The Impact of Section 302 and 404(b) Internal Control Disclosures on Prospective Investors' Judgments and Decisions: An Experimental Study

• Date: 01 July 2016
• Author: Bryan K. Church,Arnold Schneider
• Published date: 01 July 2016
• DOI: http://doi.org/10.1111/ijau.12065

The Impact of Section 302 and 404(b) Internal Control Disclosures on Prospective

Investors’Judgments and Decisions: An Experimental Study

Bryan K. Church and Arnold Schneider

Georgia Institute of Technology

This paper reports theresults of an experiment designed to investigate participants’reaction to quarterly and annual

internal controldisclosures. Quarterlydisclosures include managers’disclosure of no controldeficiencies, a significant

deficiency, or a material weakness. Annual disclosures include the auditors’opinion on internal control, which either

affirms managers’earlier disclosure or reveals new information. We find that participants react negatively to the

disclosure of a material weakness, as might be expected. Participants invest less in a target company when internal

control is ineffective rather than effective. By comparison, participants do not react negatively to the disclosure of a

significant deficiency. Indeed, we find that they react positively to such disclosure accompanied by a clean

(unqualified) audit opinion on internal control. Subsequent analyses indicate that participants’investment decisions

are affected by their assessments of the reliability of financial statements and the credibility of management.

Key words: internal control disclosure, investing decision

1. INTRODUCTION

This paper reports the results of an experiment designed to

examine the effect of internal control disclosures (quarterly

and annual) on individuals’willingness to invest in a target

company. The Sarbanes-Oxley Act of 2002 (SOX) mandates

disclosure of the effectiveness of internal controls in

companies’quarterly and annual filings with the Securities

and Exchange Commission (SEC). Section 302 of SOX

requires a company’s principal executive officers to evaluate

the effectiveness of internal controls and to report their

conclusions. Internal controls are not effective, by definition,

if a control deficiency or combination of deficiencies exist

such that there is a reasonable possibility that a material

misstatement of the financial statements could result (AS 5,

¶63, PCAOB, 2007). Such a deficiency is referred to as a

material weakness and, under Section 302, must be

disclosed.

Companies’executives also may choose to voluntarily

disclose less severe deficiencies (e.g., those potentially with

more than an inconsequential effect on financial statements).

Such instances are referred to as significant deficiencies and

are defined as a deficiency or combination of deficiencies

that is less severe than a material weakness, but important

enough to merit attention by those responsible for oversight

of the company’s financial reporting (AS 5, ¶A11, PCAOB,

2007). In addition to Section 302 disclosures, Section 404(b)

of SOX requires that the auditor opine on the effectiveness

of internal control over financial reporting (ICFR) for

companies with public float of $75 million or more

(accelerated filers).

1

The auditor’s opinion on ICFR

provides additional information as to the effectiveness of

internal control and becomes part of the company’s annual

filing with the SEC.

2

We are interested in the effect of Section 302 and 404(b)

disclosures on individuals’willingness to invest in a target

company. We probe individuals’evaluations of the target

company (reliability of financial statements and credibility

of management), as a means to gain insight into their

investment decisions. In our experimental setting, we

examine three conditions related to Section 302 disclosures:

(1)managementdisclosesamaterial weakness and asserts

that internal controls are not effective; (2) management

discloses a significant deficiency and asserts that internal

controls are effective; and (3) management does not disclose

any control deficiencies and asserts that internal controls are

effective. We test for differences between the three

conditions and, further, investigate whether individuals’

investment decisions are explained by their evaluations of

the target company.

We also examine Section 404(b) disclosures to determine

the incremental effect on individuals’judgments and

decisions –beyond that of Section 302 disclosures. We

examine two conditions related to Section 404(b) disclosures:

(1) the auditor concludes that internal controls are not

effective and issues an adverse opinion on ICFR; and (2)

the auditor concludes that internal controls are effective

and issues a clean (unqualified) opinion on ICFR. We

consider the quarterly and annual disclosures in tandem to

isolate the incremental effect of Section 404(b) disclosures.

Our design choices are such that the combination of

quarterly and annual disclosures create conditions in which

(1) the auditor’s adverse opinion on ICFR is expected versus

unexpected (i.e., management’s conclusions about internal

control are consistent or inconsistent with the auditor’s

opiniononICFR),and(2)theauditor’s clean opinion on

ICFR includes prior disclosure of a significant deficiency

versus no prior disclosure. We investigate the extent to

whichanunexpectedadverseopinion negatively impacts

participants’perceptions of the target company and the

extent to which a clean opinion, coupled with prior

disclosure of a significant deficiency,positively impacts their

perceptions.

Prior archival studies suggest that the disclosure of

internal control deficiencies, most notably material

weaknesses, is associated with a negative stock price

reaction in quarterly filings, per Section 302 (e.g., Beneish,

Billings & Hodder, 2008; Hammersley, Myers &

Shakespeare, 2008; Ashbaugh-Skaife et al.,2009).The

results are somewhatmixed with respect to annual filings,

per Section 404(b), which include the auditor’sopinionon

internal control (e.g., Schneider et al., 2009). Importantly,

Section 302 applies to all SEC filers, whereas Section

404(b) only applies to accelerated filers. The failure to

Correspondence to: Professor Bryan K. Church, Scheller College of

Business,Georgia Institute of Technology, Atlanta,GA 30308, USA. Email:

bryan.church@scheller.gatech.edu

International Journal of Auditing doi: 10.1111/ijau.12065

Int. J. Audit. 20:175–185 (2016)

©2016 John Wiley& Sons Ltd ISSN 1090-6738