Early Warnings of SOX 404 Material Weaknesses in Internal Control

Abstract

SOX Section 404(b) continues to be of interest to legislators and regulators. Prior studies show that in the initial implementation years of SOX 404, the majority of material weakness (MW) disclosures were “surprise” MWs—i.e., disclosed at year-end, but not in prior quarterly filings (Hermanson and Ye 2009; Munsif, Raghunandan, and Rama 2013). We show that during the years 2010 to 2019, 74 (72) percent of MW disclosures by accelerated (non-accelerated) filers were surprise disclosures. We also find that surprise MWs are more likely to be associated with internal control issues that involve year-end adjustments and/or documentation, procedure, or policy issues. While “early warning” MWs are more likely due to systemic internal control problems, like segregation of duties. Our findings suggest a role for auditors and substantive audit tests in the disclosure of certain types of MWs. Increased auditor emphasis on interim substantive tests may reduce the likelihood of surprise MWs.