Journal of Accounting and Public Policy 26 (2007) 300327

www.elsevier.com/locate/jaccpubpol

Audit committee quality, auditor

independence, and internal
control weaknesses
Yan Zhang a, Jian Zhou
a

a,b,*
,

Nan Zhou

School of Management, State University of New York at Binghamton, Binghamton,

NY 13902-6000, United States
Lubin School of Accounting, Whitman School of Management, Syracuse University,
NY 13244-2450, United States

Abstract
In this paper we investigate the relation between audit committee quality, auditor
independence, and the disclosure of internal control weaknesses after the enactment
of the Sarbanes-Oxley Act. We begin with a sample of rms with internal control weaknesses and, based on industry, size, and performance, match these rms to a sample of
control rms without internal control weaknesses. Our conditional logit analyses indicate that a relation exists between audit committee quality, auditor independence,
and internal control weaknesses. Firms are more likely to be identied with an internal
control weakness, if their audit committees have less nancial expertise or, more specifically, have less accounting nancial expertise and non-accounting nancial expertise.
They are also more likely to be identied with an internal control weakness, if their
auditors are more independent. In addition, rms with recent auditor changes are more
likely to have internal control weaknesses.
 2007 Elsevier Inc. All rights reserved.

Corresponding author. Tel.: +1 607 777 6067; fax: +1 607 777 4422.
E-mail addresses: yzhang@binghamton.edu (Y. Zhang), jzhou@binghamton.edu (J. Zhou),
nzhou@binghamton.edu (N. Zhou).
0278-4254/$ - see front matter  2007 Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2007.03.001

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

301

Keywords: Internal control weakness; Audit committee nancial expertise; Auditor independence;
Sarbanes-Oxley Act

1. Introduction
The Sarbanes-Oxley Act (hereafter SOX) of 2002 went into eect on July
30, 2002 to address the increasing concern of investors about the integrity of
rms nancial reporting, due to scandals involving once well-respected companies, such as Enron and WorldCom and auditors, such as Arthur Andersen. One important aspect of SOX is that it has two sections specically
focusing on internal control issues related to nancial reporting. Under Section 302, management is required to disclose all material weaknesses in internal control, when they certify the periodic, annual and quarterly, statutory
nancial reports. Under Section 404, a rm is required to assess the eectiveness of its internal control structure and procedures for nancial reporting
and disclose such information in its annual reports. Furthermore, the rms
auditor is required to provide an opinion on the assessment made by the
management in the same report. Because such mandatory disclosure under
SOX provides us with more information on internal controls, we are interested in investigating the determinants of internal control weaknesses in the
post-SOX era.
We begin with a sample of rms with internal control weaknesses, and,
based on industry, size, and performance, match these rms to a sample of control rms without internal control weaknesses. Our conditional logit analyses
indicate that a relation exists between audit committee quality, auditor independence, and internal control weaknesses. Firms are more likely to be identied with an internal control weakness, if their audit committees have less
nancial expertise or, more specically, have less accounting nancial expertise
and non-accounting nancial expertise. They are also more likely to be identied with an internal control weakness, if their auditors are more independent.
In addition, rms with recent auditor changes are more likely to have internal
control weaknesses.
Our paper is related to several recent papers on the determinants of internal control weaknesses. Krishnan (2005) examines the period prior to the
enactment of SOX, when internal control problems are only disclosed in
8-Ks led by rms when changing auditors. With information collected from
8-K lings, she nds that independent audit committees and audit committees
with more nancial expertise are signicantly less likely to be associated with
the incidence of internal control problems. Ge and McVay (2005) and Doyle
et al. (forthcoming) nd that material weaknesses in internal control are more

302

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

likely for rms that are smaller, less protable, more complex, growing rapidly, or undergoing restructuring. Ashbaugh-Skaife et al. (forthcoming) nd
that rms with more complex operations, recent changes in organization
structure, auditor resignation in the previous year, more accounting risk
exposure, and less investment in internal control systems are more likely to
disclose internal control deciencies.
We document that nancial expertise in audit committees continues to be an
important determinant of internal control weaknesses after the enactment of
SOX. Our ndings thus complement those in Krishnan (2005), who studies
the pre-SOX period. Focusing on the post-SOX period enables us to take
advantage of the wealth of information on internal control unleashed by
SOX and to construct a sample of rms with internal control problems from
both mandated disclosures in the rms 10-Q and 10-K lings under SOX
and information disclosed in 8-K lings when rms change auditors. Consisting of only those rms that change auditors in the pre-SOX period, the sample
rms in Krishnan (2005) tend to be smaller in size and are traded on smaller
stock exchanges. We avoid this sample selection bias by focusing on the
post-SOX period, given that all rms are required to disclose material internal
control weaknesses under SOX. In addition, we document that auditor independence is an important determinant of internal control weaknesses. This
adds to the literature that supports the hypothesis that auditor independence
matters, such as Frankel et al. (2002) and Krishnamurthy et al. (2006). Dierent from other researchers who also focus on the post-SOX period, such as Ge
and McVay (2005), Doyle et al. (forthcoming) and Ashbaugh-Skaife et al.
(forthcoming), we show that audit committee quality, characterized as having
more nancial expertise or, more specically, having more accounting nancial
expertise and non-accounting nancial expertise, is an important determinant
of internal control weaknesses. In addition, we nd that auditor independence,
calculated as the ratio of audit fee to total fee, is also a determinant of internal
control weaknesses.
The rest of the paper is organized as follows. Section 2 introduces the background and proposes our hypotheses. Section 3 describes the sample selection
procedures. Section 4 discusses the empirical ndings, and Section 5 presents
our conclusions.

2. Background and hypotheses

2.1. Background
SOX emphasizes internal control, which is dened as a process, eected by
an entitys board of directors, management and other personnel, designed to
provide reasonable assurance regarding the achievement of objectives,

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

303

according to the COSO framework.1 SOX Section 302 (hereafter SOX 302),
which went into eect on August 29, 2002, requires management to disclose
signicant internal control deciencies, when they certify annual or quarterly
nancial statements. Specically, the signing ocers, being responsible for
internal controls, have evaluated the internal controls within the previous
ninety days and reported in their ndings: (1) a list of all deciencies in the
internal controls and information on any fraud that involves employees who
are involved with internal control activities; (2) any signicant changes in internal controls or related factors that could have a negative impact on the internal
controls.
Section 404 took this reporting a step further. It not only requires management to provide an assessment of internal controls, but also requires auditors
to provide an opinion on managements assessment. Under Securities
Exchange Commission (SEC) Release No. 33-8238 (June 5, 2003), Section
404(a) requires issuers to disclose information concerning the scope and adequacy of the internal control structure and procedures for nancial reporting
in their annual reports. This statement shall also assess the eectiveness of such
internal controls and procedures. Section 404(b) requires the registered auditing rm, in the same report, to attest to and report on the eectiveness of the
internal control structure and procedures for nancial reporting.2 According to
SEC Release No. 33-8392 (February 24, 2004), a company that is an accelerated ler must comply with SOX Section 404 (hereafter SOX 404) for its rst
scal year ending on or after November 15, 2004.3 Appendix A provides a

1
COSO stands for the Committee of Sponsoring Organizations of the Treadway Commission,
who undertook an extensive study of internal control to establish a common denition that would
serve the needs of companies, independent public accountants, legislators, and regulatory agencies
and to provide a broad framework of criteria, against which companies could evaluate the
eectiveness of their internal control systems. COSO published its Internal Control Integrated
Framework in 1992.
2
The SOX compliance information is from www.sec.gov, and the SOX summaries are from
www.soxlaw.com.
3
In SEC Release No. 33-8238 (June 5, 2003), an accelerated ler, dened in the original
Exchange Act Rule 12b-2, referred to a US company that has equity market capitalization over $75
million and has led an annual report with the SEC. According to SEC Release No. 33-8618
(September 22, 2005), prior to December 1, 2005, accelerated ler status did not directly aect a
foreign private issuer ling its annual reports on Form 20-F or 40-F, even though the denition of
accelerated ler did not expressly exclude foreign private issuers by its terms. After December 1,
2005, a foreign private issuer meeting the accelerated ler denition, and ling its annual report on
Form 20-F or Form 40-F, became subject to the internal control reporting requirements under
SOX 404 with compliance dates given in Appendix A. SEC Release No. 33-8644 (December 21,
2005) amended the Exchange Act Rule 12b-2 denition of an accelerated ler to create a new
category of accelerated ler, the large accelerated ler, for issuers with equity market value of
$700 million or more, and re-dene the term accelerated ler to include an issuer with equity
market value of $75 million or more, but less than $700 million.

