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

Abstract

Purpose In preparing company financial statements, management is required to evaluate internal controls and disclose any material weaknesses in the internal control over financial reporting (ICFR) report. This study aims to examine how the tone of the details management provides to describe a material weakness in its ICFR report impacts investors’ perceptions of the severity of the material weakness and the desirability of the company as a potential investment. Design/methodology/approach This study uses an experimental design that manipulates whether the company’s ICFR report includes a negatively-toned detail to describe a material weakness disclosed in the report. Participants read the report and answer questions concerning their perceptions of the desirability of the company as an investment and the severity of the material weakness. Findings This study finds that using negatively-toned details to describe a material weakness, as opposed to an absence of those details, decreases investment desirability due to an increase in the perceived severity and number of distinct problems in ICFR. Originality/value This study extends prior research by showing that the tone of details used to describe a material weakness, not just the quantity of details, impacts investors’ decision-making. This study shows that management can carefully construct their ICFR report to avoid tone and potentially mitigate the negative effect of disclosing ineffective ICFR.