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Managerial Auditing Journalmerald Article: Auditors' internal control opinions: do they influence

udgments about investments?

rnold Schneider

rticle information:

o cite this document: Arnold Schneider, (2009),"Auditors' internal control opinions: do they influence judgments about

vestments?", Managerial Auditing Journal, Vol. 24 Iss: 8 pp. 709 - 723

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Auditors internal controlopinions: do they influence

judgments about investments?Arnold Schneider

College of Management, Georgia Institute of Technology,Atlanta, Georgia, USA

Abstract

Purpose The purpose of this paper is to examine the impact of internal control opinionson individuals judgments about investments.

Design/methodology/approach The approach used is a behavioral experiment whererisk assessments and judgments about investments are made for four internal control opinionscenarios.

Findings The results indicate that the type of internal control opinion made no difference for eitherrisk assessments or investment decisions.

Research limitations/implications Participants are provided with data sets that do not containall of the information they may acquire when they make actual investment decisions. Also, there is alack of real consequences for making good or poor investment decisions.

Practical implications The type of internal control opinion has no effect on risk assessments or

investing intentions. Thus, other considerations apparently dominate internal control opinions whenmaking judgments about investments.

Originality/value This is the first paper to examine whether intentions to invest might be affectedby internal control opinions.

Keywords Internal control, Auditing, Investments

Paper type Research paper

IntroductionOver the years, there have been calls for auditors to attest to clients internal controleffectiveness in order to deter the incidence of management fraud (CohenCommission, 1978; Public Oversight Board, 1993). The American Institute ofCertified Public Accountants AICPA (1993) provided guidance to auditorsengaged to examine and report on a clients internal controls. Some companiesindeed have voluntarily provided internal control reports attested to by auditors.

Prior to the Sarbanes-Oxley (SOX) Act of 2002, internal control disclosures wererequired only in 8-K filings when companies announced a change in auditors(Securities and Exchange Commission SEC, 1988). For public companies, the SOXlegislation has now made internal control reporting with auditor attestationmandatory in annual reports.

Section 404 of SOX requires public companies to make an assessment of theeffectiveness of internal controls for financial reporting. Furthermore, the companysauditor now attests to the effectiveness of the internal controls as part of the auditengagement. The Public Company Accounting Oversight Board PCAOB (2004, 2005)ruled, in Auditing Standard No. 2, that to comply with Section 404, the companys

The current issue and full text archive of this journal is available atwww.emeraldinsight.com/0268-6902.htm

Auditorsinternal control

opinions

709

Received 5 November 2008Revised 9 May 2009

Accepted 31 May 2009

Managerial Auditing JournalVol. 24 No. 8, 2009

pp. 709-723q Emerald Group Publishing Limited

0268-6902DOI 10.1108/02686900910986376


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auditor must issue two opinions: one on managements process for making its internalcontrol assessment and the other on the effectiveness of the companys internalcontrols. PCAOB (2007) eliminated the requirement for the first of these two opinionswhen it issued Auditing Standard No. 5, which superseded Auditing Standard No. 2.Hence, auditors now only need to opine on the effectiveness of the companys internalcontrols. This paper examines the impact of this internal control opinion onindividuals judgments about investments.

The need for a report on the effectiveness of internal controls, attested to by theauditor, is questionable. Auditors are required to obtain an understanding of the clientsinternal controls to properly plan and conduct their audits of financial statements.In turn, audit programs take intoaccount thedesignof internal controls and theauditorsplanned reliance on such controls. If internal control weaknesses are identified, auditprograms are modifiedaccordingly substantive tests are increased. Theauditors taskis to accumulate sufficient evidence, by whatever means necessary, to providea basis foran opinion on the fairness of the financial statements. Auditors can issue unqualifiedopinions on financial statements even if a company has material weaknesses in internalcontrols. The auditors report provides reasonable assurance for the financialstatements, regardless of the companys internal control effectiveness. Thus, thereliability of audited financial statements, in terms of assurance, should not be affectedby the auditors opinion on internal controls.

