Internal Control and Management Guidance*

Mei Feng Assistant Professor of Accounting Katz School of Business, University of Pittsburgh E-mail: mfeng@katz.pitt.edu Chan Li Assistant Professor of Accounting Katz School of Business, University of Pittsburgh E-mail: chan@katz.pitt.edu Sarah McVay Assistant Professor of Accounting David Eccles School of Business, University of Utah E-mail: sarah.mcvay@business.utah.edu

Abstract: We examine the effects of internal control quality on management guidance, and find that guidance is less accurate in the year of, and the two years preceding, the disclosure of ineffective internal controls. We find that the less accurate guidance persists if the internal controls remain ineffective, but is mitigated if the internal control problems are remediated. We also find the management forecast errors are larger when the internal control problems are most likely to affect interim numbers and thus guidance. Finally, we find changes in the characteristics of management guidance following the identification and disclosure of ineffective internal controls; managers are less likely to issue guidance, and if they do issue guidance, the guidance is less specific. We conclude that internal control quality has an economically significant effect on management guidance, providing additional support for Section 404 and expanding our knowledge on the determinants of management forecast accuracy.

We would like to thank Michael Ettredge, Harry Evans, Weili Ge, Matt Magilke and workshop participants at the University of Pittsburgh and the University of Utah for their helpful comments.

Internal Control and Management Guidance Introduction In this paper, we examine the relation between internal control quality and the accuracy of management guidance. Disclosures of internal control deficiencies became widely available for the first time following the Sarbanes-Oxley Act of 2002. Section 404 of this regulation requires management to document their firms internal controls and assess their effectiveness. Auditors are then required to attest to and report on the management assessment.1 There has been a heated debate over the relative costs and benefits of Section 404. Empirical evidence on the costs and benefits of disclosing weak internal controls is mixed, though generally results suggest that the disclosures under Section 404 tend to be largely uninformative, leading many to argue that the costs of Section 404 (both in terms of audit fees and employee time) exceed the related benefits.2 In a recent survey conducted by the U.S. Chamber of Commerce on the cost of Section 404, 89% of the respondents think the costs exceed the benefits of Section 404 compliance.3 This debate is especially important as Section 404 is currently effective only for the largest firms (accelerated filers). The deadline for non-accelerated filers has repeatedly been delayed over the last few years. While the SEC has stood firm on the 2007 deadline for the management reporting requirement for non-accelerated filers, a bill to delay the effective date for another year is pending in Congress (Whitehouse, 2007).
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Section 404 became effective for fiscal years ending after November 15, 2004, and currently applies only to the largest firms (accelerated filers). Section 302 preceded Section 404 and applies to all SEC registrants, effective in August of 2002. Section 302 requires that managers publicly disclose changes in their internal control systems. 2 For example, Beneish et al. (2008) and Ogneva et al. (2007) find no relation between cost of capital and Section 404 disclosures after controlling for known determinants of cost of capital, while Ashbaugh-Skaife et al. (2007b) do find a relation. With respect to earnings quality, while Doyle et al. (2007b) find that accruals quality is lower for firms with weak internal controls, this association is much weaker for Section 404 disclosures (versus Section 302 disclosures). 3 Approximately 50% of the respondents in this survey, released on November 8, 2007, were managers of small firms not yet subject to Section 404, while the other 50% were from firms currently operating under Section 404 (http://www.uschamber.com/publications/reports/0711soxsurvey.htm).

We add to this debate by examining a significant benefit of Section 404 that has not previously been addressed in the literature or business pressthe association between internal control quality and management guidance. While voluntary disclosures are not the focus of Section 404, we argue that internal control problems would result in lower-quality interim financial inputs, thereby resulting in lower-quality management guidance. In other words, good internal control can improve the quality of earnings guidance, which potentially brings various benefits to firms, such as increased analyst following (Lang and Lundholm, 1993) and a better reputation for transparent and accurate reporting (Graham et al., 2005; Williams, 1996). We study 2,940 firms that issued earnings guidance and filed Section 404 reports with the SEC from 2005-2007. Following previous literature (Ajinkya et al., 2005), we measure the quality of earnings guidance using ex post management forecast errors (the absolute value of the difference between actual earnings and management forecasts, scaled by the stock price at the beginning of the period).4 Consistent with our hypothesis, we find that firms disclosing material weaknesses in internal control tend to have significantly larger management forecast errors than firms reporting effective internal controls. Specifically, management forecast errors are, on average, 0.007 higher when a firm reports a material weakness in internal control, after controlling for earnings characteristics such as losses and volatility that make earnings more difficult to predict. This magnitude is quite large given the mean (median) forecast error is only 0.01 (0.004). We conduct three additional tests to further validate the link between internal control quality and the quality of management guidance.

The internal control problem could result in both an erroneous forecast and an erroneous reported earnings figure. To the extent that the errors in the forecasts and earnings are positively correlated, this will bias against finding a relation between management forecast accuracy and internal control quality. Another possibility is that weak internal controls allow managers to more easily manage earnings to meet their own forecast. This should also bias against our findings, and suggests that on average our findings are due to unintentional rather than intentional errors.

First, we examine the management forecast errors in the three years prior to the disclosed internal control deficiency. Because our measure of forecast accuracy relies on reported earnings as well as the managers forecast, additional auditor scrutiny in the year the firm reports a material weakness might lower reported earnings (Hogan and Wilkins, 2005), thereby resulting in larger ex post forecast errors solely because of this additional scrutiny. When we re-estimate our tests with historical forecast accuracy, we find a similar relation between a material weakness disclosure in year t and forecast accuracy in year t-1. This relation monotonically declines as we go back in time, and becomes insignificant in year t-3. These findings mitigate our concern that auditor scrutiny might affect our results. Rather, it appears more likely that the lower-quality financial information available to the manager is driving the association between management forecast accuracy and internal control deficiencies. Second, we examine how the relation between internal control quality and management forecast accuracy varies by the type of material weakness reported. We first identify weaknesses related to revenue and cost of goods sold, which we expect to have the greatest impact on the information used by the manager when forming the guidance (Fairfield et al., 1996). We find that weaknesses affecting these financial statement accounts are more highly associated with management forecast errors than other weaknesses. We also tabulate the number of weaknesses reported, based on the assumption that the more weaknesses present, the more severe the internal control problems, and the more likely they are to affect the accuracy of the guidance. We find that the magnitude of the forecast errors increases with the number of material weaknesses reported. Third, we examine changes in internal control quality. We find that if an internal control problem persists (i.e., the problem is reported as a material weakness in year t+1 as well as year

t), larger forecast errors also persist. However, if the internal control problems are remediated in year t+1, the forecast errors in year t+1 for the remediated firms are not statistically different from the errors for the control sample. Jointly, our tests provide strong support for the

contention that the quality of a firms internal control system exerts an economically and statistically significant impact on the accuracy of the firms earnings forecasts. Finally, we examine how managers reporting strategies change following the identification and disclosure of an internal control problem. We find that if the material

weakness is not remedied in the year following the material weakness disclosure, managers tend to either stop issuing guidance, or issue less specific guidance. However, if the firm reports an internal control problem and remedies the problem by the end of the following fiscal year, we do not find these responsesmanagers continue to issue guidance and tend to maintain the specificity of the guidance. Our findings are consistent with managers adjusting their voluntary disclosure strategies based on the quality of internal control, which is consistent with managers believing that the quality of internal control affects either the quality or the credibility of their forecast, or both. Our paper contributes to both the literature on internal control over financial reporting as well as the management forecast literature. We first add to the heated debate on the costs and benefits of Section 404. While the empirical findings for Section 404 firms regarding the relation between internal control quality and earnings quality have been weak (Doyle et al. 2007b), we document a robust and economically significant association between internal control quality and the quality of management earnings guidance, indicating that a good internal control system can help improve the quality of some voluntary disclosures. Management guidance quality is a more powerful setting than earnings quality in which to test the effect of Section 404

because auditors can help mitigate the negative effect of weak controls on earnings, but not on earnings guidance. Our results indicate that Section 404 provides an important benefit that has been previously overlookedhigher-quality management guidance. In addition, our findings have broader implications. If managers use similar inputs for their internal forecasting processes and decision-making processes, our findings suggest that managers may be making suboptimal business decisions because they are relying on faulty numbers resulting from weak internal controls. Our paper also contributes to the management forecast literature, which has previously focused primarily on how managers incentives, such as litigation concerns and insider trading motives, affect management forecast characteristics. We are not aware of prior studies

investigating how the quality of the financial information used by the managers affects management forecast characteristics, such as forecast accuracy, frequency and specificity. We find that quality of financial information is a statistically and economically significant determinant of forecast accuracy. In addition, managers appear to change their earnings

forecasting strategies based on the quality of their interim financial information.

