Inferring Remediation and Operational Risk from Material Weakness Disclosures

2016 ◽  
Vol 29 (1) ◽  
pp. 1-17 ◽  
Author(s):  
Stephen K. Asare ◽  
Arnold M. Wright
Keyword(s):  
Financial Reporting ◽  
Investment Decisions ◽  
Data Availability ◽  
Risk Assessments ◽  
Material Weakness ◽  
Nonprofessional Investors ◽  
Operational Risks ◽  
Specific Material ◽  
The Relationship ◽  
Current Standards

ABSTRACT Understanding the inferences that nonprofessional investors draw from material weakness disclosures is important because of their effect on investment decisions and for assessing whether current standards serve their needs. Prior research shows that users assess higher financial reporting risk for an entity-level material weakness compared to an account-specific material weakness because they perceive the former as presenting a higher risk of potential misstatement. We extend the literature by proposing two variables (remediation and operational risks) that mediate and incrementally explain the observed relationship between the type of material weakness and financial reporting risk assessments. In an experiment involving 181 nonprofessional investors, we find, as predicted, that the entity-level material weakness signals not just a higher potential for undetected misstatements but also higher remediation and operational risks. Further, we find that the two variables fully mediate and incrementally explain the relationship between the type of material weakness and financial reporting risk assessments. To the extent that these variables are decision relevant, our findings suggest that regulators should reconsider and possibly reengineer the current disclosure regime that allows management to disclose unaudited information about these variables. Data Availability: Contact the authors.

scholarly journals The Relationship Between Segment-Level Manipulations And Audit Fees

2013 ◽  
Vol 29 (4) ◽  
pp. 1243 ◽  
Author(s):  
David Hurtt ◽  
Bradley E. Lail ◽  
Jason MacGregor
Keyword(s):  
Financial Reporting ◽  
Firm Value ◽  
Accounting Standards ◽  
Positive Association ◽  
Audit Fees ◽  
Risk Assessments ◽  
Net Income ◽  
Bottom Line ◽  
Segment Reporting ◽  
The Relationship

We examine the auditorssensitivity to manipulative financial reporting by investigating the relationbetween audit fees and segment-level manipulations. Segment reporting provides an interestingsetting to examine auditor risk assessments because of the discretion affordedto management under existing regulations. Segment manipulations, a form of classificationsmoothing, are not in violation of accounting standards; nevertheless, thesemanipulations violate the spirit of faithful representation by distorting theperformance of a subset of the reporting unit at the expense of (or to thebenefit) of another subset. Because disaggregatedinformation is used by analysts and investors in bottom-upforecasting, these distortions can influence firm value even though they do notaffect bottom-line net income. Ourmeasure of classification smoothing measurescost shifting between core operating segments and non-core segments to proxyfor segment manipulation. We find thataudit fees, a proxy for the auditors risk assessment, have a positiveassociation with segment-level manipulations. Subsequent analyses suggest that higher auditfees are also due to the additional effort exerted in the presence of segment-levelmanipulations. Further, auditors appearjustified in charging higher fees to clients that engage in segmentmanipulations as we document evidence of a positive association betweenrestatements and segment-level manipulations. Collectively, these results suggest thatauditors are aware of the risk associated with companies that engage in segment-levelmanipulations and auditors respond appropriately by charging higher fees anddoing additional work.

The Impact of SOX Section 404 Internal Control Quality Assessment on Audit Delay in the SOX Era

2006 ◽  
Vol 25 (2) ◽  
pp. 1-23 ◽  
Author(s):  
Michael L. Ettredge ◽  
Chan Li ◽  
Lili Sun
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Small Sample ◽  
Impact Factors ◽  
Section 404 ◽  
Material Weakness ◽  
Control Quality ◽  
Sarbanes Oxley ◽  
Specific Material ◽  
The Impact

