The problems relating to business failures early in this decade exposed manipulations of financial reporting, distortions in economic performance in the accounting for and disclosure of transactions, and lapses in corporate governance. These problems resulted in Congress establishing requirements for corporate governance through its passage of the Sarbanes-Oxley Act (SOX), which requires firms to disclose material weaknesses in internal controls for financial reporting, directs management to disclose its assessment of those internal controls, and mandates that each company's independent auditor assess the management report and the company's systems of internal control. With the enactment of SOX, the U.S. Congress acknowledged major issues relating to the quality of earnings, transparency of financial reporting, and investor confidence in financial reporting and directed the SEC to study a principles-based accounting system (United States Congress 2002, Sarbanes-Oxley Act Section 108). The major objective of SOX is to attempt to protect investors by improving the accuracy and the reliability of corporate disclosures that increase the transparency of reporting.
Recent failures in the banking industry and investigations into possible fraudulent activity in several large, failed financial service firms may indicate that the provisions of SOX have not gone far enough to prevent serious failures in corporate governance that can result in significant financial losses. The purpose of this study is to investigate one specific industry, banking, and its management responses to material weaknesses in internal control within its Section 404 reporting. Because the banking industry has historically been highly regulated, one would expect few internal control problems or weaknesses, but results of our study indicate that this is not the case. Firms within the banking industry do report material weaknesses and these firms do not consistently indicate a corrective action strategy to remediate these weaknesses.
This study uses Benoit's (1995) image restoration theory to identify the type of communication strategies banking companies employ to inform the public about material weaknesses found in internal controls. We also provide examples of Section 404 reports to illustrate the use of Benoit's theory to analyze management's responses. By studying these responses, we can determine whether management reacts to material weaknesses with corrective action strategies or whether other strategies are used. If management uses communication strategies other than corrective action, stakeholders may have concerns about management's acceptance of its responsibility for establishing, maintaining, and reporting on the effectiveness of internal controls and whether the company will address and remedy these internal control weaknesses.
Our results include an analysis of management responses within 65 banking companies that reported a total of 97 material weaknesses in their 2005 SEC filings (10-Q and 10-K). Benoit's (1995) image restoration typology assists in the determination of the type of communication strategies management uses to explain how such material weaknesses occur and what strategies management intends to use to address those weaknesses. As anticipated, the results of the analysis show that the majority of companies use a corrective action strategy when addressing material weaknesses. However, several firms use other communication strategies that include denial, evasion of responsibility, and reducing the offensiveness of the problem. When companies use communication strategies other than corrective action, management reporting is potentially not transparent and may indicate that management is not taking full responsibility for implementing and maintaining effective internal controls.
SOX requirements relating to financial reporting and internal control analysis emphasize management responsibility for preparing financial reports. This has generated academic interest, resulting in several different research streams regarding firm reporting and compliance under Section 404, including the market reaction to internal control weakness disclosures (Hammersley et al. 2008; Beneish et al. 2006; De Franco et al. 2005) and the characteristics of firms that report material weaknesses (Doyle et al. 2007; Ashbaugh-Skaife et al. 2007; Ge and McVay 2005; Bryan and Lilien 2005). This study concentrates on how management communicates and addresses material weaknesses by analyzing firms' Section 404 disclosures within the banking industry.
We selected the banking industry for several reasons. First, more stakeholders exist in bank governance than in non-financial types of businesses due to banks' role in promoting the stability of the economy and the liquidity function. Therefore, loss of confidence in the banking system can cause serious economic problems and stakeholders should be concerned about the quality and transparency of financial reporting (Craig 2004). Second, Rezaee and Jain (2005) and Beasley et al. (2000) cite numerous studies that find that the financial services industries have a prevalence of fraudulent financial statements even though this is a highly regulated industry. In addition, studies by Loebbecke et al. (1989) and Akhigbe and Martin (2008) reinforce the importance of strong internal controls over top management.
Finally, we selected the banking industry because it has been subject to a higher degree of internal control regulation than nearly all other industries since the passage of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. Under FDICIA, all U.S. banks with total assets of $500 million or more are required to file an annual report with regulators in which management attests to the effectiveness of the bank's internal controls and an independent public accountant must attest to and report on management's assertions. Though banks have been subject to FDICIA requirements since the early 1990s, lapses in internal control exist. In 2003, the Basel Committee released a paper, Sound Practices for the Management and Supervision of Operational Risk, which outlines a set of principles that govern the management of operational risk at depository institutions. The Committee attributes many of the bank failures in recent years to operations risk in the form of executive fraud by manipulating internal controls, lax controls of information systems, or lack of financial competence of managers and boards of directors to monitor risk exposures. Operations risk may arise from inadequate or failed internal processes, people or systems, or from external events.
Internal control weaknesses are clearly a concern in the banking industry and SOX 404 requires that management addresses internal control weaknesses in reports to stakeholders. Image restoration communication strategies can provide insight into how these weaknesses are communicated by management and how they intend to correct those weaknesses.
Communication Theory and Image Restoration Strategies
Communication is a goal-directed activity that involves a purpose. One of the central goals of communication for the corporation is to maintain a positive image (Benoit, 1995). This is reinforced by the existence of public relations departments or public relations firms hired for the purpose of making or re-making company images. A reputation may be damaged intentionally or unintentionally through word or deed. When this happens the communicator is faced with the problem of negative public image. Benoit creates his theory based on the assumption that, due to this potential negative image, the communicator is motivated to restore its image as one of the central goals of its communication to the public.
Business communication researchers have examined narrative portions of annual reports, including the CEO letter to shareholders and management's discussion and analysis and have begun to use communication theory and image restoration research to look at how managers and corporations communicate their financial and non-financial information to the public (Hildebrandt and Snyder, 1981; Thomas, 1997; Crombie and Samujh, 1999; Jameson, 2000; Rutherford, 2005; Deumes, 2008; and Lawrence and Geppert, 2008). Accounting and finance researchers are also beginning to use communication theory models in the study of corporate disclosure of material weaknesses in internal control in Section 404 reports (Erickson et al., 2009; 2008). Erickson et al. (2009) use Benoit's image restoration typology to determine what types of communication strategies computer firms use to disclose their material weaknesses in internal control and analyze what types of material weaknesses are associated with the use of non-corrective action strategies. Erickson et al. (2008) extend their analysis to examine whether the use of non-corrective action strategies is a red flag associated with a higher likelihood of merger, bankruptcy, or other type of serious financial difficulty within the computer industry.
Benoit's Image Restoration Typology
Benoit's (1995, 1997) typology is most often used by communication researchers to analyze strategic responses to legitimacy issues. Benoit's (1995) five categories of image restoration include denial, evasion of responsibility, reducing the offensive act, taking corrective action, and mortification. These five categories include fourteen unique communication (response) strategies as shown in Table 1.
Denial can come in two forms. One is simple denial, or an outright refutation that the organization had any part in the event or was responsible in any way. The other type of denial is shifting the blame or asserting that someone (or something) else is responsible for the problem. Denial is the best strategy if the firm is truly blameless. If the firm uses a denial strategy and later is found to have blame in the event, its reputation can be irreparably...