Motivation and Hypothesis Development Prior research on internal control quality A great deal of research has followed the recent public disclosures of internal control quality under Sections 302 and 404 of the Sarbanes-Oxley Act. The initial papers were largely descriptive, providing evidence on the types of firms issuing ineffective internal controls (e.g., Ge and McVay, 2005; Ashbaugh-Skaife et al., 2007a; Doyle et al. 2007a; Bryan and Lilien, 2005). These papers find that firms with weak internal controls tend to be smaller, less

profitable, more complex, and/or undergoing changes via rapid growth or restructurings. Other

studies examined the impact of ineffective internal controls on audit cost, such as higher audit fees (e.g., Raghunandan and Rama, 2006; Hoitash et al., 2008), longer audit delays (Ettredge et al., 2006), and more auditor resignations (Ettredge et al., 2007). Studies have also begun examining the possible benefits of effective internal controls in terms of the cost of equity and earnings quality, although the results are mixed. While

Ashbaugh-Skaife et al. (2007b) find a relation between cost of capital and internal control deficiencies across Section 302 and 404 disclosures, Beneish et al. (2008) find that cost of equity and price reactions to disclosures are significant for Section 302 disclosures but not for Section 404 disclosures. Ogneva et al. (2007) find no difference in the cost of equity capital among Section 404 disclosures after controlling for known determinants of cost of equity capital. Doyle et al. (2007b) find evidence of lower-quality earnings for material weakness firms filing Section 302 disclosures, but not for Section 404 disclosers, on average. Ashbaugh-Skaife et al. (2008) and Bedard (2006) find evidence of improvements in earnings quality following remediations of internal control problems for firms disclosing material weaknesses under Section 404. This mixed evidence on the relation between internal control and earnings quality could be due to the existence of additional monitoring mechanisms (e.g., auditors, boards of directors, and institutional investors; Hogan and Wilkins, 2005; Krishnan, 2005; Tang and Xu, 2007). For example, auditors substantive testing can act as a substitute for many internal control deficiencies, mitigating the negative effects on earnings quality (Doyle et al., 2007b). While researchers have focused on reported earnings, the effect of internal control problems on management forecasts remains unexamined.5 Management forecasts are an

extremely important voluntary disclosure. Existing research shows that these forecasts are very
As we said before and will discuss in greater detail below, management guidance provides a stronger setting than reported earnings in which to examine the impact of weak internal controls, as the negative effects are not mitigated by auditors substantive testing.
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informative. The earnings surprise embedded in a management forecast influences prices (e.g., Patell, 1976; Penman, 1980; Waymire, 1984; Pownall and Waymire, 1989) and alters investors earnings expectations, as measured by subsequent revisions in analyst forecasts (Jennings, 1987; Baginski and Hassell, 1990; Williams, 1996). Prior research on management forecast accuracy has mainly focused on the incentives facing the managers and their firms (e.g., Rogers and Stocken, 2005). However, regardless of a managers incentives or ability to effectively compile information into a forecast, if the manager is using poor-quality inputs, the forecast will likely also be of poorer quality. Thus, we expect that the quality of the internal control over financial reporting will affect the quality of the financial information used by the manager to form the estimate, thereby affecting the quality of the voluntary disclosure. We anticipate that weak internal controls will affect the financial reporting inputs to management guidance in at least two ways. First, weaknesses can result in errors in the financial statement figures. While auditors substantive testing mitigates the effect of these errors on reported earnings, they do not substantively test the interim numbers used by managers to form their guidance, and thus we expect the effect to be stronger for management guidance than reported earnings. Consider the following material weakness disclosure provided by Penn

Treaty American Corporation (whose main business is providing long-term care insurance) in its 10-K filing for the fiscal year ended December 31, 2005: The Company did not maintain adequate controls over the claims processing and payment areas to analyze and record appropriate adjustments to the claims payables and expense or monitor the proper determination and processing of claim payments. Numerous deficiencies were generally aggregated into two areas: claims processing (including claim maximum benefits, authority limits, check processing, and routine payment issues), and claims quality assurance department (responsible for the identification of errors and fraud).

Given the companys business, the internal control problems over claims noted above will clearly affect the interim numbers management uses to form their earnings guidance, likely resulting in less accurate earnings guidance than if the forecast had been based on more accurate interim numbers. Second, weaknesses can result in untimely, or stale, financial statement information. For example, a company may lack personnel with adequate expertise to generate the information needed by management for forecasting on a timely basis. Dana Corporation filed the following weakness in their December 31, 2005 10-K filing: Our financial and accounting organization was not adequate to support our financial accounting and reporting needs. Specifically, lines of communication between our operations and accounting and finance personnel were not adequate to raise issues to the appropriate level of accounting personnel and we did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP commensurate with our financial reporting requirements. This control deficiency resulted in ineffective controls over the accurate and complete recording of certain customer contract pricing changes and asset sale contracts (both within and outside of the Commercial Vehicle business unit) to ensure they were accounted for in accordance with GAAP.

Thus, transactions were not fully recorded during the period, making interim numbers less informative. Managers using out-of-date information face more uncertainty and may rely on less accurate estimates when issuing forecasts. As a result, we expect their forecast errors to be larger. As with errors resulting from weak internal control, timeliness becomes less of an issue with reported earnings, because the manager is able to wait to file the report until all figures have been finalized for the period (i.e., the lag between the period end and the filing date allows some catch-up to occur). Thus, we posit that the better the underlying quality of the internal controls, the better able managers are to issue more accurate guidance. This leads to our first hypothesis:

H1:

Management forecast accuracy is higher among firms with effective internal controls.

Specifically, we expect firms reporting material weaknesses in internal control to issue less accurate management guidance. We conduct three distinct tests of H1. First, we examine the association between internal control problems and management forecast errors in both current and prior years, including controls for known determinants of management forecast accuracy and internal control quality. Second, we partition the material weaknesses by type concentrating on weaknesses affecting sales or cost of goods sold, which we expect to have a greater impact on management forecast accuracy than all other weaknesses, and those we estimate to have more severe internal control problems, measured by the number of weaknesses reported. Finally, we examine how changes in the quality of internal control map into

management forecast errors. We expect that firms remediating their internal control problems mitigate the adverse effects on their management forecast accuracy, while firms that fail to resolve their problems will continue to exhibit lower forecast accuracy. Jointly, these tests provide strong evidence for our hypothesis that managers in firms with weak internal controls will issue less accurate guidance. Our second hypothesis addresses managers responses to the identification and disclosure of weaknesses in their internal control. Prior to Sarbanes-Oxley and the culmination of Section 404, managers were not required to document their internal control procedures. While they likely had some idea of the internal control quality of their firm, they had not been required to conduct a detailed evaluation, and thus they may not have known the extent of their internal control problems. Moreover, even if they were aware of an internal control problem, they were not required to publicly disclose material weaknesses. After identifying and publicly disclosing

an internal control problem, however, managers may change their guidance behavior, either because they hesitate to rely on potentially faulty figures, or they feel the market will discount their guidance in the presence of an internal control problem. Managers might cease to provide guidance, issue less precise guidance, or perhaps delay issuing guidance until after the internal control problem has been remediated. This leads to our second hypothesis:

H2:

The identification and disclosure of poor-quality internal controls leads managers to change their guidance behavior. Specifically, we examine how the likelihood of issuing guidance, the specificity of the

guidance, and the timing of the guidance, change following the initial disclosure of a material weakness in internal control. We partition our firms by those that have a material weakness in both years t and t+1 versus those that quickly remediate their internal control problems and issue a material weakness only in year t.6 We expect the former group to be more likely to change their voluntary disclosure behavior since managers are likely aware of the t+1 internal control weakness disclosure throughout the year.7

Data and Sample Selection We collect our data from Audit Analytics (Section 404 reports), First Call (management forecasts), Annual Compustat (financial statement variables), and CRSP (stock returns to generate beta). Table 1 summarizes our sample construction. We begin with all Section 404 reports available on Audit Analytics, 11,528 firm-year observations from January 2005 to September 2007, corresponding to fiscal 2004 through fiscal 2006. We exclude 712 firm-years

As we will discuss further below, we do not conduct our main analysis in year t as it is not clear when in year t the internal control problem was discovered (see also footnote 16). 7 It is possible that managers believe the internal control problem has been remediated, and a new internal control problem arises in year t+1; this should bias against our tests.

