The Incentive Factors for the (Non‐)Disclosure of Material Weakness in Internal Control over Financial Reporting: Evidence from J‐SOX Mandated Audits

• Date: 01 July 2015
• DOI: http://doi.org/10.1111/ijau.12035
• Published date: 01 July 2015

The Incentive Factors for the (Non-)Disclosure of Material Weakness in

Internal Control over Financial Reporting: Evidence from J-SOX

Mandated Audits

Kenichi Yazawa

Aoyama Gakuin University,Tokyo, Japan

This study uses data on Japanese listed companiesfor the period from 2009 to 2012 to examine the incentive factors

for the (non-)disclosure of material weakness (MW) in internal control over financial reporting (ICFR). The

propensity score matching results of matched and potential MW companies from the research sample reveal that

companies thatdo not disclose MW have longer management tenure, Big 3 auditors, lower auditfees, larger boards

of directors, fewer outside directors, and greater main bank involvement than those companies that disclose MW.

In addition, the non-disclosure of MW at the company level is associated with longer management tenure, larger

management shareholdings, and greater main bank involvement, whereas the non-disclosure of MW at the

account-specific level is associated with longer management tenure, Big 3 auditors, lower audit fees, significant

non-audit services, and greater main bank involvement. These results suggest that the assessment and audit

process of internal control systems in Japan is sensitive to management- and audit-related (non-)disclosure

incentives. The findings provideuseful academic insights as well as practical guidance for companies in Japan, the

United States, and other countries.

Key words: Internal control over financial reporting, material weakness, Japan

INTRODUCTION

Many researchers have empirically investigated the cause

and effect factors related to the audit of internal control

over financial reporting (hereafter, ICFR) required by a

federal law of the United States namely, the Sarbanes-

Oxley Act (SOX, also known as US-SOX) of 2002 (Franco,

Guan & Lu, 2005; Ge & McVay, 2005; Bedard, 2006;

Ashbaugh-Skaife, Collins & Kinney, 2007; Doyle, Ge &

McVay, 2007a, 2007b; Ashbaugh-Skaife et al., 2008;

Beneish, Billings & Hodder, 2008; Hammersley, Myers &

Shakespeare, 2008; Epps & Guthrie, 2010). While some

authorsopine that the internal control rules haveincreased

the transparencyof the capital markets in the United States

and improved their reliability, others comment that the

auditing and reporting of internal control under Section

404 of US-SOX cannot detect internal control weakness

effectively (Glass Lewis and Co., 2007; Besch, 2009;

Whitehouse, 2010, 2011). Further, the function of an

internal control audit in countries with a different

economic system to that of the United States remains

largely unknown because few countries have introduced

ICFR auditregulation in the same way.1In other words, the

cost and effectiveness issues of ICFR auditing remain

contentious issues globally.

Japan appraised US-SOX 404 and introduced

management assessment and external auditing of ICFR

for all listed companies for business years beginning on

or after April 1, 2008. Japanese standards for the

assessment and audit of ICFR are based on both US-SOX

and the Committee of Sponsoring Organizations (COSO)

framework. However, the averagepercentage of Japanese

companies that disclose materialweakness (MW), among

companies that are required to submit internal control

reports, was less than one-tenth of the corresponding

percentage in the United States, on average, in the first

four years.2Why is there such a large difference between

the two countries? It could be premature to suggest that

the decline signals an improvement in MW, because MW

disclosure does not work in some cases (Turner &

Weirich, 2006). If management and/or auditors cannot

find and disclose MW, this suggests that there is a

problem in the internal control reporting system.3

This study analyzes the factors associated with MW

(non-)disclosure in internal control over financial

reporting in this context. The propensity score matching

results of matched and potential MW companiesfrom the

research sample reveal that the probability of companies

disclosing MW decreases when management tenure is

longer, the audit is conducted by a large audit firm, the

size of the board of directors is larger, the number of

outside directors is fewer, and main bank involvement is

greater. Additional analysis reveals that disclosure of

MW at the company level has a negative association

with management tenure, the percentage of shares

held by management, and significant main bank

involvement, although the coefficients of management

tenure and shareholdings are only marginally significant.

In addition, disclosure of MW at the account-specific

level4has a negative association with long management

tenure, large audit firms, non-audit services, and

significant main bank involvement, and a positive

association with audit fees. These findings suggest that

detection and disclosure of an MW in ICFR is affected by

the motivation of management and auditors to pursue

MW disclosure.

These results have academic and practical implications.

In academic terms, the results of this study could provide

insights for building an explanatory theory of internal

control auditing. It also contributes to the development of

future research by further developing the conceptual

model suggested by Ashbaugh-Skaife et al. (2007) and

presenting related empirical evidence. In practical terms

the analysis provides, empirical evidence that could help

to improve internal control auditing for Japan and the

Correspondence to: Kenichi Yazawa, School of Business Administration,

Aoyama Gakuin University, 4-4-25 Sibuya, Shibuya-ku, Tokyo 150-8366,

Japan. Email: yazawa@busi.aoyama.ac.jp

International Journal of Auditing doi:10.1111/ijau.12035

Int. J. Audit. 19: 103–116 (2015)

© 2015 John Wiley & Sons Ltd ISSN 1090-6738