304

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

comprehensive schedule of Section 404 compliance dates, including those for

non-accelerated lers and foreign private issuers.
According to Compliance Week, most of the internal control weakness disclosures under SOX 302 and SOX 404 are related to nancial systems and procedures. This group typically involves nancial closing processes, account
reconciliation, or inventory processes. For example, United Stationers disclosed problems with the design and eectiveness of internal controls relating
to receivables from suppliers. Personnel issues rank as the second largest category of weakness disclosures. This category is related to the poor segregation
of duties, inadequate stang, or other related training or supervision problems. For example, Sanmina-SCI cited a lack of sucient personnel with
appropriate qualications and training in certain key accounting roles. Other
common types of weaknesses include revenue recognition, documentation, and
IT system and controls (e.g., security and access controls, backup and recovery
issues). In addition, issues related to international operations and mergers and
acquisitions are sources of weakness disclosure, although they represent a relatively small percentage of all disclosures. For example, Masco cited internal
control problems attributable to historical growth through acquisition and
decentralized organizational structure, and GulfMark Oshore identied
internal control deciencies related to the complexity of their multi-national
operations.
Based on their severity, these internal control problems are classied into
three types: material weakness, signicant deciency, and control deciency.
Auditing Standard (hereafter AS) No. 2 denes a material weakness as a signicant deciency, or combination of signicant deciencies, that results in
more than a remote likelihood that a material misstatement of the annual or
interim nancial statements will not be prevented or detected. Under AS
No. 2, a signicant deciency is a control deciency, or a combination of control deciencies, that adversely aects the companys ability to initiate, authorize, record, process, or report external nancial data reliably in accordance
with generally accepted accounting principles such that there is more than a
remote likelihood that a misstatement of the companys annual or interim
nancial statements that is more than inconsequential will not be prevented
or detected. A control deciency occurs when the design or operation of a
control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatement on a timely
basis. Since only material weaknesses are required to be publicly disclosed
under SOX 302 and SOX 404, we follow Doyle et al., 2006, forthcoming,
and focus on rms that disclosed material weaknesses in our study.4 For the

This is also driven by the fact that Compliance Week lists only rms with material weaknesses
starting March 2005.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

305

sake of brevity, we will refer to material internal control weaknesses as internal

control weaknesses hereafter.
2.2. Audit committee quality and internal control
Since an entitys internal control is under the purview of its audit committee
(Krishnan, 2005), we investigate the relation between audit committee quality
and internal control weaknesses. The audit committee not only plays an important monitoring role to assure the quality of nancial reporting and corporate
accountability (Carcello and Neal, 2000), but also serves as an important governance mechanism, because the potential litigation risk and reputation impairment faced by audit committee members ensure that these audit committee
members discharge their responsibilities eectively. We thus expect that rms
with high-quality audit committees are less likely to have internal control
weaknesses than rms with low-quality audit committees.
On measuring audit committee quality, we focus on the nancial expertise in
these committees. The Blue Ribbon Committee on Improving the Eectiveness
of Corporate Audit Committees (BRC)s (1999) recommendation that each
audit committee should have at least one nancial expert highlights the importance of the nancial literacy and expertise of audit committee members.5 Section 407 of the SOX incorporates the above suggestion and requires rms to
disclose in periodic reports, whether a nancial expert serves on a rms audit
committee and, if not, why not. Such nancial expertise of audit committee
members has been shown to be important for dealing with the complexities
of nancial reporting (Kalbers and Fogarty, 1993) and for reducing the occurrence of nancial restatements (Abbott et al., 2004). In addition, DeZoort and
Salterio (2001) nd that audit committee members with nancial reporting and
auditing knowledge are more likely to understand auditor judgments and support the auditor in auditor-management disputes than members without such
knowledge. Moreover, nancially knowledgeable members are more likely to
address and detect material misstatements. Audit committee members with
nancial expertise can also perform their oversight roles in the nancial reporting process more eectively, such as detecting material misstatements (Scarbrough et al., 1998; Raghunandan et al., 2001). Indeed, Abbott et al. (2004)
nd a signicantly negative association between an audit committee having
5

The Report of the BRCs recommendation related to Audit Committee Competence states that
the audit committee should consist of at least three members, each of whom is independent
(dened in the Report as having no relationship to the corporation that may interfere with the
exercise of their independence from management and the corporation) and nancially literate
(dened as the ability to read and understand fundamental nancial statements). At least one
member of the audit committee should have accounting or nancial management expertise (dened
as past employment or professional certication in accounting or nance, or comparable experience
including service as a corporate ocer with nancial oversight responsibility).

306

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

at least one member with nancial expertise and the incidence of nancial
restatement. Krishnan (2005) presents evidence that audit committees with
nancial expertise are less likely to be associated with the incidence of internal
control problems. Therefore, we have the following directional prediction.
Hypothesis 1. Firms with greater audit committee nancial expertise are less
likely to have internal control weaknesses.
DeFond et al. (2005) document signicantly positive cumulative abnormal
returns around the appointment of accounting nancial experts to the audit
committee, suggesting that audit committees with accounting nancial expertise improve corporate governance. Therefore, we further separate audit
committee nancial expertise into accounting nancial expertise and nonaccounting nancial expertise and test the relation between these two variables
and internal control weaknesses.
In measuring the nancial expertise of an audit committee member, we follow the denition adopted in SOX Section 407, and, more specically, modify
the denition used in DeFond et al. (2005). An audit committee member is a
nancial expert if he or she can be classied into the following two categories:
(a) an accounting nancial expert who has experience as a public accountant,
auditor, principal or chief nancial ocer, controller, or principal or chief
accounting ocer; or (b) a non-accounting nancial expert who has experience
as the chief executive ocer, president, or chairman of the board in a for-prot
corporation, or who has experience as the managing director, partner or principal in venture nancing, investment banking, or money management. With
this denition, we measure audit committee nancial expertise (ACFE) as
the percentage of audit committee members who are nancial experts. We further separate audit committee nancial expertise into accounting nancial
expertise (ACCT_ACFE), measured as the percentage of audit committee
members who are accounting nancial experts, and non-accounting nancial
expertise (NONACCT_ACFE), the percentage of audit committee members
who are non-accounting nancial experts.
2.3. Auditor independence and internal control
Auditor independence can be related to the disclosure of a rms internal
control problems. When there is a strong economic bond between an auditor
and a client rm, the auditor has an incentive to ignore potential problems
and issue a clean opinion on the client rms internal controls. While some
studies (DeFond et al., 2002; Asbaugh et al., 2003; Chung and Kallapur,
2003; Reynolds et al., 2004; Francis and Ke, 2003) nd no relation between
non-audit fees and auditor independence and argue that an auditors concern
with maintaining its reputation for providing high-quality audits could restrain

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

307

it from undertaking activities that jeopardize independence, since the revenue

from each client will be a small percentage of the auditors total revenue, other
studies suggest that the provision of non-audit services compromises auditor
independence. For example, Frankel et al. (2002) nd that non-audit services
are associated with increased discretionary accruals and the achievement of
certain earnings benchmarks and Krishnamurthy et al. (2006) document that
the abnormal returns for Andersens clients around Andersens indictment
are signicantly more negative, when the market perceived the auditors independence to be compromised. Given these mixed empirical ndings, we measure auditor independence (RATIO) as the ratio of the audit fee to the total
fee, and propose the non-directional null hypothesis, as follows.
Hypothesis 2. Auditor independence is not associated with the disclosure of
internal control weaknesses.
2.4. Control variables
2.4.1. Audit committee
In addition to audit committee nancial expertise, other attributes of an
audit committee have been found to be important factors in eective monitoring. Specically, we control for audit committee independence, since Krishnan
(2005) nds that there is a positive relation between audit committee independence and the quality of internal control prior to the enactment of SOX.6 While
SOX requires that audit committees be composed of all independent directors
for rms traded on an organized stock exchange (e.g., NYSE, AMEX) or a recognized dealer quotation system (e.g., NASDAQ), exemptions may be given by
the SEC, if it determines that it is appropriate under certain circumstances. We
thus still control for audit committee independence (ACIND), dened as the
percentage of independent directors on the audit committee. Under SOX, an
audit committee member is independent, if he or she is not aliated with the
rm and does not accept any consulting fees.
We next control for the natural logarithm of audit committee size (ACSZ),
measured as the number of audit committee members, because research suggests that a large audit committee tends to enhance the audit committees status and power within an organization (Kalbers and Fogarty, 1993), to receive
more resources (Pincus et al., 1989), and to lower the cost of debt nancing
(Anderson et al., 2004). We thus expect that a large audit committee is more
likely than a small one to improve the quality of internal controls, because

Previous research has also found an association between audit committee independence and the
quality of accounting information (e.g., Klein, 2002b; Abbott et al., 2004).