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that are not covered by First Call8 and 7,174 observations that did not issue an annual point or range forecast in the corresponding fiscal year, which results in a sample of 3,642 observations. We next remove observations without the necessary financial data from the Compustat, analyst coverage from First Call, and stock return data from CRSP. Our final sample contains 2,940 firm years.9

Variable Definitions and Descriptive Statistics We create an indicator variable that is equal to one if the firm received an adverse Section 404 report, and zero if the firm received a clean report. Of the 2,940 firm-years in our final sample, 305 (10.4%) firm-year observations received adverse opinions.10 As noted above, we define management forecast errors as the absolute value of the difference between reported earnings and management forecasts scaled by the stock price at the beginning of the fiscal year. We focus on the absolute value of the forecast error as we are interested in the magnitude, rather than the direction, of the error. Internal control problems can result in both erroneous forecasts and erroneous reported earnings. As noted previously, we expect the realized earnings number to have fewer errors. If reported earnings have similar forecast errors to management forecasts, management forecast errors will be understated. This should serve to bias against finding any relation between management forecast accuracy and internal control quality. Table 2 presents descriptive statistics for the full sample, as well as the adverse and clean report firm-years separately. On average, the absolute value of management forecast errors is 0.01. Examining the
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A firm is covered by First Call if the firm is included in any of the following First Call Historical Database files: company issued guidelines, summary, detailed analysts forecasts or actual earnings files. 9 We match all annual forecasts made in a given fiscal year to that years internal control data. We do not require that the year being forecasted is the year of the material weakness disclosure. If a manager issues guidance more than once in the fiscal year, we take the average of all of the forecast errors. 10 While 10.4% is a slightly smaller percentage than existing studies examining Section 404 reports, we examine fiscal years 20042006 and the number of weaknesses monotonically declines over this time period (143, 104, and 58 for 20042006, respectively).

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errors across the two sub-samples (clean versus adverse opinions), it is clear that the magnitude of the forecast errors is significantly larger for firms with adverse opinions, providing initial support for H1. We realize, however, that earnings of firms with internal control weaknesses tend to be harder to estimate (Doyle et al., 2007b) and that auditors may have increased their scrutiny in the year of the adverse opinion (Hogan and Wilkins, 2005). Thus, we conduct multivariate tests and examine prior years forecast errors to provide additional evidence on H1. We include a multitude of control variables in our regression analyses. As noted

previously, firms with poor internal control quality tend to be systematically different from firms with strong internal controls. For example, they tend to be smaller, less profitable, more highly levered, and growing rapidly or experiencing a restructuring (Ge and McVay, 2005; AshbaughSkaife et al., 2007a; Doyle et al., 2007a; Ettredge et al., 2007). Using these known determinants as a starting point for the inclusion of control variables, we first include firm size as a control variable (LN_TA), as firm size is also likely associated with management forecast accuracy. Larger firms may have more experienced and knowledgeable staff, thereby resulting in more accurate guidance. We next control for profitability (ROA and LOSS) and leverage, as managers in firms with low profitability and/or high leverage may be less able to allocate resources to forming their guidance. Moreover, analysts have been shown to have a more difficult time estimating earnings for loss-making firms (Brown, 2001). We control for sales growth, as rapidly growing firms, which are less able to maintain strong internal controls, may also have more difficulty estimating earnings. We include an indicator variable if the firm operates in a litigious industry (following Francis et al., 1994), as Ashbaugh-Skaife et al. (2007a) hypothesize a greater concentration of material weaknesses in highly litigious industries; we also include

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Beta as an alternative proxy for litigation risk (Ajinkya et al., 2005).11 We include the magnitude of special items scaled by lagged assets (SI) to proxy for both restructurings and large asset impairments (Ashbaugh-Skaife et al., 2007a; Doyle et al., 2007a; Hogan and Wilkins, 2005); changes to the organizational structure will likely make earnings more difficult to predict.12 Both Ashbaugh-Skaife et al. (2007a) and Doyle et al. (2007a) find that M&A activity is related to the disclosure of a material weakness, and thus we include an indicator variable for M&A activity as we expect these firms may also have harder to predict earnings given these changes. Finally, we consider the type of auditor, as Ge and McVay (2005) and Ashbaugh-Skaife et al. (2007a) find that larger auditors have a greater number of material weaknesses under 302 disclosures, although Ettredge et al. (2007) find the opposite results when examining 404 disclosures, probably because Big 4 auditors either required speedy remediations or dropped their riskiest clients. Firms with large auditors may also have lower forecast errors (Ajinkya et al., 2005). We control for additional determinants of management forecast accuracy that may also be correlated with internal control quality. We include the number of analysts following the firm (ANALYSTS), as Lang and Lundholm (1993) find that firms with higher analyst following tend to have better disclosure. We include earnings volatility (STDEARN) as firms with more volatile earnings may have greater difficulty forecasting earnings, and the dispersion of analyst forecasts prior to the management guidance (DISPFOR), as this also proxies for uncertainty about earnings. Finally, we control for both when in the year the forecast is issued (HORIZON)

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Francis et al. (1994) find an association between litigious industries and the presence of earnings guidance; however, Ajinkya et al. (2005) do not find an association between the accuracy of the guidance and operating in a litigious industry. 12 Results are similar if we include an indicator variable for restructuring charges in year t as an alternative to SI.

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and the magnitude of the revision suggested by the management guidance (REVISION). In both instances, we expect larger values to be associated with larger errors (Ajinkya et al., 2005). As Table 2 shows, material weakness firms tend to be smaller and less profitable, consistent with prior research (e.g., Ge and McVay, 2005). Approximately 28% of our sample conduct their main operations in a highly litigious industry (biotech, computers, technology and retail, based on Francis et al., 1994), and there appears to be a greater concentration of firms in litigious industries among firms issuing adverse reports (38.0% versus 26.8%). This

concentration is consistent with the expectations of Ashbaugh-Skaife et al. (2007a), though they do not find a similar concentration among Section 302 disclosers. It is possible that in the Section 404 era, in which managers are required to issue a report, conclude on the effectiveness of internal control, and have auditors attest to this conclusion, litigation risk plays a greater role. An alternative proxy of litigation risk (beta) is also higher among material weakness firms, and these firms tend to have more income-decreasing special items, both consistent with prior literature (e.g., Bryan and Lilien, 2005). Approximately 92% of our sample firm-years were audited by Big 4 auditors, with fewer Big 4 audits among our adverse opinion firm-years (87.5% versus 92.7%). Analyst following is lower among material weakness firms, consistent with these firms being smaller and less profitable, and these firms also tend to have more volatile earnings.

Test Design and Results Main Test of H1 To test H1, that managers in firms with lower-quality internal control have greater forecast errors (lower forecast accuracy), we first estimate the following OLS regression model:

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ABSERROR= b0 + b1MW + b2 LN_TA + b3ROA + b4LOSS + b5LEVERAGE + b6GROWTH + b7LITIGATE + b8BETA + b9SI + b10MA + b11BIG4 + b12ANALYSTS + b13STDEARN + b14DISPFOR + b15HORIZON + b16REVISION +

(1)

where ABSERROR is the absolute value of the management forecast error (scaled by price) and MW is an indicator variable that is equal to one if the firm filed a contemporaneous adverse 404 report, and zero if the firm filed a clean report. We also include control variables that may be correlated with both weak internal controls and management forecast accuracy, discussed above: size, profitability, leverage, sales growth, operating in a litigious industry, beta, incurring special items (such as restructurings or impairments), undertaking a merger or acquisition, audit quality, the number of analysts following the firm, earnings volatility, the dispersion of the analyst forecast prior to the management guidance, when during the year the guidance is issued, and finally the magnitude of the revision suggested by the management guidance. Each of these variables is motivated above (see descriptive statistics) and defined in Table 2. Results are presented in Table 3. The first column of results pools all firm-years

together. In the subsequent three columns, we parse out our sample by fiscal year, so that each firm is included only once in the estimation procedure. Across each of the four regression estimations, MW is positive and significant (b1 = 0.006, t-statistic = 6.99 for the full sample). This indicates that firms disclosing poor internal control quality exhibit significantly larger management forecast errors (in absolute terms). Turning to our control variables, in all years but 2006, firm size is not significant. This finding is consistent with Ajinkya et al. (2005); size seems to be a stronger determinant of the occurrence of a forecast than the accuracy of any resulting forecasts. ROA is not significant, while loss firms tend to have larger forecast errors, and leverage is largely insignificant (though weakly positively associated with errors in 2006).

