There is an abundance of literature examining the effects of a poor internal control system on financial reporting quality, decision-making and auditing. However, the most commonly used proxy for internal control quality (i.e., a material weakness in the internal controls over financial reporting) occurs relatively infrequently and has declined in occurrence over the past decade (Chasan, 2013). In this study, we attempt to develop an alternative measure for internal control quality using the information reported in the S\\K portion of a firm’s 10-K. We suggest that a misclassification of audit-related fees in the unaudited disclosures of the annual report is a proxy for low internal control quality. Consistent with lower internal control quality, we find that firms misclassifying audit-related fees are more likely to report a material weakness, are less timely filers (longer report lag) and pay higher audit fees. Our findings suggest that misclassification of audit-related fees correlate with having poor internal control quality.

Introduction

One of the most commonly researched topics in accounting literature is the effects of a poor internal control system. Studies have linked internal control quality to financial reporting quality (Doyle, Ge, & McVay, 2007), auditor effort (Raghunandan & Rama, 2006), decision making (Cheng, Dhaliwal, & Zhang, 2013) and executive tenure and compensation (Hoitash, Hoitash, & Johnstone, 2012; Li, Sun, & Ettredge, 2010). Almost all of these studies use a single proxy for internal control quality: the reporting of a material weakness in the internal controls over financial reporting. However, material weaknesses are relatively uncommon especially among larger corporations and have declined in frequency since the Sarbanes-Oxley Act of 2002 (Chasan, 2013). Further, a material weakness is only reported if management fails to successfully remediate the deficiency in the internal controls by the end of the fiscal year. Material weaknesses may actually be capturing management’s incompetence or the absence of integrity rather than the quality of the financial reporting system (Järvinen & Myllymäki, 2016). Thus, identifying an alternative measure of internal control quality may help assure the validity of prior findings. In this study, we develop an alternative measure of internal control quality using unaudited disclosures in the firm’s annual Form 10-K. The Securities and Exchange Commission (SEC) requires public companies to submit an annual Form 10-K, which consists of (1) unaudited disclosures required under Regulation S\\K (Reg. S\\K) and (2) audited financial statements required under Regulation S-X (Reg. S-X). Since the same accounting system produces both sets of information, we argue that a Reg. S\\K disclosure failure is an indicator of an ineffective control environment.