308

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

increased resources and enhanced status will make the audit committee more
eective in fullling its monitoring role.
We also control for the natural logarithm of audit committee meetings
(ACMEET), measured as the number of audit committee meetings held each
year, because research shows that eective audit committees meet regularly
(Menon and Williams, 1994; Xie et al., 2003).7 Consistent with this hypothesis,
McMullen and Raghunandan (1996) nd that the audit committees of rms
with SEC enforcement actions or earnings restatements are less likely to have
frequent meetings than those without and Lennox (2002) nds that there is a
signicant increase in the number of audit committee meetings during an auditor dismissal year. However, it is also possible that an audit committee meets
more frequently to discuss internal control issues, when there are signicant
problems associated with a rms internal controls. Therefore, we make no prediction on the relation between the number of audit committee meetings and
the quality of internal controls.
2.4.2. Board of directors
The quality of an entitys internal controls is a function of the quality of its
control environment that includes the board of directors and the audit committee (Krishnan, 2005). First, we focus on board independence (BDIND), measured as the percentage of outside directors on the board,8 because research
suggests that board independence is negatively related to the likelihood of
nancial fraud and SEC enforcement actions (Beasley, 1996; Dechow et al.,
1996). We also control for the natural logarithm of board size (BDSZ), measured as the number of directors on the board. While some researchers nd
that a large board has more expertise than a small one (Dalton et al., 1999),
that it tends to be more eective in monitoring accruals (Xie et al., 2003),
and that it leads to a lower cost of debt (Anderson et al., 2004), others suggest
that a small board is more eective in mitigating the agency costs associated
with a large board (Yermack, 1996; Eisenberg et al., 1998; Hermalin and Weisbach, 1998, 2003). Given the mixed empirical evidence on board size, we expect
that the relation between board size and the likelihood of internal control
weaknesses is indeterminate. Finally, we control for the natural logarithm of
board meetings (BDMEET), as measured by the number of board meetings
held each year. While Conger et al. (1998) suggest that board meeting frequency is important to improve board eectiveness, Vafeas (1999) nds that
7

Hymowitz and Lublin (2003) report that many audit committees are spending far more time
than they used to reviewing nancial statements and overseeing auditors, meeting 10 or 11 times a
year, up from three or four times.
8
Outside directors are those who are not aliated with the rm, other than serving on its board.
We rst exclude those directors who are the rms ocers and major shareholders, and then further
exclude those who have consulting relationships or other related-party transactions with the rm.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

309

it is inversely related to rm value, because of the increased board activities following share price declines. Since board independence, size, and meeting frequency all inuence a boards eectiveness, they, in turn, are related to the
quality of internal controls.
2.4.3. Auditor types
We use a dummy variable (BIG4) to measure auditor type,9 because a rms
decision to hire a Big 4 auditor is likely to be associated with internal controls
for several reasons. Doyle et al. (forthcoming) nd that smaller and less profitable rms are more likely to have internal control problems than larger or
more protable ones. On the one hand, such rms with internal control problems are less likely to hire a Big 4 auditor, because they are constrained by
nancial resources and cannot aord it. On the other hand, they might also
be avoided by the Big 4 auditors, because they are perceived as being risky
and may expose the Big 4 to potential litigation. Given that a rm shunned
by a Big 4 auditor may signal that it has potential internal control problems,
we introduce the dummy variable BIG4 to control for auditor quality.
2.4.4. Auditor changes
Ashbaugh-Skaife et al. (forthcoming) nd that rms with recent auditor
changes are likely to have internal control problems. On the one hand, auditors
may drop risky clients as part of their risk management strategies, since rms
with material internal control weaknesses may represent high audit failure risk.
On the other hand, rms may dismiss auditors for lack of performance, when
the rms discover material internal control weaknesses. Therefore, we use a
control variable AUDCHG, which is equal to one, if there is an auditor change
in 2003 or 2004, and zero otherwise.
2.4.5. Other variables
We also control for rm characteristics that may be associated with internal
control problems. Since Doyle et al. (forthcoming) show that small and high
growth rms are likely to have internal control weaknesses, in our model, we
control for size, measured as the natural logarithm of total assets (TA), and
growth, measured as industry-median-adjusted sales growth (ADJSALEGR).
It may take some time for a rm that recently engaged in mergers and acquisition to integrate dierent internal control systems; consequently, such a rm
is more likely to have internal control problems. We thus introduce a dummy
variable (ACQUISITION), which takes the value of one, if a rm engages in
acquisitions during 2003, 2004 and from January to July of 2005, and zero
otherwise. Since a rm experiencing restructuring is also likely to have internal
control problems, because of the loss of experienced and valuable employees
9

The dummy variable (BIG4) takes a value of one, if a rm is a Big 4 client and zero otherwise.

310

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

and because of the dramatic changes associated with such an event, we follow
Ashbaugh-Skaife et al. (forthcoming) and use a dummy variable (RESTRUCTURE), coded as one, if a rm has been involved in restructuring, and zero
otherwise.10 Because rms with greater complexity and scope of operations
are more likely to have internal control problems than those without, we also
include the natural logarithm of the number of business segments (BUS) and
an indicator variable for foreign currency translation (FOREIGN) in our
model (see Ashbaugh-Skaife et al., forthcoming; Ge and McVay, 2005).

3. Sample and control rms selection

3.1. Selection of sample rms
Table 1 provides the details for the sample selection. Our initial sample is
from Compliance Week, an electronic newsletter that searches through 8-Ks,
10-Qs, and 10-Ks for all public companies to identify any rms with internal
control problems. While Compliance Week discloses rms with internal control
problems on a monthly basis starting from November 2003, we examine the
period from November 15, 2004 to July 31, 2005, so as to make it feasible to
hand-collect most of the governance information required in our study.11
For our sample period, there are 372 rms identied by Compliance Week as
having various types of internal control problems under SOX 302 or SOX
404,12 including material weakness, signicant deciency, reportable conditions, and control deciency.13 We exclude ten rms without Cusip numbers,
nine rms not in COMPUSTAT, 13 foreign rms or subsidiaries, 57 rms with
missing values for EBITDA prot margin,14 54 non-material weakness rms,15
and 21 rms without proxy information. This leaves us with a nal sample of

10
A rm is engaged in a restructuring, if it has non-zero values of COMPUSTAT data #376,
#377, #378, or #379.
11
We start from November 15, 2004, given that there is increasing attention to internal control
issues, after SOX 404 became eective for accelerated lers.
12
We exclude 31 duplicate appearances during the sample period.
13
Reportable conditions is an old term, which was dened by AICPA as a signicant
deciency in the design or operation of the internal control structure that could adversely aect the
companys ability to record, process, summarize, and report nancial data consistent with the
assertions of management in the nancial statements. Compliance Week lists some of the early
rms under this term.
14
We include this lter because our match rms are selected based on sales and EBITDA prot
margin (EBITDA/sales). If a rm has a missing value for sales, it will also have a missing value for
EBITDA prot margin.
15
These rms are identied as having signicant deciencies, control deciencies, or reportable
conditions. Starting from March 2005, Compliance Week lists only rms with material weaknesses.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

311

Table 1
Sample selection procedure
Sample characteristics

Number of rms

Total rms identied by Compliance Week as having internal control

problems from November 15, 2004 to July 31, 2005 (excluding 31
duplicate appearances)
Excluding rms without Cusip Numbers
Excluding rms not in COMPUSTAT
Excluding foreign rms or subsidiaries
Excluding rms with missing values for EBITDA prot margin
(COMPUSTAT #13/COMPUSTAT #12)
Excluding non-material weakness rms
Excluding rms with missing proxy information
Final sample

372

(10)
(9)
(13)
(57)
(54)
(21)
208

The sample consists of rms identied by Compliance Week as having material internal control
weaknesses from November 15, 2004 to July 31, 2005. We exclude rms without Cusip numbers or
not in COMPUSTAT, foreign rms or subsidiaries, rms with missing values for operating margin,
non-material weakness rms, and rms without proxy information. Data in parentheses indicate
the number of rms removed from the full set of 372 rms to obtain the nal sample of 208
companies.