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Growth is negative and significant in two of our four specifications. While growth tends to be negatively associated with internal control quality, it appears to be associated with lower forecast errors (akin to the market-to-book ratios association in Ajinkya et al., 2005). LITIGATE is not significant, consistent with Ajinkya et al. (2005), while BETA is positively associated with management forecast errors in three of our four estimations. Special items do not appear to be consistently associated with management forecast errors, while M&A activity appears to be associated with lower forecast errors in two of our four specifications. We expected the additional complexity involved with forecasting earnings for the newly combined entity to be associated with larger errors; perhaps M&A also proxies for profitability, or managers use M&As to help meet their earnings projections (e.g., Tyco). Being audited by a BIG4 is not significantly different from zero, consistent with Ajinkya et al. (2005), while ANALYSTS is significantly negatively associated with management forecast errors in three of our four estimations, consistent with expectations. Earnings volatility

(STDEARN) is not associated with errors, inconsistent with Ajinkya et al. (2005) and our expectations. Greater uncertainty among analysts (DISPFOR) is positively associated with

larger errors in each of our estimations, while the earlier in the year the forecasts are issued (HORIZON) and the larger the suggested revision (REVISION), the greater the errors, consistent with our expectations. In sum, after controlling for known determinants of ex post management forecast errors and potentially correlated determinants of internal control problems, we find evidence consistent with H1firms reporting internal control problems have less accurate management forecasts, consistent with the managers in these firms relying on lower-quality interim financial information when forming their forecasts.

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Accuracy of Historical Guidance As noted in Hogan and Wilkins (2005), auditors likely apply lower thresholds for writeoffs and other adjustments in the year a firm discloses a material weakness in internal control. These adjustments are not necessarily related to the internal control problem. Rather, what might have passed under the radar in earlier years (such as a possible impairment of equipment) now results in an impairment due to additional auditor scrutiny, as the auditors may anticipate additional scrutiny by regulators and investors over firms disclosing material weaknesses in internal control. Because this additional scrutiny might mechanically lower the forecast

accuracy (as reported earnings might be mechanically lower due to the additional scrutiny), we also examine the relation between a material weakness in the firms initial 404 report, and the forecast accuracy in years t-1 through t-3, preceding the initial Section 404 report. As noted in Doyle et al. (2007b), it is likely that the internal control problems, though first disclosed only recently, have been in existence for some time. In years prior to the disclosure, the confounding auditor effect noted in Hogan and Wilkins (2005) should not be a concern. Turning to Table 4, we have 1,007 observations for the year preceding the initial 404 report. This number is greater than the number of observations in 2004 alone, as some firms filed their initial 404 report in 2005; the number of observations decline as we move back in time as fewer firms have available data. The coefficient on MW continues to be positive and

significant in years t-1 and t-2, while in t-3 the test statistic loses significance. In year t-1, the coefficient on MW is 0.007, similar to our main test reported in Table 3. Thus, it does not appear that the additional auditor scrutiny in year t is unduly affecting the ex post management forecast errors examined in Table 3. The coefficient on MW monotonically declines as we move back in time, with a coefficient of 0.004 in year t-2 and a coefficient of 0.003 in year t-3. The

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smaller coefficients are consistent with fewer of the current-year internal control problems actually being in existence in prior years. Overall, our tests continue to support our conclusion that firms with internal control problems are more likely to issue less accurate earnings guidance.

Material Weaknesses by Type While we attempt to control for potentially correlated variables, such as profitability, our list of control variables is not exhaustive, and some correlated omitted variables, such as managerial experience, are extremely difficult to measure.13 Thus, in this section, we conduct cross-sectional tests of our hypothesis. Clearly, not all material weaknesses would be expected to reduce the quality of the financial information inputs; thus we partition our weaknesses by type and severity. We expect the greatest impact to be via material weaknesses affecting sales and cost of goods sold. These two items are very important inputs when managers form their forecasts. For example, Lundholm and Sloan (2006) note that sales are the single most important input to a forecasting model, and Fairfield et al. (1996) find that sales and cost of goods sold have the greatest value for predicting future earnings. We expect errors in these items to result in large forecast errors. We also expect a greater likelihood of an error in the interim numbers when more material weaknesses are present, as the number of weaknesses is a proxy for the overall severity of the internal control problems. Table 5 presents the two cross-sectional tests. The first compares weaknesses that affect revenue or cost of goods sold to all other weaknesses. Referring to the first column of results,

In addition to the cross-sectional tests performed in this section, which are consistent with the internal control problems causing the larger errors, and do not support managerial expertise as a correlated omitted variable, our tests examining years t-1 through t-3 also speak to the viability of this alternative. If expertise were driving the association between internal control quality and management accuracy, as managers become more experienced with their firms, their errors should decline. Thus, when examining past years, the errors should be larger. Rather, we find that as we go back in time, the errors decline, consistent with fewer of the current period weaknesses in existence the further back in time we go.

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the weaknesses affecting revenue and/or cost of goods sold increase management forecast errors by 0.012, which is much larger than the effect of other material weakness, 0.003. The difference between these two types of weaknesses is also statistically significant (p-value = 0.001; not tabulated). Therefore, forecast errors are larger when the material weakness affects the quality of important input numbers that managers use to form their forecasts. In our next cross-sectional test, we simply examine how the error varies with the number of material weaknesses reported, a general measure of severity. Consistent with our conjecture, as the number of material

weaknesses increases by one, the error significantly increases by 0.003.14 In addition, both of our results hold when we examine past years errors (the final two columns in Table 5). These tests provide strong evidence that it is the material weakness driving at least a portion of the larger management forecast error, rather than some unidentified firm characteristic.

Internal Control Quality Change Analysis Our final test of H1 examines how our results change as internal control quality improves, worsens, or stays the same. For example, we would expect that as internal control quality improves, the accuracy of the management forecast no longer suffers. To perform this analysis, we break out our sample into four categories, those that issued a clean report in both years (the benchmark group), those that issued an adverse opinion followed by a clean opinion (IC_IMPROVE), those that issued two adverse opinions sequentially (IC_ADVERSE), and those that issued a clean opinion followed by an adverse opinion (IC_WORSE). These categories are defined using the change from year t to t+1. In Table 6, we present the level of the management forecast error (in absolute terms) for year t+1 and t, conditional on the firm having issued point

When we restrict our sample to only those firms disclosing at least one material weakness, the number of material weaknesses continues to be significantly and positively related to the management forecast error (coefficient = 0.003 with a t-stat of 4.29).

14

19

or range forecast in year t+1. IC_IMPROVE firms are associated with larger absolute forecast errors in year t, consistent with our main finding, but not year t+1. In year t+1, their forecasts are as accurate, on average, as those firms with clean opinions in both years.15 IC_ADVERSE firms are associated with larger absolute forecast errors in both years, consistent with the problem existing in both years. Finally, IC_WORSE firms are associated with larger errors only in t+1, the year they report the adverse opinion. Note that this result is not inconsistent with our results in Table 4 (where we examine prior years errors, where these prior years largely preceded Section 404). IC_WORSE firms explicitly concluded effective internal controls in the prior year, but identified and disclosed a material weakness in the current year. Finding that the errors of these firms were no worse than those of the control sample in the prior year provides evidence that they had, on average, truthfully disclosed effective internal controls in the prior year. This finding links the origination of internal control problems with an increase in management forecast errors (consistent with faulty interim numbers reducing the accuracy of the forecast). Overall, across each of our tests, results are consistent with H1, that the internal control quality has a statistically and economically significant effect on the managers forecast accuracy.

Test of H2 Our second hypothesis conjectures that the identification and disclosure of an internal control problem affect the managers guidance behavior. For example, the managers (newly acquired) knowledge that they are relying on potentially faulty figures may reduce their likelihood of issuing a forecast, or perhaps lead them to decrease the specificity of the forecast or delay the timing of the forecast. Alternatively, the managers might have previously been aware
The change in forecast accuracy from year t to year t+1 among IC_IMPROVE firms is not statistically significant (p-value = 0.568, two-tailed). Looking at the effect in year t, however, it appears that remediated problems had less of an effect on errors in the first place (0.002 versus 0.007). Thus, it appears that firms more quickly remediate less severe problems.
15

20

of the internal control problem, but the public disclosure of this weakness might affect their guidance behavior. Because we do not know when during the year the material weakness was discovered, we examine two years of reports.16 We conjecture that managers who identify and disclose a material weakness in their firm in year t and do not remediate this problem by the end of year t+1 are the most likely to change their disclosure strategy in year t+1. Given that they disclose material weakness in both years, managers probably know throughout year t+1 that they have a material weakness, and that by issuing guidance in year t+1 they are relying on potentially inaccurate interim figures. The following models are used to test H2:
OCCUR = b0 + b1IC_IMPROVE+ b2IC_ADVERSE + b3LN_TA + b4ROA + b5LOSS + b6LEVERAGE + b7GROWTH + b8LITIGATE + b9BETA + b10SI + b11MA + b12BIG4 + b13ANALYSTS + b14STDEARN + b15RESTATE + b16EXECTURN + SPECIFICITY = b0 + b1IC_IMPROVE+ b2IC_ADVERSE + b3LN_TA + b4ROA + b5LOSS + b6LEVERAGE + b7GROWTH + b8LITIGATE + b9BETA + b10SI + b11MA + b12BIG4 + b13ANALYSTS + b14STDEARN + b15RESTATE + b16EXECTURN + b17DISPFOR + b18HORIZON + HORIZON = b0 + b1IC_IMPROVE+ b2IC_ADVERSE + b3LN_TA + b4ROA + b5LOSS + b6LEVERAGE + b7GROWTH + b8LITIGATE + b9BETA + b10SI + b11MA + b12BIG4 + b13ANALYSTS + b14STDEARN + b15RESTATE + b16EXECTURN + b17DISPFOR +

