Market reactions to the internal control reporting presentation format: combined vs separate audit reports

Abstract

PurposeThis paper aims to investigate whether the stock market reacts to presentation options available to auditors under AS 2 (providing separate financial statement audit and internal control over financial reporting [ICOFR] audit reports, or presenting a combined report with both audit opinions). Design/methodology/approachDrawing on psychology theory, the authors hypothesize that presenting material weaknesses in ICOFR with an unqualified financial statement audit in a combined report effectively dilutes the weight placed on the material weaknesses perceived by investors. The authors further hypothesize the presentation format effect to vary by type of material weaknesses since some material weaknesses are considered more serious than others. The authors examine ICOFR and audit reporting and cumulative abnormal return data from 2007 to 2017 using two-stage least squares regression analysis. FindingsThe results show that a combined report of ineffective ICOFR and unqualified financial statement audit reduces the negative impact of material weakness disclosures on stock price reactions, but only when the weaknesses involve more serious entity-wide controls, as opposed to controls over specific accounts. Practical implicationsThe findings help inform preparers, auditors, regulators and investors about the potentially unintended consequences of reporting format choice. Originality/valueThe findings contribute to the literature on internal control disclosures by demonstrating that market reactions to these disclosures depend not only on the types of material weaknesses disclosed but also on their presentation format.