A recent study by Joseph F. Brazel, Matthew Starliper, and Yao Yu explores the intricate dynamics of management communication styles when disclosing material weaknesses in internal control over financial reporting (ICFR). The research, published in Accounting Horizons, highlights significant findings that question how communication approaches can impact investor perceptions and decisions.
Under Section 404 of the Sarbanes-Oxley Act, publicly traded companies are required to assess and disclose the effectiveness of their internal controls. The authors analyzed 200 actual ICFR reports that disclosed material weaknesses, revealing that management often adopts a defensive communication style, primarily utilizing a “reasonable assurance” argument. This defensive tone, coupled with the frequent use of first-person pronouns, has implications for how investors respond to these disclosures.
The study indicates that the prevalent communication style—marked by defensiveness—contrasts sharply with the findings from an experimental setup. Here, nonprofessional investors showed a greater willingness to invest when management presented a less defensive version of the “reasonable assurance” argument and refrained from using first-person pronouns. This suggests a critical gap between actual management practices and optimal communication strategies that foster positive investor relations.
In the analyzed reports, a staggering 68% included the “reasonable assurance” argument, yet a majority presented it with characteristics typical of defensive communication. Such defensiveness can create a perception of control over investor attitudes and may even manipulate their decision-making processes. Interestingly, the researchers found that the use of personal pronouns, such as “we” or “our,” could further associate management with negative disclosures, thereby diminishing investor trust.
The authors propose two key responses to these challenges: first, reinforcing individual responsibility in communication by adopting clearer, less defensive language; and second, potentially shifting toward a collective form of authorship in disclosures. This would involve a comprehensive rethinking of how organizations present internal control reports, emphasizing collective responsibility over individual accountability.
The implications of this study extend beyond academia; they resonate within the corporate world, urging management and investor relations professionals to reconsider their communication strategies. By adopting a less defensive approach and avoiding personal pronouns, management can enhance investor confidence and trust, thereby improving overall investment willingness.
As the landscape of corporate governance continues to evolve, this research underscores the pressing need for clearer and more effective communication regarding internal controls. The findings presented in Accounting Horizons serve as a valuable resource for practitioners striving to navigate the complexities of financial disclosures in a manner that aligns with investor expectations.
To explore these critical insights further, the full study is available here.