(2)

(3)

(4)

where OCCUR is an indicator variable that is equal to one if the manager issued a forecast in year t+1 but did not in year t, negative one if the manager did not issue a forecast in year t+1 but did in year t, and zero if there was no change in forecast issuance. SPECIFICITY is the change in the average forecast specificity, where specificity has a value of one if the forecast is

16

We also considered changes in year t. We do not find systematic changes in behavior from year t-1 to year t for firms that ex post reported a material weakness in internal control for year t. It appears that either managers were not aware of the problem when providing guidance in year t, or they knew of their weak internal controls but changed their behavior after the public disclosure of the weakness. It is also possible that our tests lack power, as managers may have learned of the problem and changed their behavior during the year, however, our forecast measures are the averages for the year. Finally, we considered the behavior level in year t (i.e., whether guidance was issued in year t). Again, we do not find a significant association, consistent with the two explanations above.

21

qualitative, two if the forecast is a minimum or maximum, three if the forecast is a range, and four if the forecast is a point estimate. HORIZON is the change in the average number of days between the end of the period and the issuance of the management forecast, where a positive number indicates the forecasts are issued in a more timely fashion. Our control variables mirror those in Equation (1), but are in changes, rather than levels (where the changes are annual); these control variables largely follow Ajinkya et al. (2005), who examine occurrence and specificity, as well as accuracy, which we examined in Equation (1). We also introduce two new control variables for these tests, to control for alternative reasons that managers might change their forecasting behavior. The first, following Brochet et al. (2007) is a management turnover of the CEO or CFO (EXECTURN). Brochet et al. (2007) find that when a top-level executive turns over, there tends to be an associated break in guidance. Moreover, among CFO turnovers, if the guidance continues, it tends to be less specific. We also control for restatements (RESTATE); if there is a pending restatement, managers may wait to issue guidance until the restatement is resolved.17 Turning to Table 7, managers in firms issuing an adverse report followed by a clean report (IC_IMPROVE) do not appear to change either their likelihood of issuing a forecast (OCCUR) or the specificity of their forecasts (SPECIFICITY). They do, however, appear to issue guidance (HORIZON) later in the year relative to the previous year. Perhaps they wait until after they remediate their internal control problem in year t+1 to issue guidance. This finding and the potential explanation complement the improvement in forecast accuracy implied

We also include EXECTURN and RESTATE in model (1) (not tabulated). The association between internal control quality and management forecast errors remain unchanged, while RESTATE is positively associated with forecast errors (p=0.005), and EXECTURN is insignificant (p=0.148). Results also hold if we consider the existence of a turnover or restatement in either year t or year t+1 (rather than changes in these occurrences).

17

22

by Table 6 for IC_IMPROVE firms (i.e., it appears that they wait until they are more confident in the interim numbers before forming their guidance, resulting in more accurate forecasts). Managers in firms issuing adverse reports in both year t and year t+1 appear to be much more likely to stop issuing guidance, and, if they do issue guidance, appear to provide less specific and less timely guidance. This is likely a result of their reduced confidence in the numbers they rely on to form their estimates. We test the differences between the improvement group (IC_IMPROVE) and no-improvement group (IC_ADVERSE) for each change in forecast behavior (OCCUR, SPECIFICITY and HORIZON); the differences are all statistically significant.18 Turning to the control variables, while size was largely insignificant when

examining forecast accuracy, it is a strong determinant of the choice to issue a forecast, consistent with Kasznik and Lev (1995), though insignificant when explaining specificity and horizon. Firms with increasing return on assets tend to issue more specific guidance, but tend to issue the guidance later in the year, whereas loss firms tend to issue guidance more quickly. Increases in leverage tend to lead to a decrease in the likelihood of issuing guidance, but when the guidance is issued, it tends to be released earlier in the quarter. The origination of M&As tends to increase the likelihood of providing guidance, but it is not associated with the specificity or timing of the guidance. An increase in the number of analysts following the firm is associated with an increase in the occurrence of guidance, while an executive turnover is not associated with the likelihood, specificity, or timing of the guidance in our sample.19 Finally, greater dispersion in analyst forecasts leads to more timely guidance, while more timely guidance results in less specific guidance, each consistent with prior research.
In Table 6, we examined how the change in internal control quality maps into the accuracy of management forecasts. However, as noted here, it appears that managers anticipating the use of the poor-quality information inputs are more likely to stop issuing guidance. 19 Note that Brochet et al. (2007) examine a smaller subset of firms that issue guidance regularly, and are not constrained to examining accelerated filers.
18

23

Sensitivity Analyses The Informativeness of Management Forecasts We argue that internal control deficiencies result in larger errors in management guidance, and that these errors are economically important. While our analyses have provided the economic significance of the magnitude of the errors, if investors and analysts place a lower reliance on management guidance provided by firms with weak internal controls, these errors may not have an economic impact on capital markets. In this section, we investigate the informativeness of the management guidance to determine if these errors are being incorporated by market participants. We examine the degree of incorporation by analysts and test if this incorporation is lower for our material weakness sample relative to the control sample. We examine the first year the firm had an internal control problem (e.g., analyst revisions during 2004 for a firm subsequently disclosing that it had an internal control problem in 2004).20 Following prior research, we regress the revision made by analysts (ANALYST_REV) on the suggested change made by managers (REVISION) and control variables, as follows:
ANALYST_REV = b0 + b1REVISION+ b2REVISION MW + b3REVISION DOWN + b4REVISION REPUTATION + b5REVISION AGREE +

(5)

We include each management revision and analyst revision in the estimation, and control for firm fixed-effects. A positive and significant coefficient on REVISION implies that analysts are incorporating management guidance when updating their forecasts. Our variable of interest is REVISION MW, the incremental incorporation made by analysts for material weakness
Prior research has examined both price reactions and analyst forecast revisions to management guidance. We opt to examine analyst revisions rather than price reactions, as price reactions reflect both the change in expectations in the numerator, and the discount rate (or risk of the company) in the denominator. We expect material-weakness firms to have systematic differences in risk (e.g., Ogneva et al., 2007; Bryan and Lilien, 2005). We consider only the first year of the internal control problem as our intent is to determine if analysts discount these managers guidance before the public announcement of an internal control problem.
20

24

firms. If we find a negative and significant coefficient on this interaction term, this is consistent with analysts discounting guidance provided by managers in firms with material weaknesses in internal control. We include three control variables that have been shown to affect the

incorporation of guidance. First, DOWN is an indicator variable that is equal to one of the managers REVISION reduces earnings expectations (relative to the pre-existing analyst consensus forecast). REPUTATION is the accuracy of the preceding management forecast. Finally, AGREE is an indicator variable that is equal to one if the price reaction to the guidance is in the same direction as the managers suggested revision. Results are presented in Table 8. The coefficient on REVISION is 0.451, indicating that analysts respond, on average, to management guidance by updating their own forecasts in the suggested direction. The coefficient on the interaction of REVISION and MW is 0.042, which is not significantly different from zero. Therefore, analysts do not appear to discount management forecasts issued by firms with internal control weakness after controlling for the known variation in analyst incorporation. In other words, Table 8 suggests that management guidance is

incorporated by market participants, whether or not the firm has a material weakness in internal control, ex post, providing additional support for the economic importance of internal control quality on management guidance.

The Impact of Material Weaknesses among Section 302 Disclosures Section 302 of the Sarbanes-Oxley Act, effective in August 2002 for all SEC registrants, also resulted in a large number of material weakness disclosures. Because Section 302

disclosures precede Section 404 disclosures, we investigate the effects of these disclosures for our accelerated filer sample as follows. First, we replicate our main analysis on the Section 302 material weakness sample of firms. We find that management forecast errors are also larger in

25

years where Section 302 material weaknesses are disclosed (consistent with Table 3); the coefficient on MW is 0.008 with a t-statistic of 2.77 (not tabulated). Second, we examine whether the 302 material weakness firms change their forecast behavior following their 302 material weakness disclosures. We find that firms disclosing material weaknesses in two

consecutive years (beginning with the year prior to Section 404 and extending through to their initial 404 report) are more likely to stop issuing forecasts in the first year of Section 404; the coefficient on IC_ADVERSE is -0.098 with a t-statistic of 1.86 (not tabulated).21 Third, we exclude firms that disclose a material weakness under Section 302 from our main analysis on Section 404 disclosures (as they have disclosed a material weakness prior to their initial 404 report); our results remain unchanged. Thus, our results are consistent across both Section 302 and 404, consistent with material weaknesses affecting management forecast errors and management guidance behavior.

