| Many companies have had difficulty meeting the compliance requirements of the Sarbanes-Oxley Act of 2002 (SOX), specifically Section 404. SOX 404 has increased audit fees, reduced corporate growth, and reduced ventures being taken public. The purpose of this study was to explore the development of a model to identify companies having the greatest probability of material weakness. This model would restrict the burdensome internal control testing mandated under SOX 404 to those companies with the greatest control risk. The sample was collected from analysis of companies reporting material weakness under Section 302 of SOX. The key research questions examined whether weakness in debt service, cumulative profitability, and liquidity as used in Altman's ZETA model can be used to effectively predict the existence of material weakness in internal controls. Analysis of the data was conducted using the Wilcoxon Rank-Sum test, Spearman correlation, and Sign Test. The results show a positive relationship between companies having low cumulative profitability and high debt service relative to companies on the S&P 500 and the reporting of material weakness. The resulting model can be used to predict, which companies have the greatest probability of material weakness and target the detailed compliance standards to those companies. Using a predictive model and tailoring the application of SOX 404 to these companies could have a positive impact on society including focusing strict compliance on the companies most in need of oversight, increasing public confidence in the process, and freeing funds for reinvestment to stimulate productivity and economic growth. |
