Managerial Auditing Journal

Emerald Article: Auditors' internal control opinions: do they influence judgments about investments? Arnold Schneider

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To cite this document: Arnold Schneider, (2009),"Auditors' internal control opinions: do they influence judgments about investments?", Managerial Auditing Journal, Vol. 24 Iss: 8 pp. 709 - 723 Permanent link to this document: http://dx.doi.org/10.1108/02686900910986376 Downloaded on: 07-04-2012 References: This document contains references to 37 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 2080 times.

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Auditors internal control opinions: do they inuence 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 opinions on individuals judgments about investments. Design/methodology/approach The approach used is a behavioral experiment where risk assessments and judgments about investments are made for four internal control opinion scenarios. Findings The results indicate that the type of internal control opinion made no difference for either risk assessments or investment decisions. Research limitations/implications Participants are provided with data sets that do not contain all of the information they may acquire when they make actual investment decisions. Also, there is a lack 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 when making judgments about investments. Originality/value This is the rst paper to examine whether intentions to invest might be affected by internal control opinions. Keywords Internal control, Auditing, Investments Paper type Research paper

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Received 5 November 2008 Revised 9 May 2009 Accepted 31 May 2009

Introduction Over the years, there have been calls for auditors to attest to clients internal control effectiveness in order to deter the incidence of management fraud (Cohen Commission, 1978; Public Oversight Board, 1993). The American Institute of Certied Public Accountants AICPA (1993) provided guidance to auditors engaged to examine and report on a clients internal controls. Some companies indeed have voluntarily provided internal control reports attested to by auditors. Prior to the Sarbanes-Oxley (SOX) Act of 2002, internal control disclosures were required only in 8-K lings when companies announced a change in auditors (Securities and Exchange Commission SEC, 1988). For public companies, the SOX legislation has now made internal control reporting with auditor attestation mandatory in annual reports. Section 404 of SOX requires public companies to make an assessment of the effectiveness of internal controls for nancial reporting. Furthermore, the companys auditor now attests to the effectiveness of the internal controls as part of the audit engagement. The Public Company Accounting Oversight Board PCAOB (2004, 2005) ruled, in Auditing Standard No. 2, that to comply with Section 404, the companys

Managerial Auditing Journal Vol. 24 No. 8, 2009 pp. 709-723 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900910986376

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auditor must issue two opinions: one on managements process for making its internal control assessment and the other on the effectiveness of the companys internal controls. PCAOB (2007) eliminated the requirement for the rst of these two opinions when 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 internal controls. This paper examines the impact of this internal control opinion on individuals judgments about investments. The need for a report on the effectiveness of internal controls, attested to by the auditor, is questionable. Auditors are required to obtain an understanding of the clients internal controls to properly plan and conduct their audits of nancial statements. In turn, audit programs take into account the design of internal controls and the auditors planned reliance on such controls. If internal control weaknesses are identied, audit programs are modied accordingly substantive tests are increased. The auditors task is to accumulate sufcient evidence, by whatever means necessary, to provide a basis for an opinion on the fairness of the nancial statements. Auditors can issue unqualied opinions on nancial statements even if a company has material weaknesses in internal controls. The auditors report provides reasonable assurance for the nancial statements, regardless of the companys internal control effectiveness. Thus, the reliability of audited nancial statements, in terms of assurance, should not be affected by the auditors opinion on internal controls. On the other hand, regulators contend that increased scrutiny of control systems is necessary because control weaknesses are at the heart of large-scale fraudulent nancial reporting, e.g. Enron, WorldCom, Lucent, and HealthSouth, to name a few. The KPMG (2003) fraud surveys also consistently identify inadequate internal controls as a factor that contributes to the occurrence of fraud. Proponents of Section 404 argue that the reporting requirements will enhance internal control systems, e.g. control weaknesses will be identied and remedied sooner and ongoing management involvement will result in improved control systems (Rittenberg and Miller, 2005). Regulators assert that by requiring internal control disclosures, the reliability of audited nancial statements can be improved the overall nancial-reporting system can be strengthened and users perceptions enhanced. Nicolaisen (2004), as a Chief Accountant of the SEC, remarked that being able to represent that an appropriate control system is in place strengthens public condence and encourages investment in our nations industries. These arguments suggest that even when auditors issue unqualied opinions on nancial statements, adverse opinions on internal controls may signal that although current nancial statements are fairly presented, these statements are less reliable for predicting future nancial performance. In addition, adverse internal control opinions may signal that the underlying future operations of the rm are at greater risk because of the lack of internal controls. Because of the reasons for and against the relevance of internal control opinions when auditors issue unqualied opinions on nancial statements, it is unclear how investors should react when the auditor expresses an adverse opinion or discalimer of opinion on internal controls and a clean opinion on nancial statements. Some archival studies have examined the effect of internal control disclosures on stock prices, with most of them nding 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).

