Investigating the Reaction of Relatively Unsophisticated Investors To Audit Assurance on

1. Investigating the Reaction of Relatively Unsophisticated Investors To Audit Assurance on Firm-Released News Announcements J. E. Hunton – Bentley College J. L. Reck – University of South Florida R. E. Pinsker – Old Dominion University

2. Motivation • Individual investors, an understudied group, are gaining sufficient numbers to ‘move’ the market. • Information technology allows for ubiquitous access to news announcements. • It is important to investigate the perceived value of independent assurance to relatively unsophisticated investors.

3. Background • Investors use information to help them determine the value of a firm (Watts and Zimmerman 1986; AICPA 1996; Beaver 1998). • Incomplete information, hampers investors’ ability to arrive at accurate valuations. • Incomplete information increases investors’ perceptions of information risk (Masters 1989).

4. Background • As Miller (2002, p 71) succinctly states: • Incomplete information fosters [investor] uncertainty. • Uncertainty creates risk. • Risk motivates investors to demand a higher rate of return. • Demand [for a higher rate of return] results in a higher cost of capital and lower security [stock] prices.

5. Background • Incomplete information has been defined in terms of information asymmetry and information quality (Marston 1996; Beaver 1998; Miller 2002). • Of particular interest to the current study is the quality of information. • at least one characteristic of quality information is reliability (FASB 1980). • Information that is unreliable increases investor uncertainty, thus triggering the sequence of events identified by Miller (2002).

6. Background • By providing reliable information, firms can reduce investor uncertainty, decrease risk and increase stock prices (King et al. 1990; Olsen 1997; Kennedy et al. 1998). • Assessing reliability may be an especially difficult task for retail investors who are generally viewed as less sophisticated than institutional investors (Olsen 1997; Beaver 1998).

7. Prior Research • A large body of research supports the value of the assurance function in improving the quality of information (“information hypothesis”) (e.g., Fama and Laffer, 1971; Wallace 1980, 1987) • Research studies since the 1980’s continue to support the information hypothesis, for instance→

8. Prior Research • An experiment by Pany and Smith (1982) found an association between auditor assurance and perceived information reliability. • A more recent study (Hodge 2001) found a moderately strong, positive correlation between reliability of information and the perceived earnings potential of a firm.

9. Prior Research • Prior research indicates a positive association between audit functions and market value. • However, all of the prior research has focused on relatively sophisticated user groups. • Hence, there remains a question as to whether unsophisticated investors will have sufficient knowledge of auditors/audit services to allow for a positive association between audit functions and market value.

10. Research Hypotheses → H1 • H1: Stock prices will be greater when management-provided information is accompanied by independent auditor assurance, as compared to no assurance. • There is no indication that unsophisticated investors would consider the presence of audit assurance to be a negative factor, but the investor may not value audit assurance enough to significantly adjust market prices.

11. Research Hypotheses → H2 • H2: The stock price increase related to audit assurance will be greater for a series of positive information releases, as compared to negative information releases.

12. Research Hypotheses → H3 • H3: Stock price variance will be smaller when the information is accompanied with independent auditor assurance, as compared to no assurance.

13. Experimental Design • The experiment employed a 3 (direction of news: positive, mixed or negative) by 2 (assurance: absent or present) between-subjects design. • The entire experiment was computerized via Visual Basic programming. • The program randomized participants into treatment conditions • The order of dependent variable measures, manipulation check questions and post-experiment psychological debriefing items were randomized.

14. Research Procedure News Announcement 1-10 (++ : without Assurance) Welcome Screen Manipulation Checks News Announcement 1-10 (-- : without Assurance News Announcement 1-10 (+- : without Assurance Training Screens Post-Experiment Questions News Announcement 1-10 (++ : with Assurance) Company Background News Announcement 1-10 (-- : with Assurance Demographic Items News Announcement 1-10 (+/- : with Assurance

15. Sample Computer Screens

16. Sample Computer Screens

17. Sample Computer Screens

18. Usable Sample Size

19. Demographic Results Age Brackets: 18-22 9 23-29 143 30-39 27 Gender: Female 120 Male 59 College Level: Seniors 18 Masters 157 Ph.D.s 4 Liberal Arts Majors

20. Overall Means (S.D.)

21. ANCOVA Model of 10th Stock Price Valuation

22. H1 - Confirmed

23. H2 - Confirmed

24. Third Hypothesis (H3) • Variances will be greater in all ‘direction of news’ conditions (++, --. +-) with assurance, as compared to without assurance. • H3 was only supported in the negative news (--) condition. • The mixed results associated with H3 were similar to prior behavioral studies that have had difficulty finding consistent results using variance as a measure of risk/uncertainty (Hodder et al. 2001).

25. Summary • Audit assurance can significantly increase the value individual investors assign to stocks. • The results held regardless of whether the assurance was provided on a series of positive, negative or mixed sign disclosures. • The increase in stock price related to assurance was greatest when the firm released a series of positive information disclosures.

26. Summary • Stock price variance was consistently and significantly smaller when audit assurance was provided on negative news disclosures. • The variances surrounding no assurance positive disclosures were larger than the variances surrounding the no assurance negative disclosures. • Hence, it appears the positive information provided by the firm was deemed less reliable than negative information

27. Limitations • Usual external validity concerns related to experiments • Arbitrary choices made for the positive/negative news announcements • Length of the information series • Participant pool • Cost/benefit considerations

28. Future Research • Information overload concerns induced by continuous reporting/assurance • Why risk (variance) was reduced more in the negative, as compared to positive, news condition. • Impact of other credible assurance providers on perceptions of reliability • Impact of having management certify the ‘truthfulness’ of disclosures on perceptions of reliability.