CEO Characteristics and Internal Control Quality

• Author: Jeng‐Ren Chiou,Yu‐Chen Lin,Hua‐Wei Huang,Ying‐Chieh Wang
• Date: 01 January 2014
• Published date: 01 January 2014
• DOI: http://doi.org/10.1111/corg.12042

CEO Characteristics and Internal

Control Quality

Yu-Chen Lin, Ying-Chieh Wang, Jeng-Ren Chiou, and

Hua-Wei Huang*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study investigatesthe inf‌luence of CEO characteristics on internal control quality in the U.S.

Research Findings/Insights: Using a sample of 4,374 ExecuComp non-f‌inancial f‌irms, we f‌ind that CEO entrenchment and

age are signif‌icantly associated with a material internal control weakness disclosure (MW) under Sarbanes-Oxley Section

404 (SOX 404). Our results demonstrate that entrenchment and age may affect CEOs’ behavior in response to the SOX 404

internal control requirements.

Theoretical/Academic Implications: This study provides empirical support for the inf‌luence of CEO characteristics on

material internal control weakness.As a result, the effects of internal control mechanisms are likely to be decreased in f‌irms

with entrenched and younger CEOs, consistent with entrenchment theory.

Practitioner/Policy Implications: This study offers insights to regulators and lawmakers interested in the effects of CEO

characteristics on internal control weakness. Importantly,it points out that CEO entrenchment and age are likely to affect the

strength of internal control mechanisms.

Keywords: Corporate Governance, CEO characteristics, entrenchment theory, Sarbanes-Oxley Section 404, material

internal control weakness

INTRODUCTION

Anumber of major corporate accounting scandals in the

last decade or so, such as Enron and WorldCom,

adversely affected the global economy and seriously

reduced investor conf‌idence in the reliability of f‌inancial

statements. Consequently, both legislators and regulators

have emphasized the importance of internal controls to

ensure the reliability of f‌inancial reporting.1In order to

enhance the transparency of U.S. capital markets, Section

302 of the Sarbanes-Oxley Act (SOX 302) requires both the

chief executive off‌icer (CEO) and chief f‌inancial off‌icer

(CFO) to evaluate and report the effectiveness of internal

controls in their f‌irm’s annual f‌inancial reports. Further,

Section 404 of SOX (SOX 404) mandates that f‌irms must

disclose information about the quality of their internal

controls, and that external auditors have to assess the

effectiveness of these.2SOX thus aims to increase the

responsibility of top management to establish and maintain

effective internal controls in order to improve the quality of

corporate f‌inancial reporting (SEC, 2003a). Although SOX

may have strengthened monitoring and mitigated agency

conf‌licts, it has not entirely eliminated the latter, since many

cases of managerial fraud, such as those in HealthSouth

Corporation3and Hewlett-Packard’s (HP) acquisition of

Autonomy,4have been discovered post-SOX. Top managers

may be tempted to override internal control systems

and/or take full advantage of material internal control

weaknesses (MWs) to achieve better performance or higher

compensation if shareholders cannot effectively monitor

their behavior. For example, researchers f‌ind that there is a

positive relation between earnings management behavior

(as measured by reporting higher positive or absolute dis-

cretionary accruals) and MWs (Chan, Farrell, & Lee, 2008;

Doyle, Ge, & McVay, 2007). The incidence of insider trading

is also signif‌icantly higher in f‌irms reporting MWs (Skaife,

Veenman, & Wangerin, 2013). In light of public concern

about a lack of internal control quality in f‌inancial report-

ing, it is very important for researchers, practitioners, and

auditors to explore how CEO characteristics impact the

effectiveness of such controls, since the prediction of MWs

is useful, and these characteristics could serve as indicators

of potential misstatements.

*Address for correspondence: Hua-Wei Huang, College of Management, National

Cheng Kung University,No.1, Ta-Hsueh Road, Tainan701, Taiwan.Tel: 886-6-275-7575

Ext. 53423; E-mail: hwawei7@yahoo.com.tw

24

Corporate Governance: An International Review, 2014, 22(1): 24–42

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12042

The purpose of this study is to examine the association

between CEO characteristics and MWs reported under SOX

404. We use the U.S. data because internalcontrol quality can

be measured by an MW reported in the SOX 404 opinion. To

conduct our investigation, we collected 4,374 sample f‌irms

reporting CEO demographic data from 2006 to 2009 in

Compustat/ExecuComp, and adopted regression models with

the CEO entrenchment and other characteristic variables.

Jensen (1993) argues that if CEOs have more power to

control the board, the culture of openness in boardrooms

may be adverselyaffected, which in turn results in failures of

the internal control system. Following entrenchment theory

(Hu & Kumar, 2004) and the prior literature, we examine

whether entrenched CEOs are more likely to design

poorer internal controls and exploit an MW in order to

increase investments in riskier projects (Chen & Steiner,

1999; Ogneva, Subramanyam, & Raghunandan, 2007), and

whether older managers have a stronger incentive to achieve

their organizational responsibilities, such as improving an

existing MW (Steers, 1977; Stevens, Beyer, & Trice, 1978). We

also examine how the ethical nature of female managers

(Gold, Hunton, & Gomaa, 2009; Powell & Ansic, 1997)

affects the likelihood of an MW disclosure.