The current study focuses on individuals judgments about investments rather than a market-oriented approach. Individual investors are important for three reasons: (1) this portion of the investment community is signicant and potentially impacts stock 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 develop theoretical 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 an experimental approach allows one to completely control the information available to participants. The study is able to control for factors that can cause confounding in archival studies, including concurrent information disclosure, rm-specic characteristics, and self-selection. Archival studies (Doyle et al., 2007b; Ashbaugh-Skaife et al., 2007) have found that most internal control weakness disclosures are announced by weaker companies and are accompanied by restatements, restructuring, and other bad news. Although these studies have tried to mitigate these problems with self-selection control procedures, the controls implemented were probably not sufcient. Using an experimental approach, on the other hand, can overcome these problems. This study involves four cases in which the auditors opinion on internal controls is the only difference in the information presented. In all four cases, the auditors opinion on the nancial statements is unqualied. Even companies that receive adverse opinions or opinion disclaimers on internal controls overwhelmingly receive unqualied opinions on nancial statements. In a study of 170 companies that received adverse opinions on internal control effectiveness, Crawford et al. (2007) found that all of them received unqualied audit opinions on their nancial statements. The internal control opinions manipulated are unqualied, disclaimer, adverse due to a specic account, and adverse due to the general control environment. The manipulation allows for the determination of whether disclaimed or adverse internal control opinions undermine the assurance provided by an unqualied audit opinion on the nancial statements. As Moodys Investor Services (2006) suggests, some internal control weaknesses are so severe that it is difcult to audit around these problems. Perhaps, investors would believe that lesser weaknesses (e.g. ones involving specic accounts or transactions only) 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 the impact of both types of internal control weaknesses that may be associated with adverse opinions. In addition, the study examines whether judgments of graduate and continuing education students differ from those of accountants. The latter group has a greater familiarity with internal controls and may also have different tolerances for risk. Prior studies No prior studies have examined the effects of auditors internal control opinions on individuals investment decisions or intentions to invest. Various studies have investigated issues involving the effects of internal control reports on lenders and securities markets. These bodies of research are discussed next.

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One study has examined the effects of auditors internal control opinions on lending decisions. In an experiment with loan ofcers, Schneider and Church (2008) found that lenders assessments of the risk of extending a line of credit and the probability of extending the line of credit are negatively affected when the company receives an adverse internal control opinion as compared to an unqualied one. A growing body of research has been investigating the effects of internal control reports in equity markets. Whisenant et al. (2003) examined the information content of reportable events communicated by auditors in Form 8-K lings, including those identifying internal control weaknesses. While the results revealed that disclosures about nancial statement reliability issues have information content (i.e. negative stock price reaction), disclosures of only internal control weaknesses do not. Ashbaugh-Skaife et al. (2007) also found no evidence of adverse market price reactions associated with internal control weakness disclosures. In contrast, de Franco et al. (2005) provided evidence that cumulative size-adjusted abnormal returns decreased during a three-day event window for companies that report internal control deciencies. Similarly, Cheng et al. (2007) found that companies announcing material weaknesses suffered signicant negative cumulative abnormal returns over a short period surrounding the announcement date. Also, a study by Irving (2006) revealed that stock return volatility and trading volume exhibited a larger event period reaction to rms initial material weakness disclosures relative to an adjacent non-event period and to a matched sample of control rms. Additionally, Hammersley et al. (2008) document a signicant, negative stock price reaction to the disclosure of the most severe internal control weaknesses. Kim and Park (2006) found that when a company discloses its internal control deciencies, its abnormal stock returns are negatively associated with a change in the standard deviation of the daily stock returns, suggesting that if the disclosures reduce uncertainty in the market, then they have a less-negative impact on the stock price. The study also provided evidence that companies experiencing high-stock return volatilities disclose their internal control problems early. Beneish et al. (2008) found that unaudited disclosures required by Section 302 of SOX are associated with negative announcement abnormal returns, while audited disclosures required by Section 404 of SOX have no impact on stock prices. Archival ndings are mixed as to the effect of internal control disclosures on the cost of equity or debt. Results in Ashbaugh-Skaife et al. (2009) suggest that disclosures of internal control weaknesses are associated with a higher cost of equity. Ogneva et al. (2007) found that, after controlling for rm-specic characteristics, disclosures of internal control weaknesses are not associated with the cost of equity. Ghosh and Lubberink (2006) focused on the cost of debt and their results revealed that companies reporting internal control weaknesses had lower cost of debt. Beneish et al. (2008) found that unaudited disclosures required by Section 302 of SOX are associated with abnormal increases in equity cost of capital, while audited disclosures required by Section 404 of SOX have no impact on rms 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 the effectiveness of internal controls are signicantly less than for companies with an unqualied opinion. Asare and Wright (2008) examined equity analysts beliefs and recommendations relating to internal control reports. They found that analysts who were given internal control reports with entity level weaknesses, relative to those given reports with account specic weaknesses, had lower condence in the most recent audited

