An Examination of Nonprofessional Investor Perceptions of Internal and External Auditor Assurance

2018 ◽  
Vol 31 (1) ◽  
pp. 65-80 ◽  
Author(s):  
Travis P. Holt
Keyword(s):  
Internal Controls ◽  
Material Weakness ◽  
Internal Auditors ◽  
Material Weaknesses ◽  
External Auditor ◽  
Disclosure Credibility

ABSTRACT This study investigates whether assured disclosures of management's remediation of material weaknesses in internal controls affect positively unsophisticated investor perceptions of disclosure credibility and the likelihood of their investing in a firm. The results indicate that investors perceive assured material weakness remediation disclosures, whether the audit source is external or internal to the firm, to be more credible than unassured disclosures. Specifically, external assurance is seen to be more credible than the assurance provided by internal auditors but that is seen as more credible than no assurance. However, investment likelihood remains the same regardless of assurance source. Furthermore, the results indicate that investor disclosure credibility perceptions and investing likelihood are lower for internally assured pervasive material weakness remediation disclosures than internally assured account-specific remediations and all externally assured remediation disclosures. Finally, mediation results suggest that both internal and external auditor assurance increases investing likelihood indirectly through increased disclosure credibility.

The Effect of Change in the Reporting Threshold and Type of Control Deficiency on Equity Analysts' Evaluation of the Reliability of Future Financial Statements

2012 ◽  
Vol 31 (2) ◽  
pp. 1-17 ◽  
Author(s):  
Stephen K. Asare ◽  
Arnold M. Wright
Keyword(s):  
Financial Statements ◽  
Internal Controls ◽  
Material Weakness ◽  
Equity Analysts ◽  
Material Weaknesses ◽  
Lower Likelihood ◽  
The Future ◽  
Reasonable Possibility ◽  
Level Versus ◽  
Specific Material

SUMMARY We examine the joint effects of reporting threshold (more than remote versus reasonably possible) and type of control deficiency (entity level versus account specific) as described in the adverse report on internal controls on equity analysts' evaluation of the reliability of a company's future financial statements. We hypothesize that equity analysts interpret a “more than remote” threshold to mean a significantly lower likelihood than a “reasonable possibility” threshold. We also hypothesize that when the reporting threshold is more than remote, equity analysts who evaluate an entity level material weakness will indicate a higher likelihood of future material misstatements than those who evaluate an account specific material weakness. However, when the reporting threshold is reasonably possible, equity analysts will assess the same likelihood of future misstatements for both types of material weakness. The results from an experiment that employed 65 equity analysts support our hypotheses. Taken together, the findings suggest that the change to the “reasonably possible” regime has made the account specific material weakness more consequential in evaluating the reliability of the future financial statements but had no effect on the evaluation of entity level material weaknesses.

Material Weakness in Internal Controls and Stock Price Crash Risk

2017 ◽  
Vol 35 (1) ◽  
pp. 106-138 ◽  
Author(s):  
Gerald Lobo ◽  
Chong Wang ◽  
Xiaoou Yu ◽  
Yuping Zhao
Keyword(s):  
Financial Reporting ◽  
Stock Price ◽  
Positive Association ◽  
Internal Controls ◽  
Crash Risk ◽  
Significant Relation ◽  
Material Weakness ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
Section 302

We investigate the association between material weakness in internal controls (MW) disclosed under Section 302 of the Sarbanes–Oxley Act of 2002 (SOX) and future stock price crash risk. We argue that relative to firms with effective internal controls, firms with MW have lower financial reporting precision. The lower reporting precision (a) increases divergence of investor opinion with regard to firm valuation and (b) facilitates managers’ withholding of negative information, which increases the information asymmetry between managers and outside investors. We hypothesize that both these effects increase the probability of a future stock price crash. We find empirical evidence consistent with our prediction. In additional analyses, we document that the positive association between MW and crash risk is primarily driven by company level rather than by account-specific weaknesses, increases with the number of material weaknesses, and intensifies during the financial crisis. In addition, we find that both the existence and the disclosure of MW incrementally affect crash risk, and that MW facilitates managers’ withholding of bad news. Finally, we fail to find consistent evidence of a significant relation between MW disclosed under Section 404 of SOX and crash risk.

