The impact of high insider ownership on SOX 404 internal controls

Pages106-122
DOIhttps://doi.org/10.1108/CG-03-2019-0087
Date04 October 2019
Published date04 October 2019
AuthorLucy Uche Diala,Robert Houmes
Subject MatterStrategy
The impact of high insider ownership on
SOX 404 internal controls
Lucy Uche Diala and Robert Houmes
Abstract
Purpose This study aims to investigatethe effect of high insider ownership on firms’ internal controls
over financial reporting.In particular, it examines how high insider ownership affectsthe likelihood of an
adverseSarbanesOxley Act Section (SOX Section404) opinion and its subsequent remediation.
Design/methodology/approach Tests of hypotheses use ineffective controls and remediation
models. The initial tests in this study use ineffective internal controls over financial reporting probit
regression modelsto investigate how high insider ownership affectsthe ex-post likelihood of an adverse
404 opinion. Two remediationmodels a multinominal probit regression and probitregression model
are used to investigate theeffect of high insider ownership on the likelihood of successfullyremediating
an adverse404 opinion.
Findings Results show that while the ex-ante likelihood of an adverse SOX Section 404 auditor’s
internalcontrol opinion increases with high insider ownership,high insider ownership firms are morelikely
to remediate ineffective404 controls. This study rationalizesthese diverse findings by asserting that prior
to an adverse 404 opinion, entrenchedmanagers avoid internal control financial reportingoversight and
monitoring. After an adverse opinion,however, and within the context of an imminent and explicit value
reducing 404 opinion, powerful high insider owner managers are motivated to remedy ineffective
controls.
Originality/value This researchsynthesizes existing streams of literature on insiderownership and the
effectivenessof internal control over financial reportingquality to provide new information on the effectsof
high insiderownership on firms’ internal controls.
Keywords Internal controls, SOX 404, Sarbanes Oxley, High insider ownership
Paper type Research paper
1. Introduction
An important provision of the 2002 SarbanesOxley Act (SOX) (US) is that firms and their
external auditors assess and provide opinions on the effectiveness of internal controls.
Extant studies across numerous research contexts have investigated the efficacy of this
requirement (Ashbaugh-Skaife et al.,2009;Clinton et al., 2014;Doyle et al., 2007a,2007b;
and others).
A substantial body of research also exists on the effects of insider ownership, including
contending hypotheses asserting that high insider ownership (HIO) induces entrenchment
or alignment of interest effects. A general inference from these diverse findings is that the
financial effects of HIO is conditionalon the context within which they exist.
Entrenchment hypotheses assert that at levels of HIO where managers have more power to
direct firm actions, there is an increased likelihood of implementing practices toward
enhancing their entrenched positions to the detriment of the firm. For example, Attig et al.
(2006) note that owners of stocks may have selfish agendas and to increase the probability
of advancing them, they are more likely to implement poor information disclosure practices
when they are simultaneously in a position of control as exists with HIO. Alignment of
Lucy Uche Diala is based at
California State University,
Fresno, California, USA.
Robert Houmes is based at
the Department of
Accounting, Jacksonville
University, Jacksonville,
Florida, USA.
Received 8 March 2019
Revised 17 July 2019
24 August 2019
Accepted 30 August 2019
PAGE 106 jCORPORATE GOVERNANCE jVOL. 20 NO. 1 2020, pp. 106-122, ©Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-03-2019-0087
interest studies support the contrasting notion that as insider-owners acquire or purchase
more stock, their interest becomes more closely aligned with those of outside shareholders
resulting in favorable effects on corporate performance (McConnell et al.,2008). Jensen
and Meckling (1976) argue that managerial ownership reduces agency costs by fostering
an alignment of interest between the firm’s owners and managers. Warfield et al. (1995)
similarly asserts that becauseshareholding managers’ personal wealth is linked to thevalue
of the firm they manage, the greater the proportion of share-based compensation received,
the greater the motivation to increase the valueof the firm they manage.
This study adds to these streams of literature by investigating the impact of HIOon financial
reporting internal control quality.Results show that the likelihood of an adverse SOX Section
404 auditor’s internal control opinion increases with HIO. In contrast to these initialfindings,
however, we further document that HIO firms are more likely to successfully remediate
ineffective controls. Our initial findings support the theory of high insider owners as
entrenched managers with the general implication being a lack of sufficient board and
external stockowner power to monitor manager’s discretion in internal control decisions
(Yammeesri and Herath, 2010). Subsequent findings suggest, however, that when
confronted with the costly value reducing consequences of an adverse 404 opinion,
incentives associated with entrenched managers give way to alignment of interest
incentives as powerful high insider owners are more motivated and better able to remedy
publicly divulged financial reportingcontrol deficiencies.
This study adds to the existing body of literature as follows. First our study provides
additional information regarding the effect of insider ownership on financial reporting
internal control. Existing research supports contending assertions that insider ownership
either promotes or discourages optimal corporate performance. Hence an important
implication of these studies is that the effects of insider ownership are conditional on the
context within which they exist. Using the internal control context of the regulatory
framework prescribed by SOX, we provide new information incremental to the current body
of insider ownership literature. In particular, this study extends prior woks by empirically
investigating if and how high-ownership manager incentives differ and affect attitudes and
behaviors towards internal controls before and after the disclosure of an adverse SOX 404
opinion.
In addition, it is widely asserted that the SOX of 2002 was the most significant accounting
legislation enacted since SEC 1934,and the efficacy of this legislation since its passing has
been the subject of much research and debate. In light of the substantial costs associated
with its implementation application and enforcement, studies have examined the costs and
benefits of section 404 over the years since its implementation (Ribstein, 2002;Bergeret al.,
2005;Romano, 2005, etc.). This study provides further evidence on the efficacy of
SarbanesOxley to promote and emphasize the implementation and application of effective
internal controls over financial reporting (IFCR). Results of our study suggest that
SarbanesOxley has had a beneficial effect on financial reporting quality as Section 404
adverse internal control opinions motivate heretofore indifferent and entrenched high
ownership managers, to address ineffectiveinternal controls.
1.1 Internal controls over financial reporting
ICFR may be defined as:
A process designed by, or under the supervision of the company’s principal executive and
financial officers or persons performing similar functions, and effected by the company’s board
of directors, management, and other personnel, to provide reasonable assurance regardingthe
reliability of financial reporting and the preparation of financial statements for external purposes
in accordance with generally accepted accounting principles [...] (Auditing Standard No 2,
PCAOB [Public Company Accounting Oversight Board], 2004, para. 7).
VOL. 20 NO. 1 2020 jCORPORATE GOVERNANCE jPAGE 107

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