nancials, audit report on the nancials, and internal control strength. They also had higher assessments of investment risk and more unfavorable stock recommendations. Shelton and Whittington (2008) found that adverse internal control opinions are associated with investments analysts assessing company risk higher and internal control strength lower. The adverse opinions also resulted in a marginally signicant difference in the likelihood of recommending stock to clients. None of these studies with individual investors or analysts had the participants make investment decisions or express intentions to invest. The current study examines whether judgments about investments in the form of intentions might be affected by internal control reports. Hypotheses This study tests whether the auditors internal control opinion has information content for investors. Since auditors provide opinions on the nancial statements, it is arguable as to whether an audit opinion on internal controls provides additional useful information to investors. The assurance that accompanies the auditors opinion on nancial statements may very well not be affected by the opinion on internal controls. A nancial statement audit provides reasonable assurance about the fairness of nancial statements regardless of the auditors opinion on internal controls. Hence, it could be argued that investors may disregard internal control opinions and just focus on the auditors opinion on the nancial statements. Alternatively, the presence of internal control weaknesses, along with the auditors attestation of such weaknesses, may create concerns about the reliability of the nancial statements and the companys underlying future operations, thereby increasing investors uncertainty about the company. This may cause investors to discount the level of assurance associated with audited nancial statements. Consistent with this assertion, most of the research results discussed above suggest that internal control disclosures affect investors perceptions of earnings quality (Doyle et al., 2007a; Ghosh and Lubberink, 2006; Lopez et al., 2006). Even if internal control reports do not affect perceptions about the reliability of the current nancial statements, they may send a signal about the reliability of future nancial statements. Additional evidence suggests that nancial statement users will consider internal control reports in their decision making (D&T, E&Y, KPMG, and PwC, 2004, p. 4). Most of the studies reviewed above relating to the stock markets reaction to internal control disclosures 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 disclosure of material weaknesses can affect debt ratings. In the only study to examine lending decisions, Schneider and Church (2008) found that lenders decisions are negatively impacted by adverse internal control opinions as compared to unqualied ones. In the current study, investors are expected to consider internal control reports in assessing an investment. The investors may react differently to an adverse opinion on internal controls (i.e. at least one material weakness exists) as compared to an unqualied opinion (i.e. internal controls are effective). Adverse opinions on internal controls introduce concerns as to the reliability of nancial data and increase the uncertainty associated with company, which impacts the desirability of company as an investment. Thus, the rst research hypothesis is as follows: H1. Investors judgments are negatively affected by an adverse internal control opinion as compared to an unqualied internal control opinion.