This study analyzes the impact of internal control quality on audit delay following the implementation of the Sarbanes-Oxley Act (2002) (SOX). Unlike prior studies of audit delay that obtain information about internal control strength via surveys, or use fairly crude proxies for internal control quality, our study employs external auditor assessments of internal control over financial reporting (ICOFR) that are publicly disclosed in SEC 10-K filings under SOX Section 404. Thus, the empirical evidence provided in this study is both timely and reliable (i.e., not subject to small sample bias or weak proxies). Consistent with our expectation, we find that the presence of material weakness in ICOFR is associated with longer delays. The types of material weakness also matter. Compared to specific material weakness, general material weakness is associated with longer delays. Additional analyses indicate that companies with control problems in personnel, process and procedure, segregation of duties, and closing process experience longer delays. After controlling for other impact factors, this study also documents a significant increase in audit delay associated with the fulfillment of the SOX Section 404 ICOFR assessment requirement. This suggests that Section 404 assessments have made it more difficult for firms to comply with the SEC's desire to shorten 10-K filing deadlines. Our finding thus supports and helps explain the SEC's decisions in 2004 and 2005 to defer scheduled reductions in 10-K filing deadlines (from 75 days to 60 days) for large, accelerated filers.

Repairing Organizational Legitimacy Following Information Technology (IT) Material Weaknesses: Executive Turnover, IT Expertise, and IT System Upgrades

2015 ◽  
Vol 30 (1) ◽  
pp. 41-70 ◽  
Author(s):  
Jacob Z. Haislip ◽  
Adi Masli ◽  
Vernon J. Richardson ◽  
Juan Manuel Sanchez
Keyword(s):  
Information Technology ◽  
Financial Reporting ◽  
Data Availability ◽  
Organizational Legitimacy ◽  
Executive Turnover ◽  
Material Weakness ◽  
Material Weaknesses ◽  
Monitoring Mechanism ◽  
Timely Fashion ◽  
System Upgrades

ABSTRACT Since Information Technology (IT)-based internal controls are pivotal in providing access to, and security of, financial records, we argue that an IT-related material weakness (ITMW) is a significant threat to organizational legitimacy. Prior research suggests that firms work to repair legitimacy by disassociation with executives blamed for the deficiency and the establishment of a monitoring mechanism to ensure the problem is addressed (Suchman 1995). As a test of disassociation, we find that, relative to a propensity-score-matched sample of non-ITMW firms, ITMW firms experience higher CEO, CFO, and director turnover. As a test of the establishment of a monitoring mechanism to repair organizational legitimacy, we find that ITMW firms hire CEOs, CFOs, and directors with higher levels of IT expertise, and make significant IT system upgrades. We find evidence that ITMW firms remediate deficiencies in a more timely fashion when they appoint a new CFO with IT expertise or upgrade their financial reporting system. Collectively, our results suggest that firms make significant monitoring changes to re-establish organizational legitimacy after receiving an ITMW. Data Availability: The data used are publicly available from the sources cited in the text.

The Role of Financial Reporting Quality in Mitigating the Constraining Effect of Dividend Policy on Investment Decisions

2013 ◽  
Vol 88 (3) ◽  
pp. 1007-1039 ◽  
Author(s):  
Santhosh Ramalingegowda ◽  
Chuan-San Wang ◽  
Yong Yu
Keyword(s):  
Financial Reporting ◽  
Firm Value ◽  
Dividend Policy ◽  
Investment Decisions ◽  
Reporting Quality ◽  
Data Availability ◽  
Financial Reporting Quality ◽  
High Quality ◽  
Investment Projects

ABSTRACT Miller and Modigliani's (1961) dividend irrelevance theorem predicts that in perfect capital markets dividend policy should not affect investment decisions. Yet in imperfect markets, external funding constraints that stem from information asymmetry can force firms to forgo valuable investment projects in order to pay dividends. We find that high-quality financial reporting significantly mitigates the negative effect of dividends on investments, especially on R&D investments. Further, this mitigating role of financial reporting quality is particularly important among firms with a larger portion of firm value attributable to growth options. In addition, we show that the mitigating role of high-quality financial reporting is more pronounced among firms that have decreased dividends than among firms that have increased dividends. These results highlight the important role of financial reporting quality in mitigating the conflict between firms' investment and dividend decisions and thereby reducing the likelihood that firms forgo valuable investment projects in order to pay dividends. Data Availability: Data are available from public sources identified in the paper.