On the other hand, regulators contend that increased scrutiny of control systems isnecessary because control weaknesses are at the heart of large-scale fraudulent financialreporting, e.g. Enron, WorldCom, Lucent, and HealthSouth, to name a few. The KPMG

(2003) fraud surveys also consistently identify inadequate internal controls as a factorthat contributes to the occurrence of fraud. Proponents of Section 404 argue that thereporting requirements will enhance internal control systems, e.g. control weaknesseswill be identified and remedied sooner and ongoing management involvement will resultin improved control systems (Rittenberg and Miller, 2005). Regulators assert that byrequiring internal control disclosures, the reliability of audited financial statements canbe improved the overall financial-reporting system can be strengthened and usersperceptions enhanced. Nicolaisen (2004), as a Chief Accountant of the SEC, remarkedthat being able to represent that an appropriate control system is in place strengthenspublic confidence and encourages investment in our nations industries. Thesearguments suggest that even when auditors issue unqualified opinions on financialstatements, adverse opinions on internal controls may signal that although currentfinancial statements are fairly presented, these statementsare less reliable for predictingfuture financial performance. In addition, adverse internal control opinions may signal

that the underlyingfuture operations of the firm are at greater risk because of the lack ofinternal controls.

Because of the reasons for and against the relevance of internal control opinionswhen auditors issue unqualified opinions on financial statements, it is unclear howinvestors should react when the auditor expresses an adverse opinion or discalimer ofopinion on internal controls and a clean opinion on financial statements. Some archivalstudies have examined the effect of internal control disclosures on stock prices, withmost of them finding negative market reactions to the reporting of material weaknesses(Whisenant et al., 2003; de Franco et al., 2005; Cheng et al., 2007; Ashbaugh-Skaife et al.,2008; Hammersley et al., 2008).

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The current study focuses on individuals judgments about investments rather thana market-oriented approach. Individual investors are important for three reasons:

(1) this portion of the investment community is significant and potentially impactsstock prices (DeLong et al., 1991);

(2) the SEC is concerned with the welfare effects of individual investors; and

(3) an understanding of individual investor decision making is needed to developtheoretical models of investment markets (Daniel et al., 1998).

This study uses an experimental approach to investigate the effects of auditors internal

control opinions on individuals judgments about investments. The use of anexperimental approach allows one to completely control the information available toparticipants. The study is able to control for factors that can cause confounding inarchival studies, including concurrent information disclosure, firm-specificcharacteristics, and self-selection. Archival studies (Doyle e t a l., 2007b;Ashbaugh-Skaife et al., 2007) have found that most internal control weaknessdisclosures are announced by weaker companies and are accompanied by restatements,restructuring, and other bad news. Although these studies have tried to mitigate theseproblems with self-selection control procedures, the controls implemented wereprobably not sufficient. Using an experimental approach, on the other hand, canovercome these problems.

This study involves four cases in which the auditors opinion on internal controls isthe only difference in the information presented. In all four cases, the auditors opinionon the financial statements is unqualified. Even companies that receive adverse

opinions or opinion disclaimers on internal controls overwhelmingly receiveunqualified opinions on financial statements. In a study of 170 companies thatreceived adverse opinions on internal control effectiveness, Crawford et al. (2007) foundthat all of them received unqualified audit opinions on their financial statements. Theinternal control opinions manipulated are unqualified, disclaimer, adverse due to aspecific account, and adverse due to the general control environment. The manipulationallows for the determination of whether disclaimed or adverse internal control opinionsundermine the assurance provided by an unqualified audit opinion on the financialstatements.

As Moodys Investor Services (2006) suggests, some internal control weaknesses areso severe that it is difficult to audit around these problems. Perhaps, investors wouldbelieve that lesser weaknesses (e.g. ones involving specific accounts or transactionsonly) could be offset by substantive testing and that only the severe weaknesses(e.g. company-wide problems) cannot be adequately mitigated. Therefore, this study

tests theimpact of bothtypes of internal control weaknesses thatmay be associatedwithadverse opinions. In addition, the study examines whether judgments of graduate andcontinuing education students differ from those of accountants. The latter group has agreater familiarity with internal controls and may also have different tolerances for risk.

Prior studiesNo prior studies have examined the effects of auditors internal control opinions onindividuals investment decisions or intentions to invest. Various studies haveinvestigated issues involving the effects of internal control reports on lenders andsecurities markets. These bodies of research are discussed next.


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One study has examined the effects of auditors internal control opinions on lendingdecisions. In an experiment with loan officers, Schneider and Church (2008) found thatlenders assessments of the risk of extending a line of credit and the probability ofextending the line of credit are negatively affected when the company receives anadverse internal control opinion as compared to an unqualified one.

