1141THEACCOUNTINGREVIEWVol.82,No.52007pp.1141–1170AccrualsQualityandInternalControloverFinancialReportingJeffreyT.DoyleUtahStateUniversityWeiliGeUniversityofWashingtonSarahMcVayUniversityofUtahABSTRACT:Weexaminetherelationbetweenaccrualsqualityandinternalcontrolsusing705firmsthatdisclosedatleastonematerialweaknessfromAugust2002toNovember2005andfindthatweaknessesaregenerallyassociatedwithpoorlyesti-matedaccrualsthatarenotrealizedascashflows.Further,wefindthatthisrelationbetweenweakinternalcontrolsandloweraccrualsqualityisdrivenbyweaknessdis-closuresthatrelatetooverallcompany-levelcontrols,whichmaybemoredifficultto‘‘auditaround.’’Wefindnosuchrelationformoreauditable,account-specificweak-nesses.Wefindsimilarresultsusingfouradditionalmeasuresofaccrualsquality:dis-cretionaryaccruals,averageaccrualsquality,historicalaccountingrestatements,andearningspersistence.Ourresultsarerobusttotheinclusionoffirmcharacteristicsthatproxyfordifficultyinaccrualestimation,knowndeterminantsofmaterialweaknesses,andcorrectionsforself-selectionbias.Keywords:earningsquality;accrualsquality;internalcontrol;materialweaknesses.DataAvailability:Alldatausedinthepaperareavailablefrompubliclyavailablesourcesnotedinthetext;thedataoninternalcontrolweaknessesareavail-ableinmachine-readableformfromtheauthorsuponrequest.I.INTRODUCTIONInthispaperweexaminetherelationbetweenaccrualsqualityandtheinternalcontrolenvironmentofthefirm.Bydefinition,whenthereisamaterialweaknessininternalcontrol,thereis‘‘morethanaremotelikelihoodthatamaterialmisstatementoftheWethanktwoanonymousreviewers,DanCohen,PattyDechow,DanDhaliwal(theeditor),IliaDichev,KalinKolev,RussLundholm,MattMagilke,Zoe-VonnaPalmrose,ChristinePetrovits,CathyShakespeare,TomSmith,andSurajSrinivasanfortheirhelpfulcommentsandsuggestions.Thispaperhasalsobenefitedfromcommentsreceivedatthe20054-SchoolConferenceatColumbiaUniversity,the2005AAAMidwestRegionalMeeting,the2006AAAFARSMidyearMeeting,the2006AccountingandFinanceAssociationofAustraliaandNewZealandAnnualMeeting,the2006InternationalSymposiumonAuditResearchConference,andtheUniversityofMichigan.Editor’snote:ThispaperwasacceptedbyDanDhaliwal.SubmittedAugust2005AcceptedJanuary20071142Doyle,Ge,andMcVayTheAccountingReview,October2007annualorinterimfinancialstatementswillnotbepreventedordetected’’(PCAOB2004)(emphasisadded).Aweakcontrolenvironmenthasthepotentialtoallowboth(1)inten-tionallybiasedaccrualsthroughearningsmanagement(e.g.,lackofsegregationofduties),and(2)unintentionalerrorsinaccrualestimation(e.g.,lackofexperienceinestimatingthebad-debtexpenseprovision).Therefore,wehypothesizethatreportedmaterialweaknesseswillbeassociatedwithloweraccrualsquality.Whilethisrelationhasbeensuggestedinpriorliterature(Kinney2000),thelackofinternalcontroldatahasgenerallyprecludedanempiricalinvestigationand,therefore,theliteratureonearningsqualityhasbeenrelativelysilentonthematterofinternalcontroloverfinancialreporting.Forexample,neitherofthetworecentpublicationsonearningsquality(SchipperandVincent2003;DechowandSchrand2004)mentionsapossiblere-lationbetweeninternalcontrolandearnings/accrualsquality.Inthispaper,weinvestigatethisrelationusingasampleof705companiesthatdisclosedmaterialweaknessesininternalcontroloverfinancialreportingfromAugust2002toNovember2005underthenewre-quirementsofSections302and404oftheSarbanes-OxleyActof2002.1UsingtheaccrualsqualitymeasuredevelopedbyDechowandDichev(2002),asmod-ifiedbyMcNichols(2002)andFrancisetal.(2005),wegenerallyfindthatweakinternalcontrolsareassociatedwithrelativelylow-qualityaccruals,asmeasuredbyweakermap-pingsofaccrualsintocashflows.Thisrelationisrobusttotheinclusionofinnatefirmcharacteristicsthatproxyfortheinherentdifficultyinaccrualestimation(e.g.,lengthoftheoperatingcycleandcashflowvolatility[DechowandDichev2002])andadditionaldeterminantsofmaterialweaknessesthatarelikelytobedirectlycorrelatedwithaccrualsquality(e.g.,profitabilityandcomplexity[GeandMcVay2005;Ashbaugh-Skaifeetal.2007;Doyleetal.2007]).AlthoughourfocusisontheDechowandDichev(2002)measure,whichwefeelisboththeoreticallyandintuitivelyappealing,wealsoconsiderothercommonproxiesforaccrualsquality:discretionaryaccruals(Jones1991),averageaccrualsquality(DechowandDichev2002),historicalrestatements(AndersonandYohn2002),andearningspersistence(SchipperandVincent2003).Foreachofthesemeasures,wefindthatweakinternalcon-trolsareassociatedwithloweraccrualsquality.Finally,wefindthattherelationbetweenweakinternalcontrolsandloweraccrualsqualityisstrongerfortwogroupsoffirms.First,onlythosefirmswithcompany-levelmaterialweaknesses,ratherthanmoreauditable,account-specificproblems,haveloweraccrualsquality.Thefindingthataccount-specificmaterialweaknessesarenotassociatedwithloweraccrualsqualityisconsistentwithauditorsdetectingandcorrectingauditableweaknessesthroughincreasedsubstantivetestingpriortotheissuanceofthefinancialstate-ments(e.g.,HoganandWilkins2006).Second,materialweaknessdisclosuresmadeunderSection302(versusthoseunderSection404)seemtobemorestronglyassociatedwithloweraccrualsquality.Wefindthat,onaverage,Section404dis