Reporting of Internal Control Deficiencies, Restatements, and Management Forecasts

We examine the relationship between accuracy in management forecasts and the effectiveness of internal controls by focusing on the unique environment of Japan. Japanese firms are required by the stock exchange to simultaneously disclose (1) condensed financial statement (financial highlights) after the settlement of financial accounts and approval of the board and (2) management forecasts at the earnings announcement. Feng et al. (2009) find that managers of firms reporting internal control deficiencies report less accurate earnings forecasts compared with other firms in the U.S. We shed light on restatement firms (firms that restate financial highlights) and investigate Feng et al.’s premise (2009), since restatement firms obviously rely on faulty internal reports to form their forecasts. Although Feng et al. (2009) assume that firms disclosing internal control deficiencies rely on erroneous internal reports to form management forecasts, it is assured that Japanese restatement firms utilize faulty internal reports to form their forecasts. Our results show that restatement firms, which are likely to have internal control problems, report less accurate management forecasts. We provide direct evidence that the effectiveness of internal controls has a significant impact on internal reports, which are used in forming forecasts, and that they thereby induce less accurate management forecasts.