A growing body of research has been investigating the effects of internal controlreports in equity markets. Whisenant et al. (2003) examined the information content ofreportable events communicated by auditors in Form 8-K filings, including thoseidentifying internal control weaknesses. While the results revealed that disclosures aboutfinancial statement reliability issues have information content (i.e. negative stock pricereaction), disclosures of only internal control weaknesses do not. Ashbaugh-Skaife et al.(2007) also found no evidence of adverse market price reactions associated with internalcontrol weakness disclosures. In contrast, de Franco et al. (2005) provided evidence thatcumulative size-adjusted abnormal returns decreased during a three-day event windowfor companies that report internal control deficiencies. Similarly, Cheng et al. (2007)found that companies announcing material weaknesses suffered significant negativecumulative abnormal returns over a short period surrounding the announcement date.Also, a study by Irving (2006) revealed that stock return volatility and trading volumeexhibited a larger event period reaction to firms initial material weakness disclosuresrelative to an adjacent non-event period and to a matched sample of control firms.Additionally, Hammersley et al. (2008) document a significant, negative stock pricereaction to the disclosure of the most severe internal control weaknesses. Kim and Park(2006) found that when a company discloses its internal control deficiencies, its abnormal

stock returnsare negatively associated with a change in the standarddeviation of the dailystock returns, suggesting that if the disclosures reduce uncertainty in the market, thenthey have a less-negativeimpact on thestock price. Thestudy also provided evidence thatcompanies experiencing high-stock return volatilities disclose their internal controlproblems early. Beneish et al. (2008) found that unaudited disclosures required bySection 302 of SOX are associated with negative announcement abnormal returns, whileaudited disclosures required by Section 404 of SOX have no impact on stock prices.

Archival findings are mixed as to the effect of internal control disclosures on thecost of equity or debt. Results in Ashbaugh-Skaife et al. (2009) suggest that disclosuresof internal control weaknesses are associated with a higher cost of equity. Ogneva et al.(2007) found that, after controlling for firm-specific characteristics, disclosures ofinternal control weaknesses are not associated with the cost of equity. Ghosh andLubberink (2006) focused on the cost of debt and their results revealed that companiesreporting internal control weaknesses had lower cost of debt. Beneish et al. (2008)

found that unaudited disclosures required by Section 302 of SOX are associated withabnormal increases in equity cost of capital, while audited disclosures required bySection 404 of SOX have no impact on firms cost of capital.

A study investigating individual investors was conducted by Lopez et al. (2006).They found that assessed stock prices for companies with an adverse opinion on theeffectiveness of internal controls are significantly less than for companies with anunqualified opinion. Asare and Wright (2008) examined equity analysts beliefs andrecommendations relating to internal control reports. They found that analysts who weregiven internal control reports with entity level weaknesses, relative to those given reportswith account specific weaknesses, had lower confidence in the most recent audited

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financials, audit report on the financials, and internal control strength. They also hadhigher assessments of investment risk and more unfavorable stock recommendations.Shelton and Whittington (2008) found thatadverseinternal controlopinions are associatedwith investments analysts assessing company risk higher and internal control strengthlower. The adverse opinions also resulted in a marginally significant difference in thelikelihood of recommending stock to clients. None of these studies with individualinvestors or analysts had the participants make investment decisions or expressintentions to invest.The currentstudy examineswhether judgments aboutinvestments inthe form of intentions might be affected by internal control reports.

HypothesesThis study tests whether the auditors internal control opinion has information contentfor investors. Since auditors provide opinions on the financial statements, it is arguableas to whether an audit opinion on internal controls provides additional usefulinformation to investors. The assurance that accompanies the auditors opinion onfinancial statements may very well not be affected by the opinion on internal controls.A financial statement audit provides reasonable assurance about the fairness offinancial statements regardless of the auditors opinion on internal controls. Hence, itcould be argued that investors may disregard internal control opinions and just focuson the auditors opinion on the financial statements.

Alternatively, the presence of internal control weaknesses, along with the auditorsattestation of such weaknesses, may create concerns about the reliability of the financialstatements and the companys underlying future operations, thereby increasinginvestors uncertainty about the company. This may cause investors to discount thelevel of assurance associated with audited financial statements. Consistent with thisassertion, most of the research results discussed above suggest that internal controldisclosures affect investors perceptions of earnings quality (Doyle et al., 2007a; Ghoshand Lubberink, 2006; Lopez et al., 2006). Even if internal control reports do not affectperceptions about the reliability of the current financial statements, they may send asignal about the reliability of future financial statements.