Accruals Quality and Internal Control over Financial Reporting

2007 ◽  
Vol 82 (5) ◽  
pp. 1141-1170 ◽  
Author(s):  
Jeffrey T. Doyle ◽  
Weili Ge ◽  
Sarah McVay
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Discretionary Accruals ◽  
Cash Flows ◽  
Internal Controls ◽  
Earnings Persistence ◽  
Firm Characteristics ◽  
Material Weakness ◽  
Material Weaknesses ◽  
Accruals Quality

We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to “audit around.” We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

Effects of reporting relationship and type of internal control deficiency on internal auditors’ internal control evaluations

2018 ◽  
Vol 33 (3) ◽  
pp. 318-335 ◽  
Author(s):  
Audrey Gramling ◽  
Arnold Schneider
Keyword(s):  
Internal Control ◽  
Audit Committee ◽  
Internal Audit ◽  
Internal Controls ◽  
Material Weakness ◽  
Content Type ◽  
Internal Auditors ◽  
Tone At The Top ◽  
Internal Audit Function ◽  
Professional Guidance

Purpose This paper aims to explore whether an internal auditor’s evaluation of internal control deficiencies are influenced by the party with primary influence over the internal audit function and by the type of internal control deficiency. Design/methodology/approach A behavioral experiment is conducted with internal auditors as participants in a 2 × 2 between-subjects factorial design. Findings Results indicate that internal auditors are less likely to evaluate a pervasive control deficiency related to “tone at the top” as a material weakness than a process-specific control deficiency. Furthermore, internal auditors are somewhat less likely to evaluate a process-specific internal control deficiency as a material weakness when management has primary influence over the internal audit function than when the audit committee has primary influence. It is also found that the best practice of internal audit oversight (i.e., primary oversight of internal auditors by the audit committee) may lead to potential internal under-reporting of instances where the audit committee represents a material weakness in internal control. Research limitations/implications Limitations of this research include lack of economic consequences (e.g. future pay and job loss) associated with the internal control decisions made by the participants; less concise information provided to the participants than would generally be available to them; and lack of generalizability of the findings beyond the specific company setting and internal control scenario portrayed in the case materials. Practical implications Not evaluating a pervasive control deficiency related to “tone at the top” as a material weakness seems to not fully align with relevant professional guidance and can possibly result in inaccurate internal information about the quality of internal controls. Furthermore, having an internal auditor’s evaluation of a process-specific internal control deficiency influenced by the party with primary influence over the internal audit function would not appear to align with relevant professional guidance. Finally, primary oversight by the audit committee of the internal auditors may lead to potential internal under-reporting of instances where the audit committee represents a material weakness in internal controls and, thus, possible communication of inaccurate internal control information. Originality/value This study is the first to address whether the party with primary influence over the internal audit function influences an internal auditor’s evaluation of internal control deficiencies.

scholarly journals Is PCAOB Standard No. 5 Impairing Auditor Objectivity?

2015 ◽  
Vol 9 (2) ◽  
pp. C1-C7 ◽  
Author(s):  
Richard G. Brody ◽  
Christine M. Haynes ◽  
Craig G. White
Keyword(s):  
Financial Reporting ◽  
Internal Controls ◽  
Internal Auditors ◽  
External Auditors ◽  
Sarbanes Oxley ◽  
Audit Efficiency ◽  
Client Relationships ◽  
External Auditor ◽  
The Impact ◽  
Audit Effectiveness

SUMMARY Auditing Standard No. 5 (AS5) urges external auditors to rely on the work of internal auditors when auditing internal controls over financial reporting. Although relying on the work of internal auditors may enhance audit efficiency, this paper examines whether such reliance is achieved at the expense of audit effectiveness. Specifically, this commentary questions whether conformity with AS5 is advisable given that changes in auditor/client relationships may have impacted internal and external auditor objectivity. Research has demonstrated that since the implementation of the Sarbanes-Oxley Act of 2002 external auditor objectivity has improved, ostensibly due to a reduced conflict of interest between external auditors and their clients. Although this result has positive implications for relying on the work of internal auditors, research also shows that internal auditors' objectivity has not improved over time. Thus, in complying with AS5, external auditors may be incorporating internal auditors' biases into their own judgments. The impact and implications of this problem are discussed.

Does Audit Quality Influence the Relation between Earnings Management and Internal Control Weakness in the Post –SOX Period

2013 ◽  
Vol 2 (2) ◽  
pp. 70-100
Author(s):  
Judith van Ravenstein ◽  
Georgios Georgakopoulos ◽  
Petros Kalantonis ◽  
Panagiotis Kaldis
Keyword(s):  
Earnings Management ◽  
Internal Control ◽  
Audit Quality ◽  
Discretionary Accruals ◽  
Internal Controls ◽  
Material Weakness ◽  
Material Weaknesses ◽  
Internal Control System ◽  
A Company ◽  
Big Four

Material weaknesses in the internal control system of a company create more opportunities for managers to engage in opportunistic earnings management. In this study the authors investigate the relation between earnings management and disclosed material weaknesses in the internal controls, both under SOX 302 and SOX 404, and examine whether audit quality, measured as being audited by a Big Four auditor, has an effect on that relation. The results suggest that material weakness firms have more absolute discretionary accruals and greater income-decreasing discretionary accruals. So evidence is provided that material weakness firms engage in more earnings management, however not in opportunistic income-increasing earnings management. When audit quality is high, measured as being audited by a Big Four auditor, the disclosed material weaknesses are lower just as total and absolute discretionary accruals are. It is also interesting in our findings that when material weakness firms are audited by a Big Four auditor a positive relationship seems to exist with discretionary accruals, suggesting that when a firm is audited by a Big Four auditor, material weaknesses in the internal controls will lead to opportunistic earnings management.