Management Forecast Accuracy Measure There are several alternative ways to calculate our measure of forecast qualitythe ex post absolute value of the management forecast error. Our results are robust to these

alternatives. For example, as noted in footnote 9, we take the average error of all forecasts issued by a firm during the fiscal year. We replicate our analysis (Equation 1) using the last forecast issued in each fiscal year, and results are similar (the coefficient on MW is 0.006 and the corresponding t-statistic is 6.38).

Ideally we would like to examine the initial 302 disclosures followed by the subsequent year, under either Section 302 or 404. However, for Section 302 disclosures we are using the data made publicly available by Doyle et al. (2007b). This data includes only the first Section 302 material weakness, thus, if there is a material weakness disclosure in 2002, we do not know if there was a subsequent 302 material weakness in 2003. Therefore, we concentrate on material weakness disclosures made in the year prior to the initial 404 report in order to ensure completeness. We exclude firms filing earlier material weaknesses from our test.

21

26

In addition, our focus has been on annual guidance for several reasons. First, internal control reports are released annually, and thus we are best able to identify the affected period and pinpoint the guidance issued during that period using annual data. Second, our measure of forecast quality, the ex post management forecast error, is affected by errors in both the management forecast and reported earnings. Using annual figures allows auditors to help

mitigate effects of internal control problems on reported earnings, concentrating our investigation on the effects of guidance. However, we replicate our main analysis (Equation 1) using quarterly data. Results indicate the coefficient on MW is 0.001 with a t-statistic of 2.03.22 Finally, because internal control quality is not exogenous, we econometrically control for self-selection bias using a two-stage approach and estimate a probit regression of MW on the determinants of material weaknesses. The independent variables are obtained from model (1) and similar to Ashbaugh-Skaife et al. (2007a) and Doyle et al. (2007a): LN_TA, GROWTH, LOSS, LITIGATE, BIG4, ROA, LEVERAGE, MA, SI, STDEARN, BETA, and ANALYSTS.23 From this first-stage regression, which identifies the likelihood of a firm being selected as a material weakness firm, we calculate the inverse Mills ratio (see Heckman, 1979) and include this ratio in our main regression (Equation 1). After the inclusion of the inverse Mills ratio, the coefficient on MW continues to be significant, with a t-statistic of 7.78. Thus, results do not appear to be driven by firms self-selecting into the material weakness group.

Conclusion We examine the relation between internal control quality and management guidance using Section 404 disclosures made by accelerated filers from 20052007. We argue that the
22

This weaker result supports our decision to use annual earnings, which are both audited and less affected by issues with the timeliness of the earnings figures. Using annual earnings, the errors in reported earnings are more likely to have been corrected, allowing us to concentrate on the error in the management guidance. 23 Variables are defined in Table 2.

27

quality of internal control not only affects reported earnings, as previously documented, but also likely affects interim numbers used by management to provide earnings guidance. Consistent with this, we find that within firms reporting ineffective internal controls, management forecast accuracy is significantly lower, both statistically and economically. We find stronger results when the weaknesses affect revenue or cost of goods sold, consistent with these balances having the greatest effect on forecasted earnings (Fairfield et al., 1996). We also find that the

association between management forecast accuracy and internal control is no longer significant after the internal control problem has been remediated, consistent with management forecast accuracy having been affected by prior internal control problems. Finally, we provide evidence that managers change their guidance behavior following the disclosure of a material weakness in internal control. If a weakness persists, managers are more likely to stop issuing guidance, and, if they do issue guidance, tend to issue less specific guidance. Overall, our results strongly support the notion that the quality of the information inputs to earnings guidance is an important determinant of management forecast accuracy and that the quality of internal control has a broader impact than previously documented. Internal controls not only affect reported earnings; they also affect the quality of management guidance. Our paper adds to the debate on the cost/benefit tradeoff of Section 404, and opens the door to additional potential effects of internal control, such as management decision-making. If

managers rely on faulty interim numbers when making decisions in firms with internal control deficiencies, managers may make sub-optimal decisions. These decisions might include choices related to production, capital investment, M&As, R&D, advertising, and hiring or expansion decisions. Future research might consider examining the association between managerial

decision-making and internal control. Our findings also highlight how internal control continues

28

to be a challenge following the initial year of Section 404; we find that while many problems were quickly remediated following their identification and disclosure, new internal control challenges arose in subsequent years, further supporting the notion that evaluating internal controls needs to be an ongoing process. Overall, our findings strongly support that there are benefits to maintaining strong internal controls.

29

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Table 1 Sample Selection

Firm-Year Observations Firm-years with Section 404 reports from January 2005 to September 2007 Less: Those not covered by First Call Those without a point or range management earnings forecast Those missing financial information from Compustat Those missing analyst information from First Call Those missing stock information from CRSP Number of firm-years in the final sample (with management forecast errors) 11,528 712 7,174 172 297 233 2,940

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Table 2 Descriptive Statistics

diff. Z-stat.

ABSERROR LN_TA ROA LOSS LEVERAGE GROWTH LITIGATE BETA

SI MA

BIG4 ANALYSTS STDEARN DISPFOR HORIZON REVISION

Mean 0.010 21.088 0.061 0.096 0.620 0.180 0.279 1.191 0.012 0.191 0.922 1.942 0.067 0.067 210.569 0.004

Full Sample N = 2940 Median Min 0.004 0.000 20.976 17.289 0.060 -0.631 0.000 0.000 0.597 0.088 0.125 -0.398 0.000 0.000 1.144 0.047 0.002 0.000 0.000 0.000 1.000 0.000 2.079 0.000 0.028 0.001 0.045 0.000 204.500 -25.000 0.002 0.000 Max 0.129 25.783 0.367 1.000 1.807 1.768 1.000 2.579 0.218 1.000 1.000 3.367 1.009 0.526 584.500 0.040 Std. Dev. 0.018 1.679 0.104 0.294 0.301 0.246 0.449 0.475 0.031 0.393 0.269 0.779 0.122 0.071 68.138 0.006 diff. t-stat. -8.57 6.02 6.40 -7.02 0.24 -0.67 -4.17 -3.64 -5.48 -1.03 3.19 3.37 -4.57 0.87 -1.91 -0.960

Control Sample N = 2635 Mean 0.009 21.151 0.065 0.083 0.621 0.179 0.268 1.181 0.011 0.189 0.927 1.958 0.063 0.068 209.750 0.004

MW Sample N = 305 Mean 0.018 20.543 0.025 0.207 0.617 0.189 0.380 1.285 0.022 0.213 0.875 1.800 0.097 0.064 217.620 0.004

Control Sample N = 2635 Median 0.004 21.047 0.063 0.000 0.601 0.125 0.000 1.133 0.002 0.000 1.000 2.079 0.026 0.045 204.000 0.002

MW Sample N = 305 Median 0.008 20.211 0.037 0.000 0.574 0.123 0.000 1.237 0.004 0.000 1.000 1.792 0.046 0.042 208.429 0.002

-5.62 5.74 5.99 -6.96 0.91 0.06 -4.16 -2.72 -3.21 -1.03 3.18 2.60 -5.62 1.15 -1.51 -0.786

Note: p-values are based on two-tailed tests.

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Table 2, Continued

Variables Definitions: An indicator variable that is equal to one if the company receives an adverse Section 404 opinion in year t, and zero MW otherwise. The absolute value of the management forecast error (realized earnings less the management forecast), scaled by ABSERROR lagged stock price. LN_TA The natural log of total assets (Compustat #6). ROA Net income (Compustat #172) / lagged total assets (Compustat #6). LOSS An indicator variable that is equal to one if net income (Compustat #172) is negative, and zero otherwise. LEVERAGE Total liabilities (Compustat #181) / lagged total assets (Compustat #6). GROWTH Sales growth over the prior year (sales (Compustat #12) in year t less sales in year t-1 scaled by sales in year t-1). An indicator variable that is equal to one if the firms main operations are in a high-litigation industry LITIGATE [biotechnology (2833-2836 and 8731-8734), computers (3570-3577 and 7370-7374), electronics (3600-3674), and retail (5200-5961) industries, and zero otherwise (based on Francis et al., 1994)]. BETA The slope coefficient from estimating Sharpes (1964) market model using daily return data from year t-1. SI The absolute value of special items (Compustat #17) scaled by lagged total assets (Compustat #6). An indicator variable that is equal to one if the company has mergers and acquisition (Compustat AFTNT1= AA), MA and zero otherwise. BIG4 An indicator variable that is equal to one if the auditor is a Big 4 auditor, and zero otherwise. ANALYSTS The log of the number of analysts following the firm at the beginning of the fiscal year. STDEARN The standard deviation of ROA over the last five years (requiring at least three non-missing observations). DISPFOR The standard deviation of the individual analyst forecasts for year t, prior to the management guidance in year t. The number of days prior to the fiscal period-end in which the management forecast is issued, where a larger number HORIZON indicates a more timely forecast. Forecasts issued after the fiscal period-end are not excluded, and thus HORIZON can be negative. The absolute value of the revision implied by the management forecast: |(management forecast pre-existing REVISION median analyst forecast)| scaled by lagged stock price.

