e.g., Jorgensen and Kirschenheiter, 2003; Ronen et al., 2003; Clement et al., 2003; Lundholm and Van Winkle, 2006; Lira et al., 2007), only Bronson et al. (2006) investigate the relationships between some corporate governance variables and management voluntary reporting on internal control systems of 397 mid-sized U.S. companies. Using 1998 data, they analyze the nature and content of voluntary management reports on internal control systems, and characteristics of companies issuing such reports. Since extant literature suggests that the frequency of voluntary reporting on internal control systems varies widely depending on whether a company is large, medium-sized, or small (Raghunandan and Rama, 1994; McMullen et al., 1996; Bronson et al., 2006), the present study contributes to the extant literature by examining a cross-sectional data of 198 Fortune 500 companies--the largest U.S. public companies. (3) Generally, public policy decisions are based on the experiences of such large companies, as they are industry leaders and pacesetters. Importantly, this study examines 2001 data--the last year in which the companies could effectively report on their internal control systems voluntarily. (4) Unlike Bronson et al. (2006), the present study investigates the effects of both board and audit committee characteristics. The inclusion of the board characteristics in the model of this study is justified for two reasons. First, while an audit committee has an oversight responsibility for internal control system and related financial reporting matters, it is accountable to the main board, as the latter has the ultimate responsibility. (5) The audit committee has a delegated oversight responsibility. Like the nomination and compensation committees, the audit committee is just one of the standing subcommittees of the main board. Second, an audit committee derives its characteristics from those of the main board. In fact, the effectiveness of the oversight function of the audit committee depends on the attitude, philosophy, and practices of the main board. Raghunandan and Rama (2007) hypothesize and find a positive relationship between the number of audit committee meetings and the number of board meetings, suggesting that the assiduousness of the main board is reflected in the activities of its sub-committees. Using a sample of 198 Fortune 500 companies, this study analyzes whether corporate governance characteristics systematically relate to the incidence of management voluntarily reporting on internal control systems in annual reports prior to the passage of SOX. Holding constant the effects of company size, corporate performance, leverage, industry, sales growth, and external financing needs, this study finds that companies that voluntarily report on their internal control systems are more likely to have a smaller proportion of their ownership interest held by insiders, have audit committees that meet frequently, and are dominated by independent non-executive directors. …