This study provides several contributions to both aca-

demia and practice. First, we provide new evidence for the

managerial literature by investigating the associations

among CEO characteristics and internal control quality.

Although some prior studies havediscussed whether certain

top management characteristics impact internal control

quality (Ashbaugh-Skaife, Collins, & Kinney, 2007; Jensen,

1993), most focus on the issues of executive compensation

(Hoitash, Hoitash, & Johnstone, 2012) and top management

turnover (Johnstone, Li, & Rupley, 2010). In particular, due

to the limited internal control data, previous studies only

explain these associations by theoretical inferences. To f‌ill

this research gap, our paper provides empirical evidence to

support the view that entrenchment and age signif‌icantly

drive CEO behavior with regard to internal control quality.

Second, compliance with SOX 404 incurs huge costs for U.S.

domestic companies and U.S.-traded foreign companies

(Financial Executives Institutes, 2005; SEC, 2005a), and our

evidence may be of practical help to boards of directors

looking for suitable managers who can effectively improve

MWs and reduce these compliance costs. Finally, the effects

of CEO entrenchment and other characteristics on internal

control quality are neither well-clarif‌ied nor comprehen-

sively explored in the corporate governance literature.

Although most corporate governance studies explore the

effects of board and audit committee on internal control,

none of them provides evidence of how management incen-

tives affect internal control quality based on entrenchment

or theories related to CEO age. In particular, SOX 404

imposes a signif‌icant burden on and shrinks the market

value of small companies (Iliev, 2010), and while the

enhanced disclosure of top management characteristics by

small f‌irms is not costly, it may be as informative as SOX 404

opinions for both investors and debt holders. Moreover, we

explore whether top management characteristics are associ-

ated with various types and severities of MWs, an issue

which is addressed by recent studies (Bedard, Hoitash,

Hoitash, & Westermann, 2011; Hermanson, Krishnan, & Ye,

2009; Raghunandan & Rama, 2006) or the major bond rating

institutions (Moody’s Investor Service, 2004). Our f‌indings

may be valuable for auditors when assessing the risks asso-

ciated with the internal control weaknesses of their clients,

and may also have constructive implications for global regu-

lators and lawmakers when setting future f‌inancial report-

ing policies.

We organize this paper as follows. The next section dis-

cusses the related literature and develops our research

hypotheses. This is followed by a discussion of the methods

used in this paper, along with the data and results. The paper

then ends with a summary of the conclusions, and high-

lights some avenues for future research.

LITERATURE AND HYPOTHESES

DEVELOPMENT

Management Entrenchment and Internal

Control Quality

Entrenched managers are able to establish certain policies

that enable them to maximize private benef‌its at the expense

of all other shareholders (Shleifer & Vishny, 1989; Stulz,

1988). Prior researchers mostly examine this issue with a

focus on corporate f‌inancial policies, such as capital struc-

ture decisions (Berger, Ofek, & Yermack, 1997), payout poli-

cies (Hu & Kumar, 2004), and even spinoff decisions (Ahn &

Walker, 2007), and provide abundant evidence to support

the effect of managerial entrenchment. Likewise, it is also

important to investigate how this entrenchment effect

relates to accounting or auditing decisions, because f‌inancial

reporting quality may serve as a useful tool to ease

manager–shareholder conf‌licts. For example, Lennox (2005)

f‌inds that f‌irms with more entrenched managers, proxied by

the level of CEO ownership, are less likely to choose a high

quality (Big 4) audit f‌irm.

Management Ownership

A higher level of management ownership may lead to

entrenchment, and have an unfavorable effect on internal

control quality. Managers with higher shareholdings have

stronger control over the f‌irm, exacerbate the conf‌licts of

interest between shareholders and bondholders, and hence

a greater ability to pursue their own private interests

(Holderness & Sheehan, 1991; Lennox, 2005). Moreover,

managers with higher ownership usually have a stronger

incentive to make riskier investment decisions (Chen &

Steiner, 1999), and to induce discretionary investments, such

as capital expenditures and R&D (Ghosh, Moon, & Tandon,

2007). Since the strength of internal control is highly associ-

ated with management philosophy, entrenched managers

are likely to design and utilize poorer internal controls, and

exploit an MW in order to invest in high-risk projects

(Ogneva et al., 2007). In particular, managers with higher

ownership are also more diff‌icult for small investors to

remove. As a result, they are more likely to engage in such

riskier investments under poorer internal controls (Bozec &

Bozec, 2007). Furthermore, Fernández and Arrondo (2005)

document a negative relationship between managerial

CEO CHARACTERISTICS AND INTERNAL CONTROL QUALITY 25

Volume 22 Number 1 January 2014© 2013 John Wiley & Sons Ltd