This study makes important contributions regarding management’s disclosure of material weakness deficiencies. Currently, only audit-related risks are required to be addressed in material weakness deficiency disclosures. However, this study indicates that nonprofessional investors also take non-audit-related risks into consideration when making a financial reporting risk assessment. Managers do have the discretion to provide information about non-related audit risks through nonaudited disclosures. The authors suggest that in doing so managers can mitigate investors’ negative reaction the material weakness from lack of communication.

Asare, S. K., and A. M. Wright. 2017. Inferring Remediation and Operational Risk from Material Weakness Disclosures. Behavioral Research In Accounting. 

Material weakness disclosures, entity-level and account-specific, have a negative impact on nonprofessional investors financial reporting risk assessments. The authors define financial reporting risk as “an investor’s exposure to loss as a result of relying on audited financial reports generated from an ineffective ICOFR” for the purpose of the study. Prior studies have indicated that nonprofessional investors assess a higher financial reporting risk for entity-level material weakness disclosures compared to account-specific. Broadly, the primary purpose of this study is to examine audit-related and non-audit-related risks in explaining the relationship between the type of material weakness and the investor financial reporting risk assessment. The audit-related risks are as follows:

• Information risk is the pre-audit potential for financial misstatements due to the material weakness.
• Verification risk is the auditor’s ability to audit around the material weakness.

The non-audit-related risks are as follows:

• Remediation risk is management’s ability to remediate the weakness.
• Operational risk is management’s loss of operational effectiveness do to the material weakness.

Special attention in this paper is given to the relational effects between non-audit-related risks resulting from material weakness disclosures and nonprofessional investors financial reporting risk assessment.

The 181 participants in the study were all nonprofessional investors. Each participant received the following from a hypothetical company: general financial information, an audit report, and an adverse opinion on ICOFR, either on an entity-level or account-specific material weakness. Then participants were asked to evaluate the investment’s attractiveness and respond to several questions involving audit-related and non-audit-related risks. The authors used mediation analysis to evaluate the results. 

The authors find the following:

• The type of material weakness has a direct effect on information, verification, remediation, and operational risks. Nonprofessional investors consider entity-level material weaknesses as presenting higher audit-related and non-audit related risks compared to account-specific material weaknesses.
• Subsequently, these higher audit-related and non-audit related risks directly cause the nonprofessional investor’s assessment of financial reporting risk to increase.
• Thus, non-audit-related risks from material weaknesses do in fact have an impact on a nonprofessional investor’s financial reporting risk assessment.

http://commons.aaahq.org/groups/e5075f0eec/summary

This study provides empirical evidence that suggests that auditor ratification vote tallies are informative to the market. First, higher auditor ratification disapproval is associated with a more negative stock market reaction to the announcement of the vote tallies, consistent with the argument that this reflects negative investor perception of the auditor. Second, the authors provide evidence that the market reacts positively to an auditor change when there is high shareholder disapproval, and that audit and auditor characteristics moderate or exacerbate the market reaction in a way that suggests the market finds the ratification vote informative, but does not fully price it. 

Tanyi, P. N. and K. C. Roland. 2017. Market Reaction to Auditor Ratification Vote Tally. Accounting Horizons 31 (1): 141 – 157. 

In light of recent calls to mandate shareholder voting on auditor ratification, this paper illustrates that the ratification vote provides new information to investors. The push to mandate shareholder ratification is supported by many and is largely driven by concerns that most audit committees simply “rubber stamp” management’s recommendation of the auditor. Given that shareholder ratification votes are generally overwhelmingly in favor of the auditor, non-binding, and voluntary, the authors ask whether the market finds any new information in the ratification vote. The authors examine whether the proportion of votes against or abstaining from the appointment of the auditor has capital market consequences. They also examine whether the proportion of non-supporting votes affects how the market reacts to auditor dismissal. 

The authors use a sample of firm-year observations with auditor ratification votes over the period of 2010 to 2015. 

• The authors find higher shareholder disapproval of the auditor is associated with a negative market reaction to the voting outcome announcement; furthermore, they find evidence that this reaction is exacerbated by known auditor or audit-related characteristics and corporate governance measures that are suggestive of high auditor quality, indicating that the market is surprised by the shareholder disapproval.
• The authors find that the market reacts less negatively to high shareholder disapproval for clients with high non-audit fee ratios, longer auditor tenure, and accounting restatements, indicating that the market is already aware of audit independence or audit quality issues.
• The authors find that the market responds more positively to a subsequent auditor dismissal when the proportion of shareholder votes against or abstaining from the auditor’s appointment is higher. 

www.auditingresearchsummaries.org

This study provides direct testing of the effects of two forms of CEO social influence pressure on actual CFO’s reporting decisions. Examining such pressures improves the overall understanding of an individual’s decision to engage in dysfunctional behavior, which can inform auditors and audit committee members who provide oversight of the financial reporting process and have responsibility for mitigating the risk of financial misreporting. 