Perceptions of Investment Risk Associated with Material Control Weakness Pervasiveness and Disclosure Detail

2010 ◽  
Vol 85 (5) ◽  
pp. 1787-1807 ◽  
Author(s):  
Jacob M. Rose ◽  
Carolyn Strand Norman ◽  
Anna M. Rose
Keyword(s):  
Interactive Effect ◽  
Fortune 500 ◽  
Risk Assessments ◽  
Investment Risk ◽  
Material Weakness ◽  
Material Control ◽  
Nonprofessional Investors ◽  
Trust In Management ◽  
Expected Benefits ◽  
Different Levels

ABSTRACT: This research examines whether investors adjust their assessments of investment risk in response to material control weakness disclosures, the pervasiveness of material control weaknesses, and the detail of explanation provided regarding the pervasiveness of material control weaknesses. Findings from a laboratory experiment with 97 nonprofessional investors, a second experiment with 53 nonprofessional investors, and surveys of 47 investors and 28 Fortune 500 directors confirm prior archival findings that investors adjust their investment risk assessments in response to material weakness disclosures. More importantly, we find evidence of an interactive effect of material control weakness pervasiveness and disclosure detail that is counter to the expected benefits of expanded disclosure desired by corporate directors. When material weakness disclosures include specific and detailed discussion of the pervasiveness of control weaknesses, investors increase assessments of investment risk for less pervasive weaknesses and decrease assessments of risk for more pervasive weaknesses. Results indicate that these findings are driven by different levels of investor trust in management.

In GAAP We Trust: Examining How Trust Influences Nonprofessional Investor Decisions Under Rules-Based and Principles-Based Standards

2011 ◽  
Vol 24 (1) ◽  
pp. 25-46 ◽  
Author(s):  
Wendy J. Bailey ◽  
Kimberly M. Sawers
Keyword(s):  
Decision Making ◽  
Financial Reporting ◽  
Reporting System ◽  
Data Availability ◽  
Accounting System ◽  
Accounting Standard ◽  
Nonprofessional Investors ◽  
Investment Choices ◽  
A Company ◽  
Allocation Decisions

ABSTRACT In this study, we investigate whether and how trust in our current, more rules-based financial reporting system and type of accounting standard affects nonprofessional investor decision making. In an experiment, 151 nonprofessional investors analyzed two companies that were economically identical except for a single underlying financial reporting difference that allowed one company to more positively report its financial results. By itself, the type of standard (rules-based, principles-based) did not affect investment choices or allocation decisions. However, when trust was considered, nonprofessional investors who are less trusting of our current financial reporting system chose to invest in a company with more positive financial results only when evaluating principles-based financial statements. Conversely, the type of standard did not affect investor decision making for nonprofessional investors who trust our current financial reporting system. These results have implications for standard setters as we move to a more principles-based accounting system. Data Availability: Available on request.

scholarly journals Effects of Increased Reporting Frequency on Nonprofessional Investors' Earnings Predictions

2011 ◽  
Vol 24 (1) ◽  
pp. 91-107 ◽  
Author(s):  
Terence J. Pitre
Keyword(s):  
Decision Making ◽  
Financial Reporting ◽  
Historical Data ◽  
Seasonal Pattern ◽  
Data Availability ◽  
Financial Reports ◽  
Nonprofessional Investors ◽  
Recency Effects ◽  
Primacy Effects ◽  
Reporting Frequency

ABSTRACT More frequent financial reporting has been a topic of debate for many years. However, little evidence exists about the possible effects of more frequent reporting on investors' decision making. Using a between-subjects experiment, this study analyzes how altering the timing or frequency of earnings reports—weekly, as opposed to quarterly, reports—affects the accuracy and dispersion of earnings predictions by nonprofessional investors. This is important, since regulators have identified nonprofessionals as a significant audience for financial reports. I hypothesize and find that more frequent reporting results in less accurate predictions and greater variance, particularly when a strong seasonal pattern exists. Finally, investors in the more-frequent reporting condition self-reported that they were more influenced by older historical data—suggesting primacy effects—while those in the less-frequent reporting condition self-reported that they were more influenced by the newer historical data, suggesting recency effects. Data Availability: Data are available from the author on request.