208 rms with material internal control weaknesses. We retrieve all nancial
information from 2004 COMPUSTAT, obtain the acquisition information
from Securities Data Company, acquire the business segment information
from COMPUSTAT Segment les, and hand-collect all audit and non-audit
fee, audit committee, and board information from the rms proxy statements
for the year of their material weakness disclosure in Compliance Week.
3.2. Control rms selection
To study the determinants of internal control weaknesses, we use the
matched-pair design. Although using matched samples when the number of
treatment rms is not proportional to sample population may lead to biased
parameters and probability estimates (Palepu, 1986), we adopt this approach
to make it feasible for us to hand-collect audit committee and board information from the proxy statements. The 208 control rms without internal control
weaknesses are matched to the 208 sample rms with internal control weaknesses, one-to-one, based on certain key characteristics. Specically, we follow
Purnanandam and Swaminathan (2004), who use selected publicly traded rms
in the same industry as comparable rms.16 Since their procedure balances
between matching based on industry or sales, which can be too approximate,
and matching based on a list of accounting variables, which can be so
16

Guo et al. (2005) adapt this procedure to study the relative valuation of biotech IPOs.

312

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

numerous that it becomes impossible to nd match rms, we adapt their procedure to create our sample of match rms. The procedure is described as
follows:
(1) We select all rms in 2004 COMPUSTAT. From these rms, we eliminate subsidiaries and require rms to be incorporated in the US. We further require them to have information on CRSP, and be identied as
common stocks of domestic US rms (CRSP share code = 10 or 11).
(2) We use COMPUSTAT SIC codes to group the remaining rms into 48
industries using the industry classication in Fama and French (1997).
(3) The remaining rms in each industry are sorted into three portfolios by
sales, and then each sales portfolio is sorted into three portfolios by
EBITDA prot margin (EBITDA/sales), where EBITDA stands for
earnings before interest, taxes, depreciation, and amortization. As a
result, we have 9 (3 3) portfolios of comparable rms in each industry.
If there are not enough rms in an industry (fewer than 70 rms), we limit
ourselves to a 2 2 classication, which leads to 4 portfolios of comparable rms in that industry.
(4) We obtain sales and EBITDA margin for our sample rms from the 2004
COMPUSTAT and also classify them into dierent industries, according
to the Fama-French industry classication. Each sample rm is matched
with a portfolio of comparable rms based on industry, sales and
EBITDA margin. In that portfolio, one rm with the closest total sales
is selected as the match rm. If the match rm does not le a proxy or
have sucient information in proxy or has internal control weaknesses,
we replace it with a non-weakness rm from the same portfolio that
has the next closest total sales.17
Following the same procedure as for the sample rms, we obtain all the
information from COMPUSTAT and proxy statements for our control rms.
Table 2 provides summary statistics for our sample rms and control rms.
While the mean (median) sales for sample rms is $2701.43 million ($375.02
million), the mean (median) sales for match rms is $1745.72 million
($365.11 million). While the mean (median) EBITDA prot margin for sample
rms is 0.14 (0.11), the mean (median) EBITDA prot margin for match
rms is 0.45 (0.11). The large dierence in the mean comparison of sales is
driven by General Electric (GE), which has substantially larger sales than does
its closest match rm. Without GE and its match rm, the mean (median) sales
17

We check the Compliance Week list and 10-Ks to ensure that a match rm does not have
internal control weaknesses. A match rm is replaced, if it appears on the Compliance Week list
from November 2003 to July 2005 or is agged with internal control weaknesses in its 10-K led
prior to July 2005.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

313

Table 2
Mean and median comparison for sample and control rms
Variable

Sample rms
Mean
Median

Control rms
Mean
Median

Mean
Dierence
(p-value)

Median
Dierence
(p-value)

ACFE

0.75
0.75
0.22
0.25
0.53
0.67
0.78
0.83
0.92
1.00
3.46
3.00
9.31
8.00
0.68
0.70
8.14
8.00
8.49
7.00
0.81
1.00
0.16
0.00
11130.58
495.31
0.13
0.00
0.04
0.00
0.31
0.00
2.17
1.00
0.30
0.00
2701.43
375.02
0.14
0.11
208

0.83
1.00
0.23
0.25
0.59
0.67
0.75
0.78
0.93
1.00
3.52
3.00
7.89
8.00
0.70
0.71
8.33
8.00
7.43
7.00
0.79
1.00
0.10
0.00
4893.83
574.86
0.20
0.01
0.03
0.00
0.24
0.00
2.09
1.00
0.29
0.00
1745.72
365.11
0.45
0.11
208

0.08
(0.00)
0.02
(0.39)
0.06
(0.02)
0.03
(0.08)
0.01
(0.54)
0.07
(0.36)
1.42
(0.00)
0.02
(0.22)
0.19
(0.36)
1.06
(0.00)
0.02
(0.42)
0.06
(0.06)
6236.75
(0.20)
0.07
(0.51)
0.01
(0.41)
0.07
(0.04)
0.08
(0.58)
0.01
(0.81)
955.71
(0.20)
0.31
(0.20)

0.00
(0.00)
0.00
(0.31)
0.00
(0.04)
0.06
(0.02)
0.00
(0.37)
0.00
(0.31)
0.00
(0.03)
0.00
(0.21)
0.00
(0.45)
0.00
(0.03)
0.00
(0.43)
0.00
(0.06)
26.11
(0.18)
0.00
(0.71)
0.00
(0.58)
0.00
(0.04)
0.00
(0.71)
0.00
(0.81)
0.28
(0.84)
0.01
(0.16)

ACCT_ACFE
NONACCT_ACFE
RATIO
ACIND
ACSZ
ACMEET
BDIND
BDSZ
BDMEET
BIG4
AUDCHG
TOTAL ASSETS
ADJSALEGR
ACQUISITION
RESTRUCTURE
BUS
FOREIGN
SALEa
EBITDA/SALE
N

The 208 control rms that have no internal control problems are matched to the 208 sample rms
that do have internal control problems, one-on-one, based on industry, size, and performance.
Financial variables are retrieved from COMPUSTAT; the acquisition variable is obtained from
(continued on next page)

314

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

Table 2 (continued)
Securities Data Company; the business segment variable is acquired from COMPUSTAT segment
les; and audit committee-, board-, and fee variables are hand-collected from the proxy statements.
Because sample rms are matched to control rms on a one-to-one basis, we use the paired t-test to
test the dierences in mean and the Wilcoxon signed rank test to test the dierences in median. All
variable denitions are in Appendix B. Two-tailed p-values are reported in parentheses.
a
The large dierence in the mean comparison of sales is driven by General Electric, which has
substantially larger sales than does its closest match rm. Without GE and its match rm, the mean
(median) sales in millions for the sample and control will be 1983.57 (372.50) and 1742.15 (364.18),
respectively. We nd that our main results in Table 4 remain unchanged, when we exclude GE and
its match rm in our conditional logit regressions.

for the sample and control will be 1983.57 million (372.50 million) and 1742.15
million (364.18 million), respectively.18 If we exclude GE and its match rm,
sample and control rms share similar characteristics in terms of sales and
EBITDA prot margin, since our selection procedure for match rms is based
on these two variables.

4. Empirical results
4.1. Univariate analyses
Table 2 provides mean and median comparisons of the sample and control
rms for our variables of interest. Because our sample rms are matched with
control rms on a one-to-one basis, we use the paired t-test to test the dierence in means and the Wilcoxon signed rank test to test the dierence in medians.19 There are several noticeable dierences between these two groups of
rms. On average, 75% of the audit committee members of the sample rms
are nancial experts, while 83% of the audit committee members of the control
rms are nancial experts. This dierence, signicant at the 1% level, implies
that rms with more audit committee nancial expertise are less likely to have
internal control problems, providing initial support for Hypothesis 1. We further separate audit committee nancial experts into accounting nancial
experts and non-accounting nancial experts. On average, accounting nancial
experts account for 22% of the sample rms and 23% of the control rms
audit committee members, while non-accounting nancial experts account
for 53% of the sample rms and 59% of the control rms audit committee
members. The dierence in non-accounting nancial expertise between the
two groups is signicant at the 5% level.

