Sarbanes-Oxley 404 material weaknesses and discretionary accruals

This study investigates whether having a Sarbanes-Oxley Section 404 [SOX 404] material weakness allows managers of these companies to manipulate earnings to a greater extent using discretionary accruals than managers of companies with no SOX 404 material weaknesses. The study focuses on a sample of 218 companies that disclosed at least one material weakness in internal control in their 2004 SEC filings. The discretionary accruals of companies with material weaknesses are paired with companies with no material weaknesses reported in their 10K filings during the same time period. We examine the relationship of reported SOX 404 weaknesses with the behavior of discretionary accruals for the overall sample of companies and for discretionary accruals partitioned according to the greatest magnitudes, both positive and negative. The accruals are categorized into three groups: (1) high negative discretionary accruals, (2) high positive discretionary accruals and (3) low discretionary accruals. Our finding for the entire sample of 436 companies indicates that the presence of SOX 404 material weaknesses has a moderate significant negative effect (income-decreasing) on discretionary accruals. However, when the accruals are stratified into high positive, negative and low accruals, the overall findings of the research indicate that the existence of material weaknesses allows for greater manipulation of earnings using discretionary accruals regardless of the direction – income-increasing or income-decreasing.