Management Reporting on Internal Control and Accruals Quality: Insights from a “Comply-or-Explain” Internal Control Regime

2011 ◽  
Vol 30 (3) ◽  
pp. 181-209 ◽  
Author(s):  
Katrien Van de Poel ◽  
Ann Vanstraelen
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Internal Controls ◽  
Data Availability ◽  
Control Regulation ◽  
Accruals Quality ◽  
Regulatory Regimes ◽  
The Relationship ◽  
Control Regime ◽  
Comply Or Explain

SUMMARY Internal control regulation remains the subject of an ongoing global debate among academics, regulators, and practitioners in terms of costs and effectiveness. This is reflected by different internal control regulations in different countries, resulting in varying management's incentives across regulatory regimes. Prior research, however, has primarily focused on the U.S. rules-based setting to study the relationship between internal control regulation and financial reporting. The purpose of this paper is to study the relationship between internal control reporting and accruals quality in an alternative internal control regime based on the “comply-or-explain principle” in The Netherlands. We show that in this setting accruals quality is not associated with the description of the internal control system, while there is evidence of a positive association with an unaudited statement of effective internal controls. Further, we find that the noncompliance rate of providing a statement of effective internal controls is relatively high, and that companies give generic explanations for noncompliance or no explanation at all. Overall, insights from different internal control regulatory regimes may further advance our knowledge on internal control regulation effectiveness. Data Availability: All data are publicly available.

Cloud-Computing Risk Disclosure and ICFR Material Weakness: The Moderating Role of Accounting Reporting Complexity

2018 ◽  
Vol 33 (3) ◽  
pp. 1-17 ◽  
Author(s):  
Antoinette L. Smith ◽  
Yibo (James) Zhang ◽  
Peter C. Kipp
Keyword(s):  
Cloud Computing ◽  
Financial Reporting ◽  
Significant Risk ◽  
Reporting Quality ◽  
Data Availability ◽  
Risk Disclosure ◽  
Material Weakness ◽  
Computing Services ◽  
Cloud Computing Services ◽  
External Auditor

ABSTRACT Regulators have expressed concerns over management's ability to maintain effective ICFR when adopting cloud-computing services (PCAOB 2015), as well as the auditor's ability to cope with such changes (PCAOB 2015, 2017). Further, the complexity of the client's accounting concepts, proxied by their XBRL taxonomy, could adversely impact financial reporting quality. We investigate the association between a firm's disclosure of cloud-computing risks and its likelihood of disclosing a material weakness, moderated by its level of accounting reporting complexity. We find that, for firms that identify cloud-computing as a significant risk, the external auditor is less likely to issue a material weakness when the firm uses a greater number of customized XBRL tags. We also find that the external auditor is more likely to issue a material weakness for firms that do not identify cloud-computing as a significant risk to their operations when they use a greater number of customized XBRL tags. Data Availability: Data are publicly available from sources identified in the paper.

scholarly journals Audit Partners' Judgments and Challenges in the Audits of Internal Control over Financial Reporting

2020 ◽  
Vol 39 (4) ◽  
pp. 57-85
Author(s):  
Jeffrey R. Cohen ◽  
Jennifer R. Joe ◽  
Jay C. Thibodeau ◽  
Gregory M. Trompeter
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Data Availability ◽  
Audit Committees ◽  
Structured Interviews ◽  
Material Weakness ◽  
The Public ◽  
National Office ◽  
Evaluation Task ◽  
Public Company

SUMMARY Internal control over financial reporting (ICFR) audits have been the subject of intensive examination by the Public Company Accounting Oversight Board (PCAOB) and researchers but the process through which auditors make ICFR judgments is largely a “black box.” To understand ICFR judgments, we conducted semi-structured interviews with 20 audit partners. Common themes in our interviews suggest that the subjectivity inherent in the ICFR evaluation task contributes to resistance against ICFR audit findings and cougnterarguments from management. Moreover, auditors perceive that their judgments are being second-guessed by PCAOB inspectors. Auditors believe that managers have difficulty accepting that material weaknesses can exist without a detected error, that management's reflexive reaction is to deny/avoid a material weakness finding, and managers routinely claim that management review controls (MRCs) would have caught the detected control deficiency. Auditors cope with management's defenses by consulting with their national office and leveraging support from strong audit committees. Data Availability: Requests for the data should be accompanied by a description of intended uses.

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