18
We nd that our main results in Table 4 remain unchanged, when we exclude GE and its match
rm in our conditional logit regressions.
19
The Wilcoxon signed rank test is the non-parametric analog of the paired t-test.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

315

We use the ratio of audit fee to total fee to measure auditor independence,
where a low ratio indicates that the rms auditor provides more non-audit services and thus lacks independence. The average audit fee ratios are 78% for the
sample rms and 75% for the control rms. This signicant dierence indicates
that independent auditors are more likely to uncover internal control problems, rejecting the null of Hypothesis 2. In addition, the sample rms have
more audit committee and board meetings, on average, probably in response
to the sample rms internal control problems. Firms that have changed auditors or engaged in restructuring activities recently are also more likely to experience internal control weaknesses.
Table 3 presents the correlation coecients for the dependent and independent variables after we pool the sample and control rms together. We create a
dummy for internal control weaknesses (ICW), which takes the value of one if
a rm belongs to the sample rm group, and zero if it belongs to the control
rm group. This dependent variable of interest is signicantly negatively correlated with audit committee nancial expertise, indicating that rms with
greater audit committee nancial expertise are less likely to have internal control weaknesses. Moreover, it is signicantly positively correlated with the
audit fee ratio, indicating that rms with more independent auditors are more
likely to uncover internal control weaknesses. These results again provide preliminary support for Hypotheses 1 and 2. In addition, the internal control
weakness dummy variable is positively correlated with the natural logarithms
of audit committee meeting frequency and board meeting frequency. Thus,
the audit committee and board of a rm with internal control weaknesses
appear to hold additional meetings, dealing with the rms internal control
problems. Further, the internal control weakness dummy is positively correlated to the variables for audit change and restructuring, suggesting that rms
with recent auditor changes or restructuring activities are more likely to have
internal control weaknesses.
4.2. Multivariate analyses
4.2.1. Conditional logit regression models
We use the conditional logit regression models to test our hypotheses that
audit committee nancial expertise and auditor independence are related to
internal control weaknesses. Specically, we express the internal control weakness variable as a function of audit committee quality, auditor independence,
and a set of control variables.
The conditional logistic regression is useful in investigating the relation
between an outcome (whether the rm is a sample rm with internal control
weaknesses or a control rm without such weaknesses) and a set of prognostic
factors in a matched-pair study. We match control rms to sample rms to
minimize inherent variations in those factors. Because the traditional logistic

0.14***
0.05
0.09*
0.09**
0.01
0.00
0.10**
0.05
0.03
0.10**
0.03
0.09*
0.01
0.04
0.04
0.08*
0.02
0.01

0.52***
0.06
0.01
0.19***
0.06
0.03
0.06
0.01
0.03
0.06
0.02
0.06
0.01
0.01
0.00
0.01

0.11**
0.06
0.06
0.10**
0.07
0.02
0.01
0.06
0.08
0.02
0.03
0.04
0.03
0.01
0.06

0.11**
0.64***
0.54***

0.04
0.25***

0.16***

0.27***
0.67***
0.10**
0.06
0.05
0.05
0.11**
0.01
0.01
0.12***
0.04
0.02
0.03
0.01
0.06
0.03
0.07

NONACCT_
ACFE

ACCT_
ACFE

ACFE

0.02
0.02
0.12**
0.07
0.04
0.02
0.06
0.07
0.14***
0.08
0.02
0.02
0.03
0.04

0.08*
0.05
0.06
0.09*

RATIO

0.01
0.08*
0.43***
0.03
0.03
0.04
0.01
0.03
0.09*
0.07
0.02
0.07
0.05

0.03
0.06
0.01
0.04
0.01

ACIND

All variable denitions are in Appendix B.

*, **, and *** denote the two-tailed signicance at the 10%, 5%, and 1% levels, respectively.

ICW
ACFE
ACCT_ ACFE
NONACCT_ACFE
RATIO
ACIND
LOG(ACSZ)
LOG(AC MEET)
BDIND
LOG(BDSZ)
LOG(BD MEET)
BIG4
AUDCHG
LG(TA)
ADJ SALEGR
ACQUI SITION
RESTRU CTURE
LOG(BUS)
FOREIGN

ICW

Table 3
Pearson (upper right)/spearman (lower left) correlation coecients

0.19***
0.27***
0.38***
0.10**
0.00
0.02
0.30***
0.12***
0.06
0.04
0.16***
0.07

0.03
0.01
0.12***
0.09*
0.03
0.01

LOG
(ACSZ)

0.10**
0.26***
0.34***
0.21***
0.01
0.36***
0.01
0.02
0.16***
0.06
0.09*

0.11**
0.07
0.02
0.08
0.09**
0.10**
0.12***

LOG(AC
MEET)

0.21***
0.04
0.15***
0.07
0.27***
0.08*
0.08
0.13***
0.06
0.07

0.06
0.13***
0.05
0.07
0.04
0.48***
0.26***
0.06

BD IND

0.14***
0.06
0.12**
0.58***
0.10**
0.06
0.03
0.15***
0.03

0.04
0.01
0.03
0.02
0.02
0.01
0.41***
0.25***
0.16***

LOG
(BDSZ)

0.01
0.01
0.18***
0.07
0.01
0.05
0.02
0.01

0.13***
0.05
0.01
0.04
0.02
0.07
0.07
0.41***
0.02
0.15***

LOG(BD
MEET)

0.30***
0.15***
0.04
0.06
0.21***
0.23***
0.18***

0.03
0.13***
0.04
0.08*
0.07
0.03
0.01
0.22***
0.15***
0.04
0.01

BIG4

0.11**
0.04
0.12
0.01
0.06
0.04

0.09*
0.04
0.06
0.08*
0.09*
0.04
0.07
0.01
0.07
0.11**
0.02
0.30***

AUD
CHG

0.01
0.07
0.11**
0.16***
0.01

0.04
0.00
0.02
0.02
0.10**
0.03
0.35***
0.35***
0.23***
0.60***
0.19***
0.17***
0.12**

LOG(TA)

0.03
0.17***
0.11**
0.04

0.03
0.07
0.02
0.08
0.05
0.07
0.14***
0.01
0.08*
0.03
0.07
0.12***
0.01
0.08

ADJ
SALEGR

0.004
0.03
0.04

0.04
0.02
0.01
0.03
0.02
0.06
0.07
0.03
0.06
0.06
0.02
0.06
0.12***
0.06
0.20

ACQUI
SITION

0.17***
0.30***

0.08*
0.07
0.02
0.04
0.00
0.05
0.04
0.14**
0.11**
0.02
0.05
0.21***
0.01
0.08*
0.09*
0.004

RESTRU
CTURE

0.05

0.03
0.02
0.01
0.01
0.03
0.06
0.15***
0.05
0.06
0.15**
0.03
0.23***
0.06
0.21***
0.09*
0.03
0.17***

LOG
(BUS)

0.01
0.06
0.02
0.07
0.01
0.04
0.06
0.11**
0.08*
0.03
0.02
0.18***
0.04
0.02
0.00
0.04
0.30***
0.04

FOR
EIGN

316
Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

317

regression cannot take into account the correlation structure of a matched

design, we analyze our matched sample-control study using the conditional
logistic regression that takes into account the non-random nature of the data.
For each matched set consisting of one sample rm and one control rm, the
conditional likelihood is as follows:
Y
1 expb0 xi1  xi0 1
i

where xi1 and xi0 are vectors of the prognostic factors for the sample and control rm, respectively, of each ith matched set (Breslow, 1982; Hosmer and
Lemeshow, 2000).
4.2.2. Conditional logit regression results
Tables 4 and 5 present the regression results using conditional logit analyses.
All variable denitions are provided in Appendix B. Table 4 presents four
models with dierent measures of audit committee quality. Models 1 and 2
use audit committee nancial expertise (ACFE) to measure audit committee
quality. Klein (2002a) nds that the main determinant of audit committee independence is board independence, and thus audit committee characteristics and
board characteristics are highly correlated. In order to avoid multicollinearity,
we introduce only audit committee characteristics (ACIND, LOG(ACSZ), and
LOG(ACMEET)), along with audit fee ratio (RATIO), in Model 1.20 We further control for auditor type (BIG4), auditor change (AUDCHG), size
(LOG(TA)), growth (ADJSALEGR), acquisition (ACQUISTION), restructuring (RESTRUCTURE), segments (LOG(BUS)), and foreign currency translation (FOREIGN).21 The coecient on ACFE is signicant at the 1% level, and
the coecient on RATIO is signicant at the 5% level.22 This supports Hypothesis 1 and rejects the null of Hypothesis 2. Our evidence suggests that rms are
more likely to be identied with an internal control weakness, if their audit
committees have less nancial expertise or their auditors are more independent.
However, our result on auditor independence should be interpreted with caution, as there is an alternative explanation for the positive coecient RATIO.
Clients that purchase fewer non-audit services may have fewer discretionary
resources. This lack of discretionary resources may lead to a lack of investment
20

Following Klein (2002a), we take the natural logarithms of ACSZ, ACMEET, BDSZ, and
BDMEET. Our results remain unchanged, if we use the raw variables.
21
In an early version of Doyle et al. (forthcoming), restructuring is measured as special items
(#17) divided by lagged total assets (#6). We replace RESTRUCTURE with this measure in
Models 1 and 2 of Table 4 and nd that our results remain unchanged. We also measure size as log
of total assets (#6) and nd that our results in Table 4 remain unaltered.
22
Our result on auditor independence is sensitive to alternative measures of auditor independence.
Although we do not nd the expected relations on auditor independence when we replace audit fee
ratio with either log(total fee) or log(audit fee), the results on ACFE or, more specically,
accounting ACFE and non-accounting ACFE remain unchanged.