Additional evidence suggests that financial statement users will consider internalcontrol reports in their decision making (D&T, E&Y, KPMG, and PwC, 2004, p. 4). Mostof the studies reviewed above relating to the stock markets reaction to internal controldisclosures found adverse reactions (de Franco et al., 2005; Cheng et al., 2007; Irving,2006). In the credit arena, Moodys Investor Services (2006) inidicates that the disclosureof material weaknesses can affect debt ratings. In the only study to examine lendingdecisions, Schneider and Church (2008) found that lenders decisions are negativelyimpacted by adverse internal control opinions as compared to unqualified ones.

In the current study, investors are expected to consider internal control reports inassessing an investment. The investors may react differently to an adverse opinion oninternal controls (i.e. at least one material weakness exists) as compared to anunqualified opinion (i.e. internal controls are effective). Adverse opinions on internalcontrols introduce concerns as to the reliability of financial data and increase theuncertainty associated with company, which impacts the desirability of company as aninvestment. Thus, the first research hypothesis is as follows:

H1. Investors judgments are negatively affected by an adverse internal controlopinion as compared to an unqualified internal control opinion.


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It can also be argued that more serious internal control weaknesses have a strongerimpact on investors judgments than less serious internal control weaknesses. Lesserweaknesses such as ones involving specific accounts or transactions only can usuallybe offset by substantive testing (Crawford et al., 2007), whereas severe weaknessessuch as ones involving the companys overall internal control environment cannot beadequately mitigated. Indeed, credit rating agencies (Moodys Investor Services, 2006)distinguish between these two types of internal control weaknesses, using differentapproaches for each. Prior research studies (Ettredge et al., 2006; Hoitash et al., 2008;Raghunandan and Rama, 2006) have also examined these two types of internal controlweaknesses separately. The second research hypothesis is as follows:

H2. Investors judgments are more negatively affected by an adverse internalcontrol opinion relating to the companys overall control environment ascompared to an adverse internal control opinion relating to a specific account.

When an auditor is unable to issue an internal control opinion due to a scope limitation,the auditor must issue a disclaimer of opinion. It is not clear whether investors wouldperceive a disclaimer negatively, so the third hypothesis is framed non-directionally, asfollows:

H3. Investors judgments are affected differently by a disclaimer of opinion oninternal controls as compared to unqualified or adverse internal controlopinions.

Experimental task

Experimental settingThe experimental setting involves investing judgments relating to a hypotheticalcompany which is described in Appendix 1. Participants are given questionnairescontaining background information about the company, financial data, analystforecasts of earnings and recommendations, and stock prices for the past 12 months.They are also informed that the company is audited by a Big Four certified publicaccountant (CPA) firm and that the company received a clean opinion on its financialstatements. In addition, they are told that the CPA firm has issued a report on thecompanys internal controls. All questionnaires contain the same information exceptfor the type of internal control opinion and the name of the company, whichcorresponds to the type of internal control opinion. The experimental task is to assess:

. the risk associated with investing in the company;

. the probability of investing in the company; and

.

the probability of retaining the investment for at least a year.

ParticipantsQuestionnaires were distributed to two diverse groups of participants to see whetherresults would be different for those who have some level of sophistication aboutinternal controls (accountants from CPA firms) versus those who do not (graduatestudents and continuing education students taking courses in a US business school).Furthermore, these two groups may differ as to tolerances for risk. The 100 studentparticipants average age was 27, their average amount of full-time work experiencewas 3.9 years, 29 percent were female, and 59 percent had previously purchased or sold

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stock relating to a personal investment. Only 6 percent characterized their most recentfull-time work experience as being accounting/finance. The 102 accountants from29 different non-Big Four public accounting firms had an average age of 42, theiraverage amount of full-time work experience was 19 years, 26.5 percent were female,43.1 percent had masters degrees (or higher), and 82 percent had previously purchasedor sold stock relating to a personal investment. The number of student respondents perexperimental group ranges from 21 to 28, while for accountants the range is 22-29.