The Severity of Internal Controls over Financial Reporting Deficiencies: Differences among Types and Industries

2014 ◽  
pp. 55-77
Author(s):  
Tatiana Mazza ◽  
Stefano Azzali
Keyword(s):  
Information Technology ◽  
Financial Reporting ◽  
Internal Control ◽  
Service Industry ◽  
Listed Companies ◽  
Internal Controls ◽  
Service Companies ◽  
Finance Industry ◽  
Material Weaknesses ◽  
Fixed Assets

This study analyzes the severity of Internal Control over Financial Reporting deficiencies (Deficiencies, Significant Deficiencies and Material Weaknesses) in a sample of Italian listed companies, in the period 2007- 2012. Using proprietary data the severity of the deficiencies is tested for account-specific, entity level and information technology controls and for industries (manufacturing and services vs finance industries). The results on ICD severity is compared with one of the most frequent ICD (Acc_Period End/Accounting Policies): for account-specific, ICD in revenues, purchase, fixed assets and intangible, loans and insurance are more severe while ICD in Inventory are less severe. Differences in ICD severity have been found in the characteristic account: ICD in loan and insurance for finance industry and ICD in revenue, purchase for manufacturing and service industry are more severe. Finally, we found that ICD in entity level and information technology controls are less severe than account specific ICD in all industries. However, the results on entity level and information technology deficiencies could also mean that the importance of these types of control are under-evaluated by the manufacturing and service companies.

Real Earnings Management before and after Reporting SOX 404 Material Weaknesses

2015 ◽  
Vol 30 (1) ◽  
pp. 119-141 ◽  
Author(s):  
Tuukka Järvinen ◽  
Emma-Riikka Myllymäki
Keyword(s):  
Earnings Management ◽  
Internal Control ◽  
Internal Controls ◽  
Real Earnings Management ◽  
Public Disclosure ◽  
High Quality ◽  
The Public ◽  
Material Weaknesses ◽  
Internal Control System ◽  
Before And After

SYNOPSIS The purpose of this study is to investigate whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The empirical findings indicate that, compared to companies with effective internal controls, companies with existing material weaknesses in their internal controls engage in more manipulation of real activities (particularly inventory overproduction). This implies that the weak commitment by management to provide effective internal control system and high-quality financial information relates to a tendency to use real earnings management methods. Moreover, we find evidence suggesting that companies employ real earnings management (overproduction and reduction of discretionary expenses) after disclosing previous year's material weaknesses. We conjecture that the public disclosure of material weaknesses induces management to strive to mitigate the expected negative reactions of stakeholders to the disclosure by engaging in real earnings management, which is not easily detected or constrained by outsiders. Overall, this study suggests that material weaknesses in internal controls signal an environment where management is more inclined to employ real earnings management.

External Auditors' Involvement in the Internal Audit Function's Work Plan and Subsequent Reliance Before and After a Negative Audit Discovery

2016 ◽  
Vol 35 (4) ◽  
pp. 159-173 ◽  
Author(s):  
Byron J. Pike ◽  
Lawrence Chui ◽  
Kasey A. Martin ◽  
Renee M. Olvera
Keyword(s):  
Internal Control ◽  
Internal Audit ◽  
Internal Controls ◽  
Professional Standards ◽  
Data Availability ◽  
Internal Auditors ◽  
External Auditors ◽  
Internal Audit Function ◽  
Anchoring Bias ◽  
Before And After

SUMMARY To reduce redundancies and increase efficiency in the evaluation of internal controls (PCAOB 2007, 402–403), professional standards encourage coordination between external auditors and their clients' internal audit function (IAF). Recent surveys of internal auditors find that a component of this coordination is external auditors' involvement in developing the IAF's audit plans. Nevertheless, it is not known how such involvement affects external auditors' reliance on the internal control test work of the IAF, either before or after a negative audit discovery. Based on an experiment with 107 experienced auditors, we find that external auditors involved in the development of the IAF's audit plan perceive the IAF as more objective and that both objectivity and involvement contribute to these auditors' placing more reliance on the IAF as compared to external auditors with no involvement. This initial reliance results in the involved auditors' proposing reductions to the audit budget and re-performing less of the IAF's work. Consistent with an anchoring bias, we find that involvement leads to external auditors' continuing to place greater reliance on the IAF's work, even after they become aware of a negative audit discovery that should not have occurred had the client's controls been effective. Data Availability: Data are available from the authors on request.

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