318

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

Table 4
Conditional logit analysis of determinants of internal control weaknesses
Variable

Predicted sign

Model 1

Model 2

ACFE

1.84
(3.46)***

1.81
(3.32)***

ACCT_ACFE

NONACCT_ACFE

RATIO

ACIND

LOG(ACSZ)

LOG(ACMEET)

BDIND

LOG(BDSZ)

LOG(BDMEET)

BIG4

AUDCHG

LOG(TA)

ADJSALEGR

ACQUISITION

RESTRUCTURE

LOG(BUS)

FOREIGN

1.30
(2.18)**
0.32
(0.42)
0.71
(1.23)
0.31
(1.24)

0.21
(0.52)
0.85
(2.44)***
0.24
(1.37)
0.11
(0.96)
0.31
(0.47)
0.47
(1.47)*
0.17
(0.83)
0.001
(0.01)
416

1.28
(2.07)**
0.53
(0.56)
0.35
(0.56)
0.20
(0.75)
0.52
(0.58)
0.95
(1.81)*
0.56
(1.88)*
0.26
(0.64)
0.88
(2.45)***
0.26
(1.43)
0.12
(1.06)
0.27
(0.42)
0.54
(1.63)*
0.15
(0.75)
0.04
(0.14)
416

Model 3

Model 4

2.19
(2.94)***
1.78
(3.31)***
1.31
(2.19)**
0.33
(0.43)
0.79
(1.33)
0.31
(1.24)

2.21
(2.90)***
1.75
(3.17)***
1.29
(2.09)**
0.52
(0.55)
0.43
(0.67)
0.21
(0.78)
0.49
(0.55)
0.98
(1.84)*
0.56
(1.89)*
0.26
(0.64)
0.92
(2.54)***
0.25
(1.39)
0.13
(1.15)
0.19
(0.29)
0.55
(1.66)**
0.17
(0.83)
0.05
(0.18)
416

0.21
(0.53)
0.89
(2.51)***
0.23
(1.33)
0.11
(1.03)
0.23
(0.34)
0.48
(1.50)*
0.18
(0.91)
0.01
(0.02)
416

This table presents the conditional logit analysis for matched-pair regressions. The 208 control
rms that have no internal control problems are matched to the 208 sample rms that do have
internal control problems, one-on-one, based on industry, size, and performance. The dependent
variable ICW takes a value of 1, if a rm has internal control weaknesses and 0, otherwise. All
variable denitions are in Appendix B.
*, **, and *** denote signicance at the 10%, 5%, and 1% levels, respectively, on a one-tailed test for
coecients with sign predictions and a two-tailed test without sign predictions.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

319

Table 5
Conditional logit analysis of determinants of internal control weaknesses: controlling for overall
measure of corporate governance
Variable

Predicted sign

Model 1

ACFE

1.85
(3.46)***

ACCT_ACFE

NONACCT_ACFE

RATIO

GOVERN

LOG(ACMEET)

LOG(BDMEET)

BIG4

AUDCHG

LOG(TA)

ADJSALEGR

ACQUISITION

RESTRUCTURE

LOG(BUS)

FOREIGN

1.19
(1.96)**
0.22
(0.93)
0.17
(0.64)
0.47
(1.58)
0.33
(0.84)
0.87
(2.45)***
0.23
(1.24)
0.10
(0.81)
0.33
(0.51)
0.40
(1.21)
0.16
(0.82)
0.09
(0.34)
412

Model 2

2.03
(2.76)***
1.81
(3.35)***
1.19
(1.97)**
0.22
(0.95)
0.17
(0.64)
0.47
(1.58)
0.34
(0.86)
0.89
(2.47)***
0.22
(1.20)
0.10
(0.84)
0.29
(0.44)
0.40
(1.22)
0.17
(0.85)
0.10
(0.36)
412

This table presents the conditional logit analysis for matched-pair regressions. The 206 control
rms that have no internal control problems are matched to the 206 sample rms that do have
internal control problems, one-on-one, based on industry, size, and performance. The dependent
variable ICW takes a value of 1, if a rm has internal control weaknesses and 0, otherwise. We lost
two pairs of observations, since we cannot nd the institutional ownership data which are necessary
to calculate the overall governance measure. All variable denitions are in Appendix B.
*, **, and *** denote signicance at the 10%, 5%, and 1% levels, respectively, on a one-tailed test for
coecients with sign predictions and a two-tailed test without sign predictions.

in internal controls, resulting in internal control weaknesses. In addition, the

coecient on AUDCHG is signicant at the 1% level and the coecient on
RESTRUCTURE is signicant at the 10% level. Consistent with Doyle et al.
(forthcoming) and Ashbaugh-Skaife et al. (forthcoming), our ndings imply
that rms with recent auditor changes or restructuring activities are more likely

320

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

to have internal control weaknesses.23 Finally, it is worth noting that a few of

the insignicant results, noticeably the one on size, might be due to the
matched sample design used in this study.
In Model 2, we add board characteristics (BDIND, LOG(BDSZ), and
LOG(BDMEET)) to Model 1, and nd that our results on ACFE, RATIO,
AUDCHG and RESTRUCTURE remain unchanged. Moreover, rms with
a large board are less likely to have internal control weaknesses. Klein
(2002a) nds that board size is positively associated with audit committee independence, implying that rms with a large board are more likely to have eective audit committees and thus are more likely to demand high-quality auditing
services. Thus, our nding on board size is consistent with that in Klein (2002a).
Finally, board meeting frequency is found to be positively related to internal
control weaknesses. Therefore, rms with internal control weaknesses are more
likely to hold additional meetings, dealing with their internal control problems.
We do not nd the relation between audit committee independence and internal
control weaknesses in Models 1 and 2, as does Krishnan (2005), because SOX
requires audit committees to be composed of all independent board members.
Models 3 and 4 replicate Models 1 and 2 by replacing ACFE with two separate measures: accounting nancial expertise (ACCT_ ACFE) and nonaccounting nancial expertise (NONACCT_ACFE). The coecients on
ACC_ ACFE and NONACCT_ ACFE are all signicant at the 1% level, suggesting that both accounting and non-accounting nancial experts are helpful
in improving internal controls. Other results are similar to those reported for
Models 1 and 2. Thus, our ndings are robust to dierent ways of measuring
audit committee nancial expertise.
Some board variables, namely board size and board meeting frequency, are
found to be related to internal control weaknesses in Table 4. This suggests that
rms with strong corporate governance may be less likely to have internal control problems. As a natural extension to Table 4, we control for corporate governance in Table 5. Specically, we use the overall measure of corporate
governance developed in DeFond et al. (2005, pp. 168170). They capture
the strength of the governance environment using a summary measure that
combines the following six governance characteristics into a single dichotomous variable: board size, board independence, audit committee size, audit
committee independence, shareholders rights as captured by the G index used
in Gompers et al. (2003), and institutional ownership. Because the G index

23
Our results on audit committee nancial expertise and auditor change need to be interpreted
with caution, as it is possible that causality runs in the opposite direction implied by our logistic
regression analysis. It is plausible that having weak internal controls makes it more dicult to
attract nancial experts to the audit committee, and a material internal control weakness results in
the change in auditors.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