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It can also be argued that more serious internal control weaknesses have a stronger impact on investors judgments than less serious internal control weaknesses. Lesser weaknesses such as ones involving specic accounts or transactions only can usually be offset by substantive testing (Crawford et al., 2007), whereas severe weaknesses such as ones involving the companys overall internal control environment cannot be adequately mitigated. Indeed, credit rating agencies (Moodys Investor Services, 2006) distinguish between these two types of internal control weaknesses, using different approaches 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 control weaknesses separately. The second research hypothesis is as follows: H2. Investors judgments are more negatively affected by an adverse internal control opinion relating to the companys overall control environment as compared to an adverse internal control opinion relating to a specic 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 would perceive a disclaimer negatively, so the third hypothesis is framed non-directionally, as follows: H3. Investors judgments are affected differently by a disclaimer of opinion on internal controls as compared to unqualied or adverse internal control opinions. Experimental task Experimental setting The experimental setting involves investing judgments relating to a hypothetical company which is described in Appendix 1. Participants are given questionnaires containing background information about the company, nancial data, analyst forecasts 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 certied public accountant (CPA) rm and that the company received a clean opinion on its nancial statements. In addition, they are told that the CPA rm has issued a report on the companys internal controls. All questionnaires contain the same information except for the type of internal control opinion and the name of the company, which corresponds 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. Participants Questionnaires were distributed to two diverse groups of participants to see whether results would be different for those who have some level of sophistication about internal controls (accountants from CPA rms) versus those who do not (graduate students and continuing education students taking courses in a US business school). Furthermore, these two groups may differ as to tolerances for risk. The 100 student participants average age was 27, their average amount of full-time work experience was 3.9 years, 29 percent were female, and 59 percent had previously purchased or sold

stock relating to a personal investment. Only 6 percent characterized their most recent full-time work experience as being accounting/nance. The 102 accountants from 29 different non-Big Four public accounting rms had an average age of 42, their average 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 purchased or sold stock relating to a personal investment. The number of student respondents per experimental group ranges from 21 to 28, while for accountants the range is 22-29. Experimental design treatments The independent variable in the study is the type of opinion on internal controls. The four levels are Unqualied (i.e. clean), Disclaimer, Adverse-S, and Adverse-E and the descriptions used in the questionnaires are provided in Appendix 2. The reason given for the Disclaimer is that there were restrictions on the auditors work imposed by the circumstances. One form of adverse opinion, Adverse-S, indicated that the control weakness related to a specic account, namely accounts receivable. The choice of this account is reasonable, as a study of internal control reports revealed that sales revenue, accounts receivable, inventory, and accounts payable experienced the most control deciencies (Williams, 2005, p. 69). The more serious form of adverse opinion, Adverse-E, indicated that the control weakness related to the overall control environment, stating that the company generally has a lack of consistent policies and procedures. Investor assessments dependent variables Three dependent variables are elicited in the study. The rst asks participants to assess the 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 participants might invest in high-risk companies, two other dependent variables are included. The second measure asks participants to assess the probability (0-100 percent) that they would invest at least 10 percent of an endowed $1,000 in the common stock of the company. Since different 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 the investment for at least one year, given that they own $1,000 of the stock. The experimental materials were developed to avoid the situation in which participants responses would cluster at either end of the response scales. After pre-testing with business school faculty members and students who had investing experience, the experimental materials were modied so that the company would not be perceived as either very strong or very weak. As well, wording changes were made for clarication. In addition to risk and probability assessments, participants were asked to rate the importance of various factors in making their assessments. The ratings were elicited on a ten-point scale from 1 no importance to 10 very important. These ratings may provide additional insights about their risk and probability assessments. Results Overall, the results for students revealed an average risk assessment of 5.59 (with very low risk equal to 1 and very high risk equal to 10), a 31.9 percent average probability of investing 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 the pre-testing, the responses did not cluster at either end of the response scales. Breakdowns of these three dependent variables for the four groups of student respondents are shown in Panel A of Table I. A one-way ANOVA was conducted for each of the three dependent variables. The risk variable yielded an F-value of 0.49 ( p 0.69), the probability of investing in the company produced an F-value of 0.74 ( p 0.53), and the probability of retaining the investment resulted in an F-value of 1.02 ( p 0.39). Hence, neither the risk nor the two probability assessments were statistically signicant for type of internal control opinion. Therefore, the type of internal control opinion made no difference for either the risk or the probability assessments of these students. These ANOVAs were repeated using data from only those students with previous investing experience and these results appear in Panel B of Table I. Again, none of the three dependent variables were statistically signicant 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 were conducted with participants age and amount of work experience as covariates. Once again, none of the three dependent variables were statistically signicant at the 0.05 level 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 of investing in the companys stock, and a 55.8 percent probability of retaining an investment in the company for at least one year. These gures are fairly similar to those of the students reported earlier. Breakdowns of the three dependent variables for the 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 in the company, and an F-value of 0.62 ( p 0.61) for the probability of retaining the investment. As with the students, the accountant data indicated that neither the risk nor the two probability assessments were statistically signicant for type of internal
Type of internal control opinion Disclaimer Adverse-S 24 5.50 0.28 0.50 12 6.08 0.20 0.43 27 5.35 0.33 0.61 16 5.44 0.31 0.64