Experimental design treatmentsThe independent variable in the study is the type of opinion on internal controls. Thefour levels are Unqualified (i.e. clean), Disclaimer, Adverse-S, and Adverse-E and thedescriptions used in thequestionnaires areprovided in Appendix 2. Thereasongiven forthe Disclaimer is that there were restrictions on the auditors work imposed by thecircumstances. One form of adverse opinion, Adverse-S, indicated that the controlweakness related to a specific account, namely accounts receivable. The choice of thisaccount is reasonable, as a study of internal control reports revealed that sales revenue,accounts receivable, inventory, and accounts payable experienced the most controldeficiencies (Williams, 2005, p. 69). The more serious form of adverse opinion,Adverse-E, indicated that the control weakness related to the overall controlenvironment, stating that the company generally has a lack of consistent policies andprocedures.

Investor assessments dependent variables

Three dependent variables are elicited in the study. The first asks participants to assessthe level of risk, on a ten-point scale from 1 very low risk to 10 very high risk,associated with investing in the common stock of the company. Since some participantsmight invest in high-risk companies, two other dependent variables are included. Thesecond measure asksparticipantsto assess the probability (0-100 percent) thattheywouldinvest at least 10 percentof an endowed $1,000 in thecommon stockof thecompany.Sincedifferent decision making criteria may be used for purchasing versus selling investments,a third dependent variable elicits the probability (0-100 percent) that they would retain theinvestment for at least one year, given that they own $1,000 of the stock.

The experimental materials were developed to avoid the situation in whichparticipants responses would cluster at either end of the response scales. Afterpre-testing with business school faculty members and students who had investingexperience, the experimental materials were modified so that the company would not beperceived as either very strong or very weak. As well, wording changes were made for

clarification.In addition to risk and probability assessments, participants were asked to rate theimportance of various factors in making their assessments. The ratings were elicitedon a ten-point scale from 1 no importance to 10 very important. These ratings mayprovide additional insights about their risk and probability assessments.

ResultsOverall, the results for students revealed an average risk assessment of 5.59 (with verylow risk equal to 1 and very high risk equal to 10), a 31.9 percent average probability ofinvesting in the companys stock, and a 57.5 percent probability of retaining


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an investment in the company for at least one year. As expected, from thepre-testing, theresponses did not cluster at either end of the response scales. Breakdowns of these threedependent variables for the four groups of student respondents are shown in Panel A ofTable I.

A one-way ANOVA was conducted for each of the three dependent variables. Therisk variable yielded an F-value of 0.49 (p 0.69), the probability of investing in thecompany produced an F-value of 0.74 (p 0.53), and the probability of retainingthe investment resulted in an F-value of 1.02 (p 0.39). Hence, neither the risk nor thetwo probability assessments were statistically significant for type of internal controlopinion. Therefore, the type of internal control opinion made no difference for either the

risk or the probability assessments of these students. These ANOVAs were repeatedusing data from only those students with previous investing experience and theseresults appear in Panel B of Table I. Again, none of the three dependent variables werestatistically significant at the 0.05 level for type of internal control opinion. In addition,for the full student data set as well as for the experienced investors, ANCOVAs wereconducted with participants age and amount of work experience as covariates. Onceagain, none of the three dependent variables were statistically significant at the 0.05level for type of internal control opinion. Hence, all of these tests indicate that neither

H1 and H2, nor H3 were supported for the student respondents.The results for accountants revealed an average risk assessment of 6.51 (with very

low risk equal to 1 and very high risk equal to 10), a 27.9 percent average probability ofinvesting in the companys stock, and a 55.8 percent probability of retaining aninvestment in the company for at least one year. These figures are fairly similar tothose of the students reported earlier. Breakdowns of the three dependent variables forthe four groups of accountants are shown in Panel A of Table II.

One-way ANOVAs for the accountant data produced an F-value of 1.58 (p 0.20)for the risk assessment, an F-value of 0.34 (p 0.80) for the probability of investing inthe company, and an F-value of 0.62 (p 0.61) for the probability of retaining theinvestment. As with the students, the accountant data indicated that neither the risknor the two probability assessments were statistically significant for type of internal

Type of internal control opinionStudent data Unqualified Disclaimer Adverse-S Adverse-E

Panel A: all studentsNumber of respondents 21 24 27 28Avg. risk assessment 5.76 5.50 5.35 5.78Avg. probability of investing 0.38 0.28 0.33 0.30

Avg. probability of retaining 0.61 0.50 0.61 0.58Panel B: students with prior investing experienceNumber of respondents 12 12 16 19Avg. risk assessment 5.83 6.08 5.44 6.37Avg. probability of investing 0.30 0.20 0.31 0.19Avg. probability of retaining 0.60 0.43 0.64 0.57

