The Effect of Change in the Reporting Threshold and Type of Control Deficiency on Equity Analysts' Evaluation of the Reliability of Future Financial Statements

Abstract

SUMMARY We examine the joint effects of reporting threshold (more than remote versus reasonably possible) and type of control deficiency (entity level versus account specific) as described in the adverse report on internal controls on equity analysts' evaluation of the reliability of a company's future financial statements. We hypothesize that equity analysts interpret a “more than remote” threshold to mean a significantly lower likelihood than a “reasonable possibility” threshold. We also hypothesize that when the reporting threshold is more than remote, equity analysts who evaluate an entity level material weakness will indicate a higher likelihood of future material misstatements than those who evaluate an account specific material weakness. However, when the reporting threshold is reasonably possible, equity analysts will assess the same likelihood of future misstatements for both types of material weakness. The results from an experiment that employed 65 equity analysts support our hypotheses. Taken together, the findings suggest that the change to the “reasonably possible” regime has made the account specific material weakness more consequential in evaluating the reliability of the future financial statements but had no effect on the evaluation of entity level material weaknesses.