Bishop, C. C., F. T. DeZoort and D. R. Hermanson. 2017. The Effect of CEO Social Influence Pressure and CFO Accounting Experience on CFO Financial Reporting Decisions. Auditing: A Journal of Practice and Theory 36 (1): 21 – 41.

CFOs play critical stewardship roles related to financial reporting quality and a prominent and increasing role in accounting manipulations, particularly in conjunction with their CEO. This study examines how CEO pressure on the CFO and CFO accounting experience influence public company CFOs’ financial reporting judgments and decisions. 

The authors conducted an experiment involving a hypothetical CFO’s earnings manipulation decision. Using a between-subjects manipulation, they utilize three levels of CEO pressure (a control group where the CEO does not pressure the CFO, a compliance pressure group where the CEO asks the CFO to revise an estimate, and an obedience pressure group where the CEO tells the CFO to revise an estimate). 

• The authors find that two different forms of CEO social influence pressure (obedience pressure and compliance pressure) are both effective in motivating some CFOs to misreport, with no significant difference between the two.
• The authors find that the CFOs do not abdicate the financial reporting responsibility under pressure, despite predictions from the obedience theory; instead, the CFOs acknowledge that they still have ultimate responsibility.
• The authors find an inverse relation between CFO accounting experience and revision of the initial adjustment, consistent with accounting experience empowering CFO resistance to pressure. 

www.auditingresearchsummaries.org

This study provides evidence that reporting openness can have the unintended effect of increasing collusion.  Recognizing that reporting openness can have a downside can help executives make more informed decisions when considering how much organizational openness they want. Furthermore, this study demonstrates that, despite increasing trust and reciprocity among managers, open internal reporting can potentially result in more managerial collusion because openness fosters greater “honor among thieves.”

Evans III, J. H., D. V. Moser, A. H. Newman, and B. R. Stikeleather. 2016. Honor Among Thieves: Open Internal Reporting and Managerial Collusion. Contemporary Accounting Research 33 (4): 1375-1402.

The authors examine whether open internal reporting, in which a manager observes another manager’s communications with senior executives, increases collusion between the managers. Open internal reporting environments certainly have benefits, but they can also expose firms to collusion, which is a significant control problem for firms. For this reason, documenting how open internal reporting affects managers’ collusion is important because the related insight can help top executives decide how much internal reporting openness they want in their firm. 

The authors use an experiment to examine the effect of reporting openness of misreporting and collusion because an experiment allows them to control the managers’ economic incentives and also to isolate the effect of social norms on managers’ behavior.           

• The authors find that agreements to collude lead to more misreporting in the open than in the closed reporting condition.
• The authors find that individual managers were more than twice as likely to honor their agreements to misreport in the open condition, and pairs of managers colluded successfully nearly five times as often in the open condition.
• The authors find that open internal reporting facilitated managers’ collusion, which significantly lowered firm welfare in the open reporting condition. 

www.auditingresearchsummaries.org

The results of this study suggest that, while both types of incentive schemes are effective in promoting whistle-blowing behavior in the absence of close working relationships, the effectiveness of a rewarding incentive scheme is more likely to be undermined by the presence of close working relationships than a penalizing incentive scheme. 

Boo, E., T. B. Ng, and P. G. Shankar. 2016. Effects of Incentive Scheme and Working Relationship on Whistle-Blowing in an Audit Setting. Auditing: A Journal of Practice and Theory 35 (4): 23 – 38. 

Prior research shows that providing an incentive, either in the form of a reward or a penalty, can help promote whistle-blowing behavior. Other studies show that close relationships between employees can exert a negative impact on whistle-blowing behavior. An important yet unanswered question is whether and to what extent the effectiveness of different types of incentive schemes to promote whistle-blowing could be undermined by the presence of close working relationships likely to be forged among team members in audit firms and other organizations. Furthermore, the current incentive system in the auditing profession is dominated by penalties; however, many are calling for a shift toward incorporating more ways to reward auditors rather than penalize them, suggesting the importance of understanding the implications of alternative incentive systems. Also, there has not been much research done on the effectiveness of punitive schemes, despite their prevalence in the profession. Finally, whistle-blowing has been found to be a significant means by which frauds and other forms of misconduct are detected, which suggests the crucial importance of understanding factors that could enhance or undermine its effectiveness. 

The authors conduct an experiment involving 90 auditors from a Big 4 firm in Singapore. The participants are presented with a hypothetical scenario in which an audit manager encountered a wrongdoing by the engagement partner who allowed the client to materially misstate sales revenue, and assess their propensity to report the act through the firm’s whistle-blowing hotline after making no headway despite having voiced concerns to the partner. 

• The authors find that a rewarding incentive scheme, relative to the control group, increases auditors’ whistle-blowing propensity in the absence, but not in the presence, of a close working relationship.
• The authors find that a penalizing incentive scheme increases auditors’ whistle-blowing propensity regardless of the presence of a close working relationship.
• The authors find that auditors’ whistle blowing propensity is reduced by the presence of a close working relationship in the rewarding incentive scheme, but not in the penalizing incentive scheme or the control group. 

www.auditingresearchsummaries.org