Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    The Effect of Change in the Reporting Threshold and Type of...
    research summary posted November 5, 2014 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses 
    51 Views
    Title:
    The Effect of Change in the Reporting Threshold and Type of Control Deficiency on Equity Analysts’ Evaluation of the Reliability of Future Financial Statements
    Practical Implications:

    Taken together, the findings suggest that the change to the “reasonably possible” regime has made an account specific material weakness more consequential in evaluating the reliability of the future financial statements but has no effect on the evaluation of entity level material weaknesses. Even though the phrase “more than remote” necessarily includes “reasonably possible”, equity analysts interpret the former term as significantly less likely than the latter term. Standard setters, audit firms and other stakeholders should take this behavioral phenomenon into account when setting, implementing or evaluating standards that use such reporting thresholds.

     

    For more information on this study, please contact Stephen K. Asare.

    Citation:

    Asare, S. and A. Wright. 2012. The Effect of Change in the Reporting Threshold and Type of Control Deficiency on Equity Analysts’ Evaluation of the Reliability of Future Financial Statements. Auditing: A Journal of Practice & Theory (May): 1-17.  

    Keywords:
    adverse control reports; reporting thresholds; type of control deficiencies; early warning signal; users’ likelihood assessments.
    Purpose of the Study:

    The adverse report on a company’s internal controls describes the likelihood (i.e., the reporting threshold) that a material misstatement of the annual or interim financial statements will not be prevented or detected. PCAOB Auditing Standard No. 5 changed the reporting threshold to ‘‘reasonably possible,’’ from ‘‘more than remote,’’ which was used in the previous Auditing Standard No. 2. However, as a definitional matter, the reporting thresholds were intended by the PCAOB to be equivalent. The purpose of the study was to examine whether this change in reporting threshold affected equity analysts’ evaluation of the reliability of a company's future financial statements and, if so, whether the effect depended on the nature of the control deficiency (i.e., whether it was entity-level or account specific). 

    Design/Method/ Approach:

    The authors obtained data from an experiment conducted in 2010 in which 65 equity analysts assessed the likelihood they attached to the reporting threshold described in the adverse ICOFR report as well as the likelihood of material misstatements in the forthcoming year (i.e., the reliability of the future financial reports) of a hypothetical client. Each equity analyst worked on only one of the four cases that the authors created by varying the reporting threshold (more than remote versus reasonably possible) and deficiency type (entity level versus account specific). The background information and audit report on the hypothetical client’s current financial statements was unqualified in all four cases. Thus, except for the variations in the reporting threshold and deficiency type, the equity analysts evaluated identical clients.

    Findings:

    The study finds that the equity analysts interpret the “more than remote” threshold as a significantly lower likelihood than a "reasonable possibility” threshold. When the reporting threshold is reasonably possible, analysts assess the same likelihood of future misstatements for both types of material weakness, therefore, not distinguishing the severity of these two types of weaknesses.  However, when the reporting threshold is more than remote, the prior requirement under PCAOB AS 2, equity analysts in the entity level condition indicate a relatively higher likelihood of material misstatement for the forthcoming year than those in the account specific condition. 

    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses