The Effects of Internal Control Weakness and its Remediation on Both Accrual-Based and Real Earnings Management

Abstract

I investigate the effects of internal control weakness (ICW) and its remediation on the two types of earnings management: accrual-based earnings management (AEM) and real earnings management (REM). Based on a sample of US firms in the 2004-2011 period, I find that firms with ICW engage in significantly higher degree of AEM and REM compared to other firms. Furthermore, I find that both AEM and REM decrease upon remediation of the weakness. However, decrease in REM is not as drastic as decrease in AEM, consistent with the idea that controlling for AEM activities is the prior objective of internal controls. Overall, this study highlights the importance of maintaining strong internal control systems by showing that it contributes to reducing REM as well as AEM.