Inferring Remediation and Operational Risk from Material Weakness Disclosures

Abstract

ABSTRACT Understanding the inferences that nonprofessional investors draw from material weakness disclosures is important because of their effect on investment decisions and for assessing whether current standards serve their needs. Prior research shows that users assess higher financial reporting risk for an entity-level material weakness compared to an account-specific material weakness because they perceive the former as presenting a higher risk of potential misstatement. We extend the literature by proposing two variables (remediation and operational risks) that mediate and incrementally explain the observed relationship between the type of material weakness and financial reporting risk assessments. In an experiment involving 181 nonprofessional investors, we find, as predicted, that the entity-level material weakness signals not just a higher potential for undetected misstatements but also higher remediation and operational risks. Further, we find that the two variables fully mediate and incrementally explain the relationship between the type of material weakness and financial reporting risk assessments. To the extent that these variables are decision relevant, our findings suggest that regulators should reconsider and possibly reengineer the current disclosure regime that allows management to disclose unaudited information about these variables. Data Availability: Contact the authors.