Failed remediation of material weaknesses: The role of incentives and remediation actions

Prior research provides evidence of many economic benefits associated with the remediation of material weaknesses. However there is anecdotal evidence suggesting that not all remediation efforts adequately strengthen internal controls. I define a failed remediation as a case where a remediated company-year is subsequently restated. I examine whether incentives to disclose remediation and whether the timing of remediation disclosure and extent of remediation actions employed are associated with the likelihood of a failed remediation. I find that 18.5% of remediated company-years fail to adequately strengthening controls. Also, constituent based incentives to restore financial reporting credibility and capital market pressures to disclose remediation in the form of financial distress are associated with the likelihood of a failed remediation. Further, remediation failures are less likely for companies that disclose remediation in the subsequent annual filing as opposed to an earlier date and are less likely for companies that take a holistic approach to strengthening controls. These results indicate that incentives play a role in whether disclosed remediation adequately improves underlying control problems and that remediation disclosures provide information that is useful in assessing the likelihood of a failed remediation.