Student data

Unqualied

Adverse-E 28 5.78 0.30 0.58 19 6.37 0.19 0.57

Panel A: all students Number of respondents 21 Avg. risk assessment 5.76 Avg. probability of investing 0.38 Avg. probability of retaining 0.61 Panel B: students with prior investing experience Number of respondents 12 Avg. risk assessment 5.83 Avg. probability of investing 0.30 Avg. probability of retaining 0.60

Table I. Data for student groups

Notes: Unqualied, 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 specic account, whereas Adverse-E indicates an adverse opinion due to internal control weaknesses pertaining to the companys overall control environment

Accountant data

Unqualied

Type of internal control opinion Disclaimer Adverse-S 26 6.23 0.26 0.57 23 6.17 0.24 0.58 29 6.93 0.26 0.60 21 7.33 0.24 0.57

Adverse-E 22 6.73 0.31 0.49 17 6.82 0.31 0.51

Panel A: all accountants Number of respondents 25 Avg. risk assessment 6.16 Avg. probability of investing 0.30 Avg. probability of retaining 0.56 Panel B: accountants with prior investing experience Number of respondents 21 Avg. risk assessment 6.43 Avg. probability of investing 0.26 Avg. probability of retaining 0.55

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Notes: Unqualied, 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 specic account, whereas Adverse-E indicates an adverse opinion due to internal control weaknesses pertaining to the companys overall control environment

Table II. Data for accountant groups

control opinion, indicating that the type of internal control opinion made no difference for either the risk or the probability assessments. ANOVAs using data from only those accountants who had previous investing experience also resulted in none of the three dependent variables being statistically signicant at the 0.05 level for type of internal control opinion. These results appear in Panel B of Table II. In addition, for the full accountant data set as well as for the experienced investors, ANCOVAs were conducted with participants age and amount of work experience as covariates. Once again, none of the three dependent variables were statistically signicant at the 0.05 level for type of internal control opinion. Hence, all of these tests indicate that neither H1 and H2, nor H3 were supported for the accountant respondents. Respondents also rated the importance of various factors in making their judgments, as shown in Table III (1 no importance; 10 very important). Interestingly, for both students and accountants, the auditors opinion on internal controls had relatively high-importance ratings 6.4 for students and 7.5 for accountants. However, despite these stated importance ratings, the analyses above indicate that type of internal control report had no effect on risk assessments and investing intentions. Thus, other considerations apparently dominate internal control opinions when making judgments about investments.
Factor Company description Standard industrial classication Use of a Big 4 CPA rm Auditors opinion on nancial statements Auditors opinion on internal controls Financial data Analyst recommendation Historical stock prices Notes: 1 No importance; 10 very important Students avg. rating 6.7 4.7 5.3 6.5 6.4 8.1 6.1 7.4 Accountants avg. rating 6.9 3.7 4.3 7.7 7.5 8.8 6.2 7.3

Table III. Factor importance scores

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Conclusions This study reports the results of an investigation into the effects of auditors internal control reports on judgments about investments. Section 404 of SOX requires the auditor to issue an opinion on the effectiveness of a companys internal controls as part of the audit engagement. The results indicated that the type of internal control opinion made no difference for either risk assessments or probability assessments relating to investments. Findings for participants who have some level of sophistication about internal controls (accountants from CPA rms) were similar to those who do not (graduate students and continuing education students). Differing risk tolerances between 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 of internal control opinion, the accountants expressed higher average risk assessments for the investments than did the students. The same is true when comparing risk assessments for only those with prior investing experience (Tables I and II, Panel B). Nevertheless, for both groups, it appears that other considerations such as nancial data and historical stock prices overshadow information about the companys internal controls. It is possible, however, that for both students and accountants, risk tolerances among the four internal control group participants differed and may have negated any differences produced by the internal control opinions, yielding non-signicant results for both groups. Therefore, future research should attempt to either control or measure risk preferences of the participants. A major limitation of this study is that the research was conducted under one company setting only and therefore is not necessarily generalizable to other settings. Inasmuch as most of the archival studies cited earlier have found signicant impacts of internal control reports, the lack of signicant results in this study might suggest that a non-representative company scenario was used. Consider that the response to the average probability of investing in the companys stock was only 31.9 percent for students and 27.9 percent for accountants. Perhaps, because most respondents were not inclined to invest in the company, the internal control opinion was not relevant. For companies in which respondents would show more inclination to invest, the internal control opinion could possibly matter more. Therefore, future research should investigate the impact of internal control reports with company scenarios having alternative characteristics as to industry, competitive environment, risk, nancial performance, and management practices. The study also examined only two cases of internal control weaknesses. Future research can investigate whether the results of this study can be generalized to other types of weaknesses. As well, future research can determine whether the results are generalizable to situations where the auditors report on the nancial statements is not unqualied. This study is also subject to the usual limitations of behavioral accounting experimental research such as providing participants with data sets that do not contain all of the information they may acquire when they make actual investment decisions or lack of real consequences for making good or poor investment decisions. In particular, the information provided about internal controls was not as detailed as an investor might typically nd in SEC lings. Regarding the lack of real consequences, the participants did not actually put any capital at risk in this experiment. Future research can go beyond examining the investing intentions done in this study by capturing

