In this article, Professor Robert Felix and his co-authors were interested to see whether a firm's likelihood of having a material weakness in a particular year is affected by an audit committee members' prior experience with a material weakness disclosure. Internal controls are the policies and procedures put in place to ensure the integrity of the financial reporting system.
The Sarbanes Oxley Act (SOX) requires publicly traded firms to disclose the status of their internal control system, and to specifically state if their internal controls have a material weakness. A material weakness indicates that the internal control system has a problem big enough that could potentially lead to misstatement in financial reports. As such, reporting a material weakness is viewed negatively and is generally associated with a host of consequences. Moreover, the audit committee is the subset of the board of directors charged with monitoring financial reporting quality broadly, and internal controls specifically. They found that a firm is less likely to have a material weakness when one of its audit committee members experienced a material weakness at another firm in the past.
Their findings indicate that the prior experiences of directors outside the firm influences their work on the audit committees inside the firm. To that end, their study suggests that directors diffuse important insights based on their prior experience and serve as a catalyst for improvements in a firm’s internal control and financial reporting practices.
Read the full research, "Spillover Effects of Internal Control Weakness Disclosures: The Role of Audit Committees and Board Connections."