Notes: Unqualified, Disclaimer, and Adverse refer to the auditors opinion on internal controls.Adverse-S indicates an adverse opinion due to internal control weaknesses pertaining to a specificaccount, whereas Adverse-E indicates an adverse opinion due to internal control weaknessespertaining to the companys overall control environment

Table I.Data for student groups

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control opinion, indicating that the type of internal control opinion made no differencefor either the risk or the probability assessments. ANOVAs using data from onlythose accountants who had previous investing experience also resulted in none of thethree dependent variables being statistically significant at the 0.05 level for type ofinternal control opinion. These results appear in Panel B of Table II. In addition, for thefull accountant data set as well as for the experienced investors, ANCOVAs were

conducted with participants age and amount of work experience as covariates. Onceagain, none of the three dependent variables were statistically significant at the0.05 level for type of internal control opinion. Hence, all of these tests indicate thatneither H1 and H2, nor H3 were supported for the accountant respondents.

Respondents also rated the importance of various factors in making theirjudgments, as shown in Table III (1 no importance; 10 very important).Interestingly, for both students and accountants, the auditors opinion on internalcontrols had relatively high-importance ratings 6.4 for students and 7.5 foraccountants. However, despite these stated importance ratings, the analyses aboveindicate that type of internal control report had no effect on risk assessments andinvesting intentions. Thus, other considerations apparently dominate internal controlopinions when making judgments about investments.

Type of internal control opinionAccountant data Unqualified Disclaimer Adverse-S Adverse-E

Panel A: all accountantsNumber of respondents 25 26 29 22Avg. risk assessment 6.16 6.23 6.93 6.73Avg. probability of investing 0.30 0.26 0.26 0.31Avg. probability of retaining 0.56 0.57 0.60 0.49

Panel B: accountants with prior investing experienceNumber of respondents 21 23 21 17

Avg. risk assessment 6.43 6.17 7.33 6.82Avg. probability of investing 0.26 0.24 0.24 0.31Avg. probability of retaining 0.55 0.58 0.57 0.51

Notes: Unqualified, Disclaimer, and Adverse refer to the auditors opinion on internal controls.Adverse-S indicates an adverse opinion due to internal control weaknesses pertaining to a specificaccount, whereas Adverse-E indicates an adverse opinion due to internal control weaknessespertaining to the companys overall control environment

Table II.Data for accountant

groups

Factor Students avg. rating Accountants avg. rating

Company description 6.7 6.9Standard industrial classification 4.7 3.7Use of a Big 4 CPA firm 5.3 4.3Auditors opinion on financial statements 6.5 7.7Auditors opinion on internal controls 6.4 7.5Financial data 8.1 8.8Analyst recommendation 6.1 6.2Historical stock prices 7.4 7.3

Notes: 1 No importance; 10 very importantTable III.

Factor importance scores


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ConclusionsThis study reports the results of an investigation into the effects of auditors internalcontrol reports on judgments about investments. Section 404 of SOX requires theauditor to issue an opinion on the effectiveness of a companys internal controls as partof the audit engagement. The results indicated that the type of internal control opinionmade no difference for either risk assessments or probability assessments relating toinvestments. Findings for participants who have some level of sophistication aboutinternal controls (accountants from CPA firms) were similar to those who do not(graduate students and continuing education students). Differing risk tolerancesbetween these two groups, however, could have offset any knowledge differences.A comparison of Tables I and II, Panel A, reveals that for each of the four types ofinternal control opinion, the accountants expressed higher average risk assessmentsfor the investments than did the students. The same is true when comparing riskassessments for only those with prior investing experience (Tables I and II, Panel B).Nevertheless, for both groups, it appears that other considerations such as financialdata and historical stock prices overshadow information about the companys internalcontrols. It is possible, however, that for both students and accountants, risk tolerancesamong the four internal control group participants differed and may have negated anydifferences produced by the internal control opinions, yielding non-significant resultsfor both groups. Therefore, future research should attempt to either control or measurerisk preferences of the participants.

A major limitation of this study is that the research was conducted under onecompany setting only and therefore is not necessarily generalizable to other settings.

Inasmuch as most of the archival studies cited earlier have found significant impacts ofinternal control reports, the lack of significant results in this study might suggest thata non-representative company scenario was used. Consider that the response to theaverage probability of investing in the companys stock was only 31.9 percent forstudents and 27.9 percent for accountants. Perhaps, because most respondents werenot inclined to invest in the company, the internal control opinion was not relevant. Forcompanies in which respondents would show more inclination to invest, the internalcontrol opinion could possibly matter more. Therefore, future research shouldinvestigate the impact of internal control reports with company scenarios havingalternative characteristics as to industry, competitive environment, risk, financialperformance, and management practices.