We winsorize the top and bottom 1% of each of our continuous variables to avoid the influence of outliers.

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Table 3 Internal Control Quality and Management Forecast Accuracy

Intercept MW LN_TA ROA LOSS LEVERAGE GROWTH LITIGATE BETA

SI MA

BIG4 ANALYSTS STDEARN DISPFOR HORIZON REVISION

Coeff. -0.001 0.006 0.000 0.000 0.014 0.002 -0.003 0.000 0.002 0.013 -0.001 -0.001 -0.002 0.003 0.040 0.000 1.047

Full Sample t-stat. p-value -0.29 0.775 6.99 0.001 -0.31 0.754 0.01 0.994 11.25 0.001 1.60 0.111 -2.17 0.030 -0.46 0.645 3.91 0.001 1.38 0.169 -1.81 0.071 -0.60 0.549 -4.51 0.001 1.07 0.283 10.01 0.001 6.94 0.001 20.25 0.001 Coeff. -0.007 0.006 0.000 0.004 0.015 -0.001 0.000 0.000 0.002 0.029 -0.003 0.000 -0.003 0.002 0.038 0.000 0.816 p-value 0.633 0.001 0.847 0.720 0.001 0.200 0.327 0.597 0.002 0.155 0.965 0.533 0.002 0.459 0.001 0.001 0.001 Coeff. 0.009 0.005 -0.001 0.000 0.011 0.003 -0.007 0.000 0.001 -0.038 -0.001 -0.002 0.000 0.002 0.049 0.000 1.212

Dependent Variable = ABSERROR 2004 2005 t-stat. p-value Coeff. t-stat. -0.94 0.348 -0.004 -0.48 5.00 0.001 0.006 3.68 0.81 0.420 0.000 0.19 0.80 0.423 -0.002 -0.36 7.25 0.001 0.018 7.70 -0.46 0.646 0.002 1.28 -0.21 0.834 -0.002 -0.98 -0.06 0.949 -0.001 -0.53 1.70 0.090 0.004 3.14 1.88 0.060 0.024 1.42 -2.27 0.023 0.000 0.04 0.25 0.803 -0.001 -0.62 -3.93 0.001 -0.003 -3.19 0.61 0.539 0.004 0.74 5.82 0.001 0.035 4.73 4.29 0.001 0.000 3.72 9.46 0.001 1.107 12.17 2006 t-stat. 1.08 2.85 -1.78 0.05 5.03 1.89 -3.02 -0.13 1.49 -2.20 -0.66 -1.06 -0.16 0.38 7.15 4.04 13.30

p-value 0.282 0.004 0.076 0.956 0.001 0.059 0.003 0.897 0.138 0.028 0.508 0.288 0.876 0.701 0.001 0.001 0.001

Total Obs. MW Obs. F-value Adjusted R2 0.001

2940 305 104.90 0.361

941 143 41.3 0.368

0.001

1028 104 50.41 0.383

0.001

971 58 38.85 0.354

0.001

Note: p-values are based on two-tailed tests. See Table 2 for variable definitions.

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Table 4 The Relation between Internal Control Quality and Management Forecast Accuracy for Fiscal Years Preceding the Disclosure

Intercept MW LN_TA ROA LOSS LEVERAGE GROWTH LITIGATE BETA

SI MA

BIG4 ANALYSTS STDEARN DISPFOR HORIZON REVISION

Coeff. -0.005 0.007 0.000 0.008 0.017 0.003 -0.002 -0.002 0.006 -0.006 0.000 0.001 -0.003 -0.002 0.019 0.000 1.259

t-1 t-stat. -0.48 4.84 -0.21 1.21 6.92 1.31 -0.95 -1.39 4.19 -0.36 -0.32 0.28 -3.52 -0.68 2.06 6.00 13.71 p-value 0.630 0.001 0.837 0.226 0.001 0.190 0.343 0.164 0.001 0.717 0.750 0.778 0.001 0.496 0.039 0.001 0.001 Coeff. 0.009 0.003 -0.001 0.004 0.012 0.006 -0.002 0.001 0.000 -0.015 0.001 0.000 -0.004 -0.008 0.050 0.000 0.642

Dependent Variable = ABSERROR t-2 Coeff. t-stat. p-value -0.001 -0.11 0.910 0.004 2.86 0.004 0.000 -0.93 0.354 0.009 1.30 0.194 0.010 5.19 0.001 0.006 2.85 0.005 -0.003 -1.08 0.281 0.000 0.02 0.984 0.003 1.87 0.061 0.013 0.80 0.423 0.000 -0.10 0.918 -0.003 -1.05 0.292 -0.002 -1.75 0.080 0.006 2.04 0.042 0.036 3.58 0.001 0.000 8.28 0.001 1.277 12.53 0.001 t-3 t-stat. 0.65 1.62 -0.81 0.38 4.98 2.16 -1.09 0.42 0.18 -0.88 0.30 0.12 -3.24 -2.31 5.34 7.00 7.12

p-value 0.513 0.105 0.418 0.700 0.001 0.031 0.274 0.677 0.855 0.382 0.768 0.907 0.001 0.021 0.001 0.001 0.001

Total Obs. MW Obs. F-value Adjusted R2 0.001

1007 160 38.82 0.376

911 145 35.27 0.376

0.001

760 124 20.94 0.296

0.001

Note: p-values are based on two-tailed tests. See Table 2 for variable definitions.

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Table 5 The Relation between Types of Internal Control Problems and Management Forecast Accuracy Dependent Variable = ABSERROR Year t Year t Year t-1 to t-2 Year t-1 to t-2
Coeff. -0.001 t-stat. -0.16 p-value 0.877 t-stat. -0.40 8.52 2.81 p-value 0.692 0.001 0.005 Coeff. -0.001 t-stat. -0.21 p-value 0.835 Coeff. -0.003 0.009 0.003 t-stat. -0.47 6.00 2.61 p-value 0.635 0.001 0.009

Intercept REV/COGS OTHER NUMBERMW LN_TA ROA LOSS LEVERAGE GROWTH LITIGATE BETA

Coeff. -0.002 0.012 0.003

SI MA

BIG4 ANALYSTS STDEARN DISPFOR HORIZON REVISION 2940 108 197 0.367 2940

0.000 0.000 0.014 0.002 -0.002 0.000 0.002 0.015 -0.001 -0.001 -0.002 0.002 0.040 0.000 1.055

-0.19 0.12 11.16 1.58 -2.01 -0.45 3.85 1.59 -1.93 -0.75 -4.45 0.97 10.02 6.93 20.49

0.850 0.903 0.001 0.114 0.044 0.653 0.001 0.112 0.054 0.455 0.001 0.332 0.001 0.001 0.001

0.003 0.000 0.001 0.014 0.002 -0.003 0.000 0.002 0.014 -0.001 0.000 -0.002 0.002 0.041 0.000 1.050 0.000 0.008 0.012 0.004 -0.003 -0.001 0.005 0.002 0.000 -0.001 -0.002 0.001 0.027 0.000 1.304 -0.77 1.57 8.05 2.72 -1.80 -1.35 5.04 0.20 -0.33 -0.77 -3.67 0.73 4.03 10.24 19.22 0.440 0.116 0.001 0.007 0.072 0.177 0.001 0.838 0.741 0.440 0.001 0.464 0.001 0.001 0.001

10.90 -0.44 0.31 10.96 1.46 -2.26 -0.39 3.84 1.46 -1.88 -0.28 -4.42 0.92 10.24 6.95 20.54

0.001 0.660 0.755 0.001 0.144 0.024 0.696 0.000 0.144 0.061 0.781 0.001 0.356 0.001 0.001 0.001

0.002 0.000 0.007 0.012 0.004 -0.003 -0.001 0.006 0.004 0.000 -0.001 -0.002 0.001 0.028 0.000 1.304 1930

4.90 -1.12 1.45 7.81 2.98 -1.61 -1.18 5.39 0.33 -0.32 -0.62 -3.62 0.59 4.10 10.08 19.15

0.001 0.263 0.147 0.001 0.003 0.108 0.236 0.001 0.741 0.747 0.532 0.001 0.552 0.001 0.001 0.001

Total Obs. REV/COGS Obs. OTHER Obs. Adjusted R2

0.376

1930 125 192 0.382

0.377

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Table 5, Continued

Note: p-values are based on two-tailed tests. Our variables are defined as follows: REV/COGS is an indicator variable that is equal to one if the firm reports a material weakness in the revenue or cost of goods sold/inventory accounts, and zero otherwise. OTHER is an indicator variable that is equal to one if the firm reports a material weakness in internal control and none of these weaknesses are related to the revenue or cost of goods sold/inventory accounts, and zero if the firm reports a material weakness in the revenue or cost of goods sold/inventory accounts or does not report a material weakness. NUBMERMW is equal to the total number of material weaknesses in internal control reported in fiscal year t. Additional variable definitions are provided in Table 2.

