Does the Format of Internal Control Disclosures Matter? An Experimental Investigation of Nonprofessional Investor Behavior

Abstract

We investigate whether the format of internal control weakness (ICW) disclosures required by the Sarbanes-Oxley Act of 2002 influences perceptions of nonprofessional investors. Using a 2 x 2 between-participants experiment, we examine two facets of ICW disclosure formats: ICW presentation salience (high versus low) and ICW disaggregation type (disaggregated versus aggregated). We hypothesize and find evidence of an interactive effect between presentation salience and disaggregation type, such that investors perceive ICWs as less negative when they are saliently disclosed and this effect is enhanced when the material weakness is disaggregated into its individual control deficiencies. We also find evidence of moderated mediation such that high salience of ICW disclosures has a positive indirect effect on investing judgments through management trust, but only when the ICW is disaggregated into its individual control deficiencies.

The impact of tone management on investor judgments: evidence from ICFR reports

“…This study contributes to ICFR research and directly extends the work of Rose et al (2010) and Tadesse and Murthy (2021). In contrast to their findings that more detail describing a pervasive internal control error improves investor perceptions of a company, these results suggest that investors do not treat all ICFR details the same and that adding details about an internal control error that are negative in tone can hurt investors’ perceptions of a company.…”

“…A structural equation model (SEM) analysis using SPSS AMOS is used to test this prediction. The model in this study is similar in nature to the SEM models developed in Rose et al (2010) and Tadesse and Murthy (2021), which test for a mediator variable between their ICFR report manipulation variable and their investment desirability variable. Figure 2 shows the model tested.…”

“…Rose et al (2010) find that investors react more positively to a more pervasive internal control error when management provides more detail, as opposed to less detail, concerning the error in the ICFR report. Tadesse and Murthy (2021) add to the work of Rose et al (2010) and find that investors react more positively when additional details in the ICFR report are disclosed with more transparency. However, neither of these studies examines the role of the tone of the details in ICFR reports on investor perceptions.…”

“…Rose et al (2010) find that management can improve investors’ perception of the company when they provide more, rather than less, detail to describe a pervasive material weakness in ICFR. Similarly, Tadesse and Murthy (2021) find disclosing a material weakness in a disaggregated format (i.e. presenting the individual parts of the weakness) rather than an aggregated format in the ICFR report increases investors perception of the company because the disaggregation increases investors’ perceptions of management transparency.…”

“…presenting the individual parts of the weakness) rather than an aggregated format in the ICFR report increases investors perception of the company because the disaggregation increases investors’ perceptions of management transparency. The results from both Rose et al (2010) and Tadesse and Murthy (2021) suggest that providing additional details concerning the classification of internal control errors (i.e. control deficiency, significant deficiency) that are involved in a pervasive material weakness should improve investors’ perceptions of the company over not providing those additional details.…”