The study also examined only two cases of internal control weaknesses. Futureresearch can investigate whether the results of this study can be generalized to othertypes of weaknesses. As well, future research can determine whether the results are

generalizable to situations where the auditors report on the financial statements is notunqualified.

This study is also subject to the usual limitations of behavioral accountingexperimental research such as providing participants with data sets that do not containall of the information they may acquire when they make actual investment decisions orlack of real consequences for making good or poor investment decisions. In particular,the information provided about internal controls was not as detailed as an investormight typically find in SEC filings. Regarding the lack of real consequences, theparticipants did not actually put any capital at risk in this experiment. Future researchcan go beyond examining the investing intentions done in this study by capturing

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investment decisions in an experimental market setting where the participantscompensation is based on the quality of their investment decisions.

In conclusion, while this study did not find evidence that internal control opinionsaffected investment decisions, this does not necessarily mean that internal controlopinions are generally ineffective for assessing investment risks. The lack ofsignificance for type of internal control opinion could have been an artifact of theconditions inherent in this studys experimental setting. As noted above, the followingexplanations might individually or collectively account for why internal controlopinions had no impact on investment decisions:

.

Other considerations such as financial data and historical stock prices may havedominated the internal control opinions.. Risk tolerances of the respondents among the four internal control groups may

have differed so as to negate any differences caused by internal control opinions.. The company characteristics, which resulted in rather low-investing

probabilities, could have made the internal control opinions irrelevant.. The particular types of internal control weaknesses portrayed were not viewed

as serious, whereas other types of weaknesses could possibly produce an impactfor the differing internal control opinions.

. Lack of detail on the internal control weaknesses may have contributed to thelack of an impact on investment decisions.

Future research should examine the effects of internal control opinions in other settings

and conditions to ascertain whether investment decisions are generally affected byinternal control opinions.

References

AICPA (1993), Statement on Standards for Attestation Engagements No. 2. Reporting on anEntitys Internal Control Structure Over Financial Reporting, American Institute of CertifiedPublic Accountants, New York, NY.

Asare, S.K. and Wright, A. (2008), Equity analysts reactions to type of control deficiency andlikelihood threshold in adverse control reports, paper presented at the 2008 AmericanAccounting Association Annual Meeting, Sarasota, FL.

Ashbaugh-Skaife, H., Collins, D. and Kinney, W. (2007), The discovery and reporting ofinternal-control deficiencies prior to SOX-mandated audits, Journal of Accounting andEconomics, Vol. 44 Nos 1/2, pp. 166-92.

Ashbaugh-Skaife, H., Collins, D., Kinney, W. and LaFond, R. (2008), The effect of SOX internalcontrol deficiencies and their remediation on accrual quality, Accounting Review, January,pp. 217-50.

Ashbaugh-Skaife, H., Collins, D., Kinney, W. and LaFond, R. (2009), The effect of SOX internalcontrol deficiencies on firm risk and cost of equity, Journal of Accounting Research,March, pp. 1-43.

Beneish, M.D., Billings, M.B. and Hodder, L.D. (2008), Internal control weaknesses andinformation uncertainty, Accounting Review, May, pp. 665-703.

Cheng, C.S.A., Ho, J.L.Y. and Tian, F. (2007), Impact of the Sarbanes-Oxley Act Section 404internal control disclosures on firm valuation, working paper, September.


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Cohen Commission (1978), The Commission on Auditors Responsibilities: Report, Conclusions,and Recommendations, AICPA, New York, NY.

Crawford, W., Klamm, B.K. and Watson, MW. (2007), Surviving three SOX opinions, StrategicFinance, May, pp. 47-52.

Daniel, K., Hirshleifer, D. and Subrahmanyam, A. (1998), Investor psychology and securitymarket under- and overreactions, Journal of Finance, Vol. 53, pp. 1839-86.

de Franco, G., Guan, Y. and Lu, H. (2005), The wealth change and redistribution effects ofSarbanes-Oxley internal control disclosures, working paper, April.