321

information is only available for 52 pairs of our sample and control rms,24 we
adapt the procedure in DeFond et al. (2005) and create our governance variable (GOVERN) based on the following dichotomous measures of the ve governance characteristics for each rm.
(1) Board size We code rms 1 (for strong governance), if the rms board
size is less than the sample median and 0, otherwise.
(2) Board independence We code rms 1 (for strong governance), if 60% or
more of the directors are independent and 0, otherwise.
(3) Audit committee size We code rms 1, if the proportion of the rms
audit committee size to its full board size is greater than the sample median and 0, otherwise.
(4) Audit committee independence We code rms 1, if the committee is
composed only of independent members and 0, if the committee includes
at least one aliated member.
(5) Institutional ownership We code rms 1, if the rms percentage of institutional ownership is greater than the sample median and 0, otherwise.25
We rst summarize the ve dichotomous measures for each rm and then
create a dichotomous variable based on the median of the summed values. This
governance measure is equal to one, indicating strong governance, if it is equal
to or greater than the median summed values and zero, otherwise. Note that
the number of observations for Table 5 is 206 pairs or 412 rms, because the
institutional ownership information is missing for two pairs.
Table 5 presents the empirical results after controlling for the above summarized measure of corporate governance (GOVERN). Note that we no longer
include ACIND, ACSZ, BDIND, and BDSZ in our models, because these
variables are incorporated into GOVERN. The ndings in Table 5 are very
similar to those in Table 4. To measure audit committee quality, we use ACFE
in Model 1, and ACCT_ACFE and NONACCT_ACFE in Model 2. The coefcients on these variables are all signicant at the 1% level, whereas the coefcient on GOVERN is not signicant. After we control for the inuence of
corporate governance, the relation between audit committee quality and internal control weaknesses still holds. In addition, the coecients on RATIO and
AUDCHG are signicant at the 5% level or better. Thus, auditor independence
and auditor change continue to be positively associated with the disclosure of
internal control weaknesses.
24

When we run regressions based on these 52 pairs for Models in Table 5, we have one-tailed
signicance at the 10% level for the coecient on audit committee nancial expertise in Model 1
and the coecient on non-accounting nancial expertise in Model 2, respectively.
25
We retrieve the institutional ownership information from Compact D and supplement thirteen
rms that have missing ownership data with information collected from Yahoo! Finance. Our
results in Table 5 are unchanged, when these thirteen rms are excluded from our analyses.

322

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

4.2.3. Robustness checks

We perform the following additional tests to verify that our results in Tables
4 and 5 are robust:
(1) We use the natural logarithm of sales or market value of equity instead of
the natural logarithm of total assets.26
(2) We use the acquisition value dened in Doyle et al. (forthcoming),
instead of the acquisition dummy.
(3) We use raw ACSZ, ACMEET, BDSZ, and ACMEET, instead of the natural logarithms of these variables.
In all these cases, our results are robust to these alternative specications,
adding credence to our ndings.
5. Conclusion
In this paper, we examine the relation between audit committee quality, auditor independence, and the disclosure of internal control weakness after the
enactment of the Sarbanes-Oxley Act. We begin with a sample of rms with
internal control weaknesses and, based on industry, size, and performance,
match these rms to a sample of control rms without internal control weaknesses. The results from our conditional logit analyses suggest that a relation
exists between audit committee quality, auditor independence, and internal control weaknesses. Firms are more likely to be identied with an internal control
weakness, if their audit committees have less nancial expertise or, more specifically, have less accounting nancial expertise and non-accounting nancial
expertise. They are also more likely to be identied with an internal control
weakness, if their auditors are more independent. In addition, rms with recent
auditor changes are more likely to have internal control weaknesses.
Acknowledgements
We thank two anonymous reviewers for detailed and insightful suggestions
that have signicantly improved the paper. We also thank Gary Peters and
workshop participants at the 2006 American Accounting Association (AAA)
Annual Meeting, the 2006 AAA Auditing Midyear Meeting, and the 2006
International Conference on Accounting Standards at Xiamen University for
comments; Raj Addepalli, Shanshan Chen, Yujing Pan, Gaurav Rastogi, Eric
Romano, Grace Witte, and Meng Zhao for research assistance.
26

Because of missing information, there are only 206 pairs or 412 rms, when we use the market
value of equity.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

323

Appendix A
Section 404 compliance dates (Proposed requirements are in italics. Final
requirements are not.)a
Filer status

SEC release no.

404(a)
Managements
Assessment

US issuer
Large
accelerated
ler
Accelerated
ler

No. 33-8392
Fiscal year ending
(February 24, 2004) on or after
November 15, 2004
No. 33-8392
Fiscal year ending
(February 24, 2004) on or after
November 15, 2004
NonNo. 33-8731
Fiscal year ending
on or after
accelerated (August 9, 2006)
ler
December 15, 2007
(proposed)
Foreign private issuer
Large
No. 33-8730
accelerated (August 9, 2006)
ler
Accelerated
No. 33-8730
ler
(August 9, 2006)
NonNo. 33-8731
accelerated (August 9, 2006)
ler
Newly public
companyb

No. 33-8731
(August 9, 2006)

404(b) Auditor
Attestation

Fiscal year ending

on or after
November 15, 2004
Fiscal year ending
on or after
November 15, 2004
Fiscal year ending
on or after
December 15, 2008
(proposed)

Fiscal year ending

on or after July 15,
2006
Fiscal year ending
on or after July 15,
2006
Fiscal year ending
on or after
December 15, 2007
(proposed)

Fiscal year ending

on or after
November 15, 2006
Fiscal year ending
on or after
November 15, 2007
Fiscal year ending
on or after
December 15, 2008
(proposed)

After ling one

annual report with
the SEC (proposed)

After ling one

annual report with
the SEC (proposed)

a
Adapted from the table in Proposed and nal rules to postpone Section 404 internal-control
reporting for selected lers by Walton Conn, Jr., Melanie Dolan, and Tracey Driver. KPMG
Dening Issues, No. 06-23, August 2006 (Available at: www.aro.kpmg.com).
b
This proposed rule would apply to any company that becomes public through an initial public
oering or a registered exchange oer or that otherwise becomes subject to the Exchange Act
reporting requirements, including foreign private issuers that list on a US exchange for the rst
time.

324

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

Accelerated ler: Exchange Act Rule 12b-2(1) denes it as an issuer that,

among other criteria, has an aggregate worldwide market value of the voting
and non-voting common equity held by its non-aliates of $75 million or
more, but less than $700 million, as of the last business day of the issuers most
recently completed second scal quarter.
Large accelerated ler: Exchange Act Rule 12b-2(2) denes it as an issuer
that, among other criteria, has an aggregate worldwide market value of the voting and non-voting common equity held by its non-aliates of $700 million or
more, as of the last business day of the issuers most recently completed second
scal quarter.
Non-accelerated ler: An Exchange Act reporting company that does not
meet the Exchange Act Rule 12b-2 denition of either an accelerated ler
or a large accelerated ler.

Appendix B. Variable denitions

ICW

1, if a rm is identied with a material internal control

weakness; 0, otherwise
ACFE
Percentage of audit committee members who are
nancial experts
ACCT_ACFE
Percentage of audit committee members who are
accounting nancial experts
NONACCT_ACFE Percentage of audit committee members who are nonaccounting nancial experts
RATIO
Ratio of audit fee to total fee
ACIND
Percentage of outside directors on the audit committee
ACSZ
Audit committee size
ACMEET
Number of audit committee meetings
BDIND
Percentage of outside directors on the board
BDSZ
Size of the board of directors
BDMEET
Number of board meetings
BIG4
1, if the auditor is a member of the Big 4; 0, otherwise
AUDCHG
1, if there is an auditor change in 2003 or 2004; 0,
otherwise
TOTAL ASSETS
Total assets (#6)
ADJSALEGR
Two-digit industry-median-adjusted sales growth,
measured as the percentage change in sales from the
previous year minus the two-digit industry median sales
growth
ACQUISITION
1, if a rm engages in acquisitions during 2003, 2004 and
from January to July of 2005; 0, otherwise

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

325

RESTRUCTURE

1, if a rm engages in a restructuring (non-zero values of

#376, #377, #378, or #379); 0, otherwise
BUS
Number of business segments reported in 10-K
FOREIGN
1, if there is a foreign currency translation (#150); 0,
otherwise
SALES
Total sales (#12), in millions
EBITDA/SALES
Ratio of EBITDA (#13) to sales (#12)
GOVERN
Please see denition in the text.
Note: COMPUSTAT item numbers are in parentheses.

