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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 
    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.


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

    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. 


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