investment decisions in an experimental market setting where the participants compensation is based on the quality of their investment decisions. In conclusion, while this study did not nd evidence that internal control opinions affected investment decisions, this does not necessarily mean that internal control opinions are generally ineffective for assessing investment risks. The lack of signicance for type of internal control opinion could have been an artifact of the conditions inherent in this studys experimental setting. As noted above, the following explanations might individually or collectively account for why internal control opinions had no impact on investment decisions: . Other considerations such as nancial data and historical stock prices may have dominated 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 impact for the differing internal control opinions. . Lack of detail on the internal control weaknesses may have contributed to the lack 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 by internal control opinions.
References AICPA (1993), Statement on Standards for Attestation Engagements No. 2. Reporting on an Entitys Internal Control Structure Over Financial Reporting, American Institute of Certied Public Accountants, New York, NY. Asare, S.K. and Wright, A. (2008), Equity analysts reactions to type of control deciency and likelihood threshold in adverse control reports, paper presented at the 2008 American Accounting Association Annual Meeting, Sarasota, FL. Ashbaugh-Skaife, H., Collins, D. and Kinney, W. (2007), The discovery and reporting of internal-control deciencies prior to SOX-mandated audits, Journal of Accounting and Economics, Vol. 44 Nos 1/2, pp. 166-92. Ashbaugh-Skaife, H., Collins, D., Kinney, W. and LaFond, R. (2008), The effect of SOX internal control deciencies 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 internal control deciencies on rm 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 and information 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 404 internal control disclosures on rm valuation, working paper, September.

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PCAOB (2004), Auditing Standard No. 2: An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements, Public Companies Accounting Oversight Board, Washington, DC, March 9. PCAOB (2005), Standard Advisory Group Meeting on Reasonable Assurance, Public Companies Accounting Oversight Board, Washington, DC, available at: www.pcaob.com/Standards/ Standing_Advisory_Group/Meetings/2005/10-05-06/Reasonable_Assurance.pdf (accessed October 5-6). PCAOB (2007), Auditing Standard No. 5: An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements, Public Companies Accounting Oversight Board, Washington, DC, May 24. Public Oversight Board (1993), In the Public Interest: A Special Report by the Public Oversight Board of the SEC Practice Section, AICPA, New York, NY. Raghunandan, K. and Rama, D. (2006), SOX Section 404 material weakness disclosures and audit fees, Auditing: A Journal of Practice & Theory, Vol. 25 No. 1, pp. 99-114. Rittenberg, L.E. and Miller, P.K. (2005), Sarbanes-Oxley Section 404 Work: Looking at the Benets, Institute of Internal Auditors Research Foundation, Altamonte Springs, FL. Schneider, A. and Church, B.K. (2008), The effect of auditors internal control opinions on loan decisions, Journal of Accounting & Public Policy, Vol. 27 No. 1, pp. 1-18. SEC (1988), Disclosure amendments to regulation S-K, form 8-K and schedule 14A regarding changes in accountants and potential opinion shopping situations, Financial Reporting Release No. 31 (April), SEC Docket 1140-1147, Securities and Exchange Commission, Washington, DC. Shelton, S.W. and Whittington, O.R. (2008), The inuence of the auditors report on investors evaluations after the Sarbanes-Oxley Act, Managerial Auditing Journal, Vol. 23 No. 2, pp. 142-60. Whisenant, J.S., Sankaraguruswamy, S. and Raghunandan, K. (2003), Market reactions to disclosure of reportable events, Auditing: A Journal of Practice & Theory, Vol. 22 No. 1, pp. 181-94. Williams, K. (2005), Evaluating internal controls and SOX compliance, Strategic Finance, Vol. 25, p. 69. Appendix 1. Background information about the company in the experimental materials was as follows: Brief description: Dolan Enterprises designs, develops, manufactures, and markets power protection and management solutions for computer communications and electronic applications worldwide. The companys products include uninterruptible power supply products, direct current-power systems, electrical surge protection devices, power conditioning products, precision cooling equipment and associated software, services, and accessories. These products are used with sensitive electronic devices that rely on electric utility power, including, but not

