The Financial Reporting Quality Before the Issuance of the Existence of Internal Control Weakness

Abstract

In 2005, Korean regulators required that external auditor must evaluate appropriateness of internal control system and disclose review opinion on the system in a separate report. If a firm has internal control weakness, it is expected that the internal control weakness is not first occurred at the year disclosing internal control weakness, but has been existed for the firm for several years before the disclosure of the weakness. Because the internal control weakness is too small to be identified and to be disclosed as weakness, or external auditor and firms manager fail to detect the existence of the weakness, it could be not detected before. Regardless of the reason, even before the issuance of existence of internal control weakness, the financial reporting quality is likely to be poor. In this study, I examine this prediction using empirical data. Though several prior research investigated that firms with weakness on internal control have lower financial reporting quality, the financial reporting quality before the issuance of the internal control weakness have almost never been examined. I find that the firms with internal control weakness have higher absolute value of discretionary accrual and more income-increasing discretionary accruals than firm without internal control weakness for the years before issuance as well as for the issuance year.