Study: Internal Controls Weakness Associated With Increased Risk of Accounting Fraud

Chris Gaetano
Published Date:
Sep 11, 2017
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A study published by the American Accounting Association has found that there is a strong association between material weaknesses in internal controls and future fraud revelation.

The study examined a total sample of 14,093 firm-years, 1,488 of which were shown by the firms' 403(b) filings to have at least one material internal controls weakness at the year-end. It then looked at settled securities class-action lawsuits that allege violations of Generally Accepted Accounting Principles from between 2005 to 2010, as well as SEC and Department of Justice enforcement actions regarding fraud or other intentional accounting misconduct from the same time period. Overall, this sample contains 87 unique lawsuits and 71 unique enforcement actions corresponding to 127 unique cases (31 cases have both a lawsuit and an enforcement action). 

What they found was that there is a statistically and economically significant association between material internal control weaknesses and the future revelation of fraud. The paper said this association is driven entirely by instances where the internal control issue reflects a general opportunity to commit fraud, versus deficiencies in account- or process-specific controls. It found that, of the 127 cases lawsuits and enforcement actions samples, in 115 of them either the CFO or CEO was named in the action. The study's authors noted that, until now, there had been no empirical evidence linking internal control weaknesses to future fraud revelations. 

The study comes at a time when prominent voices have begun to question the legacy of the Sarbanes-Oxley Act and the internal controls audits they required. Tom Farley, the head of the New York Stock Exchange, said that the mandate has increased costs for public companies and discouraged the formation of new public companies, a stance also expressed by the new head of the SEC, Jay Clayton. 

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