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Appendix 1.Background information about the company in the experimental materials was as follows:

Brief description: Dolan Enterprises designs, develops, manufactures, and markets powerprotection and management solutions for computer communications and electronic applicationsworldwide. The companys products include uninterruptible power supply products, directcurrent-power systems, electrical surge protection devices, power conditioning products,

precision cooling equipment and associated software, services, and accessories. These productsare used with sensitive electronic devices that rely on electric utility power, including, but not

Most recent year in $ One year ago in $ Two years ago in $

Total assets 1.4b 1.3b 1.1bTotal revenues 1.4b 1.5b 1.3bCash flows from operations 117 m 17 m 277.9 mEarnings per share 0.59 0.83 1.05

Table AI.Financial data


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limited to, home electronics, personal computers, high-performance computer workstations,servers, networking equipment, communications equipment, internetworking equipment, datacenters, mainframe computers, and facilities.

Standard industrial classification: electronic and other electric equipment (SIC Code 3600).The consensus analyst forecast of earnings per share for the coming year is $0.63. The

consensus analyst recommendation for this stock is buy. Please note that analysts mayrecommend strong buy, buy, hold, sell, or strong sell.

On the following chart (Figure A1) historical stock prices are the closing prices per month forthe past 12 months. The months are denoted t, t2 1, t2 2, . . . t2 11, where month tis the lastmonth of the most recent fiscal year.

The closing price of the stock on the last day of the fiscal year was $14.86. The high price for

the year was $16.77 and the low price was $10.96. All stock prices are adjusted for dividends andstock splits.

Appendix 2.The experimental manipulations were as follows:

Unqualified opinion on internal controls (Unqualified): the companys auditor is a Big FourCPA firm. The company received a clean opinion audit report on its financial statements. A cleanopinion is issued when the auditor determines that financial statements present fairly thecompanys financial position and results of operations and cash flows in accordance withprescribed standards. Also, in compliance with the Sarbanes-Oxley (SOX) Act of 2002, CrownsCPA firm issued a clean opinion on Crown Enterprises internal controls over financial reporting,stating that the company has maintained effective internal controls.

Disclaimer of opinion on internal controls (Disclaimer): the companys auditor is a Big Four CPAfirm. Thecompanyreceived a clean opinion audit report on itsfinancial statements. A cleanopinionis issued when the auditor determines that financial statements present fairly the companys

financial position and results of operations and cashflows in accordance with prescribed standards.Also, in compliance with the SOX Act of 2002, Dolans CPA firm disclaimed an opinion (i.e. wasunable to issue an opinion) on Dolan Enterprises internal controls over financial reporting, statingthat there were restrictions on the auditors work imposed by the circumstances.

Adverseopinion on internalcontrols specificaccount (Adverse-S): thecompanysauditoris a BigFour CPA firm. The company received a clean opinion audit report on its financial statements.A clean opinion is issued when the auditor determines that financial statements present fairly thecompanysfinancial positionand results of operations and cash flowsin accordance with prescribedstandards. Also, in compliance with the SOX Act of 2002, Smiths CPA firm issued an adverseopinion on Smith Enterprises internal controls over financial reporting, stating that the companyhad not maintained effective internal controls over its accounts receivable.

Figure A1.Historical stock prices

Closing price per month for the past 12 months

$5.00

$10.00

$15.00

$20.00

$25.00

t-11 t-10 t-9 t-8 t-7 t-6 t-5 t-4 t-3 t-2 t-1 t

Closing price

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Adverse opinion on internal controls control environment (Adverse-E): the companys auditor isa Big Four CPA firm. The company received a clean opinion audit report on its financialstatements. A clean opinion is issued when the auditor determines that financial statementspresent fairly the companys financial position and results of operations and cash flows inaccordance with prescribed standards. Also, in compliance with the SOX Act of 2002, EatonsCPA firm issued an adverse opinion on Eaton Enterprises internal controls over financialreporting, stating that the company generally has a lack of consistent policies and procedures.

About the authorArnold Schneider is a Professor of Accounting and the Accounting Area Coordinator at GeorgiaInstitute of Technology. He received a BS in Accounting from Case Western Reserve University,a PhD from Ohio State University, and obtained a CPA Certificate in Maryland. He was formerlyan Auditor with the US Government Accountability Office. He has also held Visiting Facultypositions at Macquarie University (Australia) and Emory University. He has co-authored amanagerial accounting textbook and has published over 50 journal articles on auditing andcost/managerial accounting topics. He has also served on the editorial boards of several journals.Arnold Schneider can be contacted at: [email protected]


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