The Impact of Section 302 and 404(b) Internal Control Disclosures on Prospective Investors' Judgments and Decisions: An Experimental Study

Abstract

This paper reports the results of an experiment designed to investigate participants' reaction to quarterly and annual internal control disclosures. Quarterly disclosures include managers' disclosure of no control deficiencies, a significant deficiency, or a material weakness. Annual disclosures include the auditors' opinion on internal control, which either affirms managers' earlier disclosure or reveals new information. We find that participants react negatively to the disclosure of a material weakness, as might be expected. Participants invest less in a target company when internal control is ineffective rather than effective. By comparison, participants do not react negatively to the disclosure of a significant deficiency. Indeed, we find that they react positively to such disclosure accompanied by a clean (unqualified) audit opinion on internal control. Subsequent analyses indicate that participants' investment decisions are affected by their assessments of the reliability of financial statements and the credibility of management.

Internal control effectiveness, textual risk disclosure, and their usefulness: U.S. evidence

“…This evidence adds to previous research on the usefulness of ICW reported by the external auditor to the capital markets (e.g., Dowdell et al, 2013;Gupta et al, 2018). It also accords with the experimental results of Lopez et al (2009) and Church and Schneider (2016) about the valuerelevance of ICW reporting and complements the findings of Clinton et al (2014) that illustrate that analysts' coverage declines following ICW reporting. Market liquidity results are in line with the findings of Campbell et al (2014) about the impact of aggregate risk disclosure on bid-ask spread.…”

“…Second, the ways in which the internal control system or external auditor's opinion under SOX 404(b) may help managers to increase the level and improve usefulness of their TRD should be of particular interest to regulators (e.g., AICPA; SEC; PCAOB) when assessing the related regulations. Third, our results extend the evidence provided by Clinton et al (2014) regarding the negative implications of ICW for financial analysts and provide external validity and generalization to the experimental evidence on the informativeness of ICW reporting (Lopez, Vandervelde, & Wu, 2009;Church & Schneider, 2016).…”

Internal control quality, voluntary disclosure, and cost of equity capital: The case of an unregulated market

“…Gao and Jia () documented that internal control weaknesses are associated with higher firms' cost of raising equity capital, suggesting that underwriters charge a risk premium on internal control weaknesses issuers. Similarly, Church and Schneider () investigated the effect of internal control disclosures on an individual's willingness to invest in a target company and documented that survey participants react negatively to the disclosure of a material weakness and reduce the level of the planned investment in a target company when internal control is ineffective rather than effective.…”

Investor reactions to restatements conditional on disclosure of internal control weaknesses

“…Those studies suggest that internal control weakness is associated with greater cost of capital. Furthermore, the experimental study by Church and Schneider (2016) reports that prospective investors react negatively to material weaknesses of internal control system.…”