References
Abbott, L., Parker, S., Peters, G., 2004. Audit committee characteristics and restatements.
Auditing: A Journal of Practice and Theory 23 (1), 6987.
Anderson, R., Mansi, S., Reeb, D., 2004. Board characteristics, accounting report integrity, and the
cost of debt. Journal of Accounting and Economics 37 (3), 315342.
Asbaugh, H., LaFond, R., Mayhew, B., 2003. Do non-audit services compromise independence?
Further evidence. The Accounting Review 78 (3), 611639.
Ashbaugh-Skaife, H., Collins, D., Kinney, W., forthcoming. The discovery and consequences of
internal control deciencies prior to SOX-mandated audits. Journal of Accounting and
Economics.
Beasley, M., 1996. An empirical analysis of the relation between the board of director composition
and nancial statement fraud. The Accounting Review 71 (4), 443465.
Breslow, N.E., 1982. Covariance adjustment of relative-risk estimates in matched studies.
Biotmetrics 38 (3), 661672.
Blue Ribbon Committee (BRC), 1999. Report and Recommendations of the Blue Ribbon
Committee on Improving the Eectiveness of Corporate Audit Committees. Stamford, CT:
BRC.
Carcello, J., Neal, T., 2000. Audit committee composition and auditor reporting. The Accounting
Review 75 (4), 453467.
Chung, H., Kallapur, S., 2003. Client importance, non-audit services and abnormal accruals. The
Accounting Review 78 (4), 931955.
Dechow, P.M., Sloan, R.G., Sweeney, A.P., 1996. Causes and consequences of earnings
management: an analysis of rms subject to enforcement actions by the SEC. Contemporary
Accounting Research 13 (1), 136.
Conger, J., Finegold, D., Lawler III, E., 1998. Appraising boardroom performance. Harvard
Business Review 76, 136148.
Dalton, D.R., Daily, C.M., Johnson, J.L., Ellstrand, A.E., 1999. Number of directors and nancial
performance: a meta-analysis. Academy of Management Journal 42 (6), 674686.
DeFond, M., Hann, R., Hu, X., 2005. Does the market value nancial expertise on audit
committees of boards of directors. Journal of Accounting Research 43 (2), 153193.
DeFond, M., Raghunandan, K., Subramanyam, K.R., 2002. Do nonaudit service fees impair
auditor independence? Evidence from going concern auditor opinions. Journal of Accounting
Research 40 (4), 12471274.
DeZoort, F., Salterio, S., 2001. The eects of corporate governance experience and nancial
reporting and audit knowledge on audit committee members judgments. Auditing: A Journal
of Practice and Theory 20 (2), 3147.

326

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

Doyle, J., Ge, W., McVay, S., 2006. Accruals quality and internal control over nancial reporting.
Working paper, Utah State University, University of Washington, and New York University.
Doyle, J., Ge, W., McVay, S., forthcoming. Determinants of weaknesses in internal control over
nancial reporting. Journal of Accounting and Economics.
Eisenberg, T., Sundgren, S., Wells, M., 1998. Larger board size and decreasing rm value in small
rms. Journal of Financial Economics 48 (1), 3554.
Fama, E., French, K., 1997. Industry costs of equity. Journal of Financial Economics 43 (2), 153
193.
Francis, J., Ke, B., 2003. Do fees paid to auditors increase a companys likelihood of
meeting analysts forecasts? Working Paper, University of Missouri and Pennsylvania
State University.
Frankel, R., Johnson, M., Nelson, K., 2002. The relation between auditors fees for non-audit
services and earnings quality. The Accounting Review 77 (Suppl.), 71105.
Ge, W., McVay, S., 2005. The Disclosure of material weaknesses in internal control after the
Sarbanes-Oxley Act. Accounting Horizon 19 (3), 137158.
Gompers, P., Ishii, J., Metrick, A., 2003. Corporate governance and equity prices. Quarterly
Journal of Economics 118 (1), 107155.
Guo, R., Lev, B., Zhou, N., 2005. The valuation of biotech IPOs. Journal of Accounting, Auditing
and Finance 20 (4), 423459.
Hermalin, B., Weisbach, M., 1998. Endogenously chosen boards of directors and their monitoring
of the CEO. American Economic Review 88 (1), 96118.
Hermalin, B., Weisbach, M., 2003. Board of directors as an endogenously determined institution: a
survey of the economic literature. Economic Policy Review-Federal Reserve Bank of New
York, 7-26.
Hosmer, D., Lemeshow, S., 2000. Applied Logistic Regression, second ed. John Wiley and Sons,
New York, NY.
Hymowitz, C., Lublin, J., 2003. Corporate reform: the rst year: Boardrooms under renovation;
scandals prompted changes, but critics say more are needed to prevent another Enron. The Wall
Street Journal (Eastern Edition), New York, NY, July 22. B1.
Kalbers, L., Fogarty, T., 1993. Audit committee eectiveness: an empirical investigation of the
contribution of power. Auditing: A Journal of Practice & Theory 12 (1), 2449.
Klein, A., 2002a. Economic determinants of audit committee independence. The Accounting
Review 77 (2), 435452.
Klein, A., 2002b. Audit committee, board of director characteristics, and earnings management.
Journal of Accounting and Economics 33 (3), 375400.
Krishnamurthy, S., Zhou, J., Zhou, N., 2006. Auditor reputation, auditor independence, and the
stock-market impact of Andersens indictment on its client rms. Contemporary Accounting
Research 23 (2), 465490.
Krishnan, J., 2005. Audit committee nancial expertise and internal control: an empirical analysis.
The Accounting Review 80 (2), 649675.
Lennox, C., 2002. Opinion shopping, audit rm dismissals, and audit committees. Working Paper,
Hong Kong University of Science and Technology.
McMullen, D., Raghunandan, K., 1996. Enhancing audit committee eectiveness. Journal of
Accountancy 182 (2), 7981.
Menon, K., Williams, J., 1994. The use of audit committees for monitoring. Journal of Accounting
and Public Policy 13 (2), 121139.
Palepu, K., 1986. Predicting takeover targets: A methodological and empirical analysis. Journal of
Accounting and Economics 8 (1), 335.
Pincus, K., Rusbarsky, M., Wong, J., 1989. Voluntary formation of corporate audit
committees among NASDAQ rms. Journal of Accounting and Public Policy 8 (4), 239
265.

Y. Zhang et al. / Journal of Accounting and Public Policy 26 (2007) 300327

327

Public Company Accounting Oversight Board (PCAOB), 2004. An audit of internal control over
nancial reporting performed in conjunction with an audit of nancial statements. Auditing
Standard No. 2. Washington, DC, PCAOB.
Purnanandam, A., Swaminathan, B., 2004. Are IPOs really underpriced? Review of Financial
Studies 17 (3), 811848.
Reynolds, K., Deis, D., Francis, J., 2004. Professional service fees and auditor objectivity.
Auditing: A Journal of Practice & Theory 23 (1), 2952.
Raghunandan, K., Read, W., Rama, D., 2001. Audit committee composition, gray directors,
and interaction with internal auditing. Accounting Horizons 15 (2), 105118.
Securities Exchange Commission (SEC), June 5, 2003. Managements Report on Internal Control
over Financial Reporting and Certication of Disclosure in Exchange Act Periodic Reports.
Release No. 33-8238. Washington, DC, SEC.
Securities Exchange Commission (SEC), February 24, 2004. Managements Report on Internal
Control over Financial Reporting and Certication of Disclosure in Exchange Act Periodic
Reports. Release No. 33-8392. Washington, DC, SEC.
Securities Exchange Commission (SEC), September 22, 2005. Managements Report on Internal
Control Over Financial Reporting and Certication of Disclosure in Exchange Act Periodic
Reports of Companies that Are Not Accelerated Filers. Release No. 33-8618. Washington, DC,
SEC.
Securities Exchange Commission (SEC), December 21, 2005. Revisions to Accelerated Filer
Denition and Accelerated Deadlines for Filing Periodic Reports. Release No. 33-8644.
Washington, DC, SEC.
Securities Exchange Commission (SEC), August 9, 2006a. Internal Control Over Financial
Reporting in Exchange Act Periodic Reports of Foreign Private Issuers That Are Accelerated
Filers. Release No. 33-8730. Washington, DC, SEC.
Securities Exchange Commission (SEC), August 9, 2006b. Internal Control Over Financial
Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers and Newly Public
Companies. Release No. 33-8731. Washington, DC, SEC.
Scarbrough, D., Rama, D., Raghunandan, K., 1998. Audit committee composition and interaction
with internal auditing: Canadian evidence. Accounting Horizons 12 (1), 5162.
Vafeas, N., 1999. Board meeting frequency and rm performance. Journal of Financial Economics
53 (1), 113142.
Xie, B., Davidson, W., DaDalt, P., 2003. Earnings management and corporate governance: the role
of the board and the audit committee. Journal of Corporate Finance 9 (3), 295316.
Yermack, D., 1996. Higher market valuation of companies with a small board of Directors. Journal
of Financial Economics 40 (2), 185212.

All in-text references underlined in blue are linked to publications on ResearchGate, letting you access and r