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Most recent year in $ Total assets Total revenues Cash ows from operations Earnings per share 1.4b 1.4b 117 m 0.59

One year ago in $ 1.3b 1.5b 17 m 0.83

Two years ago in $ 1.1b 1.3b 277.9 m 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, data centers, mainframe computers, and facilities. Standard industrial classication: 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 may recommend strong buy, buy, hold, sell, or strong sell. On the following chart (Figure A1) historical stock prices are the closing prices per month for the past 12 months. The months are denoted t, t 2 1, t 2 2, . . . t 2 11, where month t is the last month of the most recent scal year. The closing price of the stock on the last day of the scal 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 and stock splits. Appendix 2. The experimental manipulations were as follows: Unqualied opinion on internal controls (Unqualied): the companys auditor is a Big Four CPA rm. The company received a clean opinion audit report on its nancial statements. A clean opinion is issued when the auditor determines that nancial statements present fairly the companys nancial position and results of operations and cash ows in accordance with prescribed standards. Also, in compliance with the Sarbanes-Oxley (SOX) Act of 2002, Crowns CPA rm issued a clean opinion on Crown Enterprises internal controls over nancial reporting, stating that the company has maintained effective internal controls. Disclaimer of opinion on internal controls (Disclaimer): the companys auditor is a Big Four CPA rm. The company received a clean opinion audit report on its nancial statements. A clean opinion is issued when the auditor determines that nancial statements present fairly the companys nancial position and results of operations and cash ows in accordance with prescribed standards. Also, in compliance with the SOX Act of 2002, Dolans CPA rm disclaimed an opinion (i.e. was unable to issue an opinion) on Dolan Enterprises internal controls over nancial reporting, stating that there were restrictions on the auditors work imposed by the circumstances. Adverse opinion on internal controls specic account (Adverse-S): the companys auditor is a Big Four CPA rm. The company received a clean opinion audit report on its nancial statements. A clean opinion is issued when the auditor determines that nancial statements present fairly the companys nancial position and results of operations and cash ows in accordance with prescribed standards. Also, in compliance with the SOX Act of 2002, Smiths CPA rm issued an adverse opinion on Smith Enterprises internal controls over nancial reporting, stating that the company had not maintained effective internal controls over its accounts receivable.
Closing price per month for the past 12 months $25.00 Closing price $20.00 $15.00 $10.00

Figure A1. Historical stock prices

$5.00 t-11 t-10 t-9 t-8 t-7 t-6 t-5 t-4 t-3 t-2 t-1 t

Adverse opinion on internal controls control environment (Adverse-E): the companys auditor is a Big Four CPA rm. The company received a clean opinion audit report on its nancial statements. A clean opinion is issued when the auditor determines that nancial statements present fairly the companys nancial position and results of operations and cash ows in accordance with prescribed standards. Also, in compliance with the SOX Act of 2002, Eatons CPA rm issued an adverse opinion on Eaton Enterprises internal controls over nancial reporting, stating that the company generally has a lack of consistent policies and procedures.

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About the author Arnold Schneider is a Professor of Accounting and the Accounting Area Coordinator at Georgia Institute of Technology. He received a BS in Accounting from Case Western Reserve University, a PhD from Ohio State University, and obtained a CPA Certicate in Maryland. He was formerly an Auditor with the US Government Accountability Ofce. He has also held Visiting Faculty positions at Macquarie University (Australia) and Emory University. He has co-authored a managerial accounting textbook and has published over 50 journal articles on auditing and cost/managerial accounting topics. He has also served on the editorial boards of several journals. Arnold Schneider can be contacted at: arnold.schneider@mgt.gatech.edu

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