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Table 6 The Change of Internal Control Quality and the Level of Management Forecast Accuracy
Dependent Variable = ABSERROR Year t+1 Year t t-stat. p-value Coeff. t-stat. -0.46 0.648 0.001 0.14 1.45 0.147 0.002 2.11 3.85 0.001 0.007 4.06 2.67 0.008 0.000 0.08 -0.32 0.749 0.000 -0.63 -0.09 0.930 0.016 3.88 9.08 0.001 0.013 7.93 2.09 0.037 0.001 0.79 -2.03 0.042 0.000 0.38 0.04 0.970 0.000 -0.01 2.66 0.008 0.001 1.48 -0.90 0.371 -0.019 -1.64 -0.68 0.499 -0.001 -1.57 0.17 0.863 0.000 0.39 -2.79 0.005 -0.001 -2.23 1.65 0.099 -0.001 -0.19 8.05 0.001 0.034 7.23 4.84 0.001 0.000 4.24 16.46 0.001 1.042 15.65 0.007 0.210 0.115 0.012 0.199 0.001 1381 114 37 767 0.319

Intercept IC_IMPROVE IC_ADVERSE IC_WORSE LN_TA ROA LOSS LEVERAGE GROWTH LITIGATE BETA

SI MA
BIG4 ANALYSTS STDEARN DISPFOR HORIZON REVISION

Coeff. -0.003 0.002 0.009 0.004 0.000 0.000 0.016 0.003 -0.004 0.000 0.002 -0.012 -0.001 0.000 -0.002 0.007 0.042 0.000 1.119

p-value 0.885 0.035 0.001 0.934 0.526 0.000 0.001 0.432 0.702 0.993 0.139 0.101 0.116 0.696 0.026 0.846 0.001 0.001 0.001

diff. between b1 and b2 (p-value) diff. between b1 and b3 (p-value) diff. between b2 and b3 (p-value) Total Observations IC_IMPROVE Obs. IC_ADVERSE Obs. IC_WORSE Obs. Adjusted R2 1740 141 43 84 0.374

Note: p-values are based on two-tailed tests. Our variables are defined as follows: IC_IMPROVE is an indicator variable that is equal to one if the 404 opinion is adverse in year t and clean in year t+1. IC_ADVERSE is an indicator variable that is equal to one if the 404 opinions are adverse in both year t and year t+1. IC_WORSE is an indicator variable that is equal to one if the 404 opinion in is clean in year t and adverse in year t+1. Additional variable definitions are provided in Table 2.

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Table 7 The Change of Internal Control Quality and the Change in Management Forecast Behavior

Intercept IC_IMPROVE IC_ADVERSE LN_AT ROA LOSS LEVERAGE GROWTH LITIGATE BETA

SI MA

BIG4 ANALYSTS STDEARN RESTATE EXECTURN DISPFOR HORIZON 0.003 4,980 429 184 0.008

Coeff. -0.017 -0.020 -0.114 0.079 0.022 -0.012 -0.070 -0.021 0.006 0.026 0.086 0.026 -0.010 0.022 -0.021 -0.006 -0.007

OCCUR t-stat. -2.34 -1.08 -4.16 2.97 0.34 -0.70 -2.92 -1.43 0.48 2.35 0.65 2.10 -0.35 1.78 -0.32 -0.48 -0.66 p-value 0.020 0.279 0.001 0.003 0.736 0.484 0.004 0.154 0.628 0.019 0.518 0.036 0.730 0.075 0.749 0.629 0.510 Coeff. -3.161 -13.850 -30.442 -3.269 -52.460 13.786 33.437 -3.981 0.158 -4.772 -40.183 3.082 15.159 -3.443 -19.755 -0.288 -2.172 183.983 0.020 1,693 129 49 0.008

Dependent Variable SPECIFICITY Coeff. t-stat. p-value 0.006 0.53 0.599 0.015 0.52 0.606 -0.104 -2.24 0.025 -0.018 -0.39 0.693 0.422 3.42 0.001 0.038 1.19 0.235 -0.011 -0.27 0.790 0.040 1.30 0.194 -0.010 -0.59 0.555 -0.013 -0.65 0.513 -0.023 -0.09 0.925 0.017 0.97 0.330 -0.009 -0.15 0.884 0.004 0.20 0.841 -0.113 -0.89 0.371 0.009 0.51 0.612 0.018 1.22 0.221 -0.016 -0.13 0.898 0.000 -1.76 0.078 HORIZON t-stat. -1.24 -2.01 -2.83 -0.31 -1.82 1.85 3.62 -0.56 0.04 -1.07 -0.70 0.78 1.01 -0.71 -0.67 -0.07 -0.62 6.49

p-value 0.217 0.045 0.005 0.756 0.068 0.065 0.000 0.577 0.968 0.284 0.487 0.437 0.311 0.475 0.504 0.944 0.533 <.0001 0.174 1,693 129 49 0.044

F-test on the diff. between b1 and b2

Total Observations IC_IMPROVE Observations IC_ADVERSE Observations Adjusted R2

41

Table 7, Continued

Note: p-values are based on two-tailed tests. Our variables are defined as follows: OCCUR is an indicator variable that is equal to one if the manager issued a forecast in year t+1 but did not in year t, negative one if the manager did not issue a forecast in year t+1 but did in year t, and zero if there was no change in forecast issuance. SPECIFICITY is the change in average forecast specificity, where specificity has a value of one if the forecast is qualitative, two if the forecast is a minimum or maximum, three if the forecast is a range, and four if the forecast is a point forecast. HORIZON is the change in the average number of days between the issuance of the management forecast and the end of the period, where a positive number indicates the forecasts are issued in a more timely fashion. RESTATE is an indicator variable that is equal to one if the firm announced a restatement in year t+1 but did not in year t, negative one if the firm did not announce a restatement in year t+1 but did in year t, and zero if there was no change in restatement announcement. EXECTURN is an indicator variable that is equal to one if the firm had an executive (CEO or CFO) turnover in year t+1 but not in year t, negative one if the firm did not have an executive turnover in year t+1 but did in year t, and zero if there was no change in executive turnover. Each of the change variables is measured from the year of the material weakness to the year following the material weakness disclosure. Additional variables are defined in Table 2 and Table 6.

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Table 8 Analyst Forecast Revisions Following Management Guidance

Dependent Variable = ANALYST_REV Coeff. t-stat. p-value REVISION REVISION x MW REVISION x DOWN REVISION x MGR_REPUTATION REVISION x AGREE Firm fixed effects Total Observations MW Observations Adjusted R2 0.451 0.042 0.152 -7.499 0.214 Included 2,339 305 0.839 16.72 1.45 5.42 -6.15 10.16 0.001 0.147 0.001 0.001 0.001

Note: p-values are based on two-tailed tests. Our variables are defined as follows: REVISION is the absolute value of the revision implied by the management forecast: |(management forecast pre-existing median analyst forecast)| scaled by lagged stock price. ANALYST_REV is the magnitude of the analyst forecast revision, the revised consensus analyst forecast less the pre-existing consensus analyst forecast, scaled by lagged stock price. The pre-existing consensus analyst forecast is the most recent consensus before the management forecast (within two to 30 days). The revised consensus analyst forecast is the updated consensus forecast following the management forecast (within 15 days). If there is no updated analyst posterior consensus forecast, ANALYST_REV is zero. DOWN is an indicator variable that is equal to one if the management forecast falls below the pre-existing consensus analyst forecast, and zero otherwise. MGR_REPUTATION is the accuracy of the preceding management forecast, following Williams (1996). AGREE is an indicator variable that is equal to one if the three-day abnormal return around the management forecast (1, +1) has the same sign as the management guidance, and zero otherwise. The abnormal return is equal to the difference between the firm return and the value-weighted return.

43