The Failure to Remediate Previously Disclosed Material Weaknesses in Internal Controls

TLDR

Regulators, credit rating agencies, and academics emphasize the importance of remediating material weaknesses, making the observed failure to remediate surprising. The study investigates why some firms fail to remediate disclosed material weaknesses and the characteristics and consequences associated with this failure. Researchers compared firms that remedied disclosed weaknesses with those that did not, analyzing the nature of the weaknesses, firm attributes, and post‑disclosure outcomes. Firms with pervasive weaknesses, complex operations, or small audit committees are less likely to remediate, and non‑remediating firms experience higher audit fees, increased auditor resignations, more modified or going‑concern audit opinions, missed filing deadlines, and higher debt‑costs. Data are publicly available from the sources cited in the paper.

Abstract

SUMMARY In this paper, we study a sample of companies that fail to remediate previously disclosed material weaknesses (MWs) in their internal control systems and, thus, disclose the same MWs in two consecutive annual reports. Their failure to remediate is surprising given that regulators, credit rating agencies, and academics contend that the remediation of MWs is important. We form a control sample of companies that initially disclosed MWs in their internal control systems, but subsequently remediated these weaknesses, and investigate the characteristics of the remediated and unremediated MWs, the characteristics of remediating versus non-remediating companies, and the consequences to non-remediating companies. Regarding the characteristics of companies failing to remediate, we find that companies are less likely to remediate previously disclosed MWs when the weaknesses are more pervasive (i.e., when they are described as at the entity level, when there are more individual weaknesses) and when their operations are more complex (i.e., they have more segments and have foreign operations). In addition, companies with smaller audit committees are less likely to remediate. Regarding the consequences, we find that companies failing to remediate MWs experience larger increases in audit fees and a higher likelihood of auditor resignation as the number of MWs increases. We also find that non-remediating companies are more likely to receive modified audit opinions and going-concern opinions. Finally, we find that companies failing to remediate are more likely to miss filing deadlines and experience increased cost of debt capital (i.e., they receive poorer credit ratings when entity level MWs are present, and are charged higher interest rates). Data Availability: Data are publicly available from sources identified in the text.