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    Inferring Remediation and Operational Risk from Material...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 14.0 Corporate Matters 
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    Title:
    Inferring Remediation and Operational Risk from Material Weakness Disclosures
    Practical Implications:

    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.

    Citation:

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

    Keywords:
    material weakness; financial reporting risk; mediation analysis; investors’ judgments
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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. 

    Findings:

    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.
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
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