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    Material Control Weakness Corrections: The Enduring Effects...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses 
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    Title:
    Material Control Weakness Corrections: The Enduring Effects of Trust in Management
    Practical Implications:

    Overall, the authors’ findings indicate that variations in the detail of disclosures of material control weaknesses alter trust in management, and these changes in trust have lasting implications for investors’ perceptions of risk associated with the disclosing firm.  

    Citation:

    Rose, A. M., J. M. Rose, and C. S. Norman. 2016. Material Control Weakness Corrections: The Enduring Effects of Trust Management. Behavioral Research in Accounting 28 (2): 41 – 53. 

    Keywords:
    control weakness, disclosure detail, investment risk, remediation, and trust.
    Purpose of the Study:

    Previous research has shown that trust is a key driver in the association between material weakness in internal control disclosures and perceptions of investment risk. If this is the case, the authors expect the effects of material weakness disclosures to persist as long as their effects on trust endure. In other words, when trust in management’s ability and intention to promote quality financial reporting is gained or lost, the changes in trust will influence the interpretation of evidence regarding management’s oversight of financial reporting activities, including correction of material control weaknesses. This paper specifically examines the effects of the remediation of material control weaknesses on investors’ risk assessments.  By studying investor judgment in a controlled laboratory setting, the authors examine how the content of control weakness disclosures can be expected to influence equity market responses to future control weakness corrections. 

    Design/Method/ Approach:

     The authors study investor judgment in a controlled laboratory setting. They also replicate a previous experiment completed by others, with new control weaknesses, to verify the generalizability of their results and extend their study to examine the effects of disclosure detail and control weakness pervasiveness on investor decisions made after remediation of control weaknesses. 

    Findings:
    • The authors find that when material weakness disclosures have specific and detailed discussion of the pervasiveness of the weaknesses, investors increase assessments of investment risk for less pervasive weaknesses and decrease assessments of risk for more pervasive weaknesses.
    • The authors find that providing detailed explanations that a control weakness is isolated increases risk assessments relative to not providing a detailed explanation; conversely, offering a detailed explanation that a weakness is very pervasive decreases assessments of investment risk relative to not offering a detailed explanation.
    • The authors find that the interactive effects of control weakness pervasiveness and explanation detail on risk assessments endure after remediation of control weaknesses, indicating that trust in management continues to influence risk assessments after control weaknesses are corrected. 
    Category:
    Internal Control
    Sub-category:
    Reporting Material Weaknesses