The Unintended Consequences of Material Weakness Reporting on Auditors' Acceptance of Aggressive Client Reporting

2019 ◽  
Vol 95 (4) ◽  
pp. 51-72
Author(s):  
Tim D. Bauer ◽  
Anthony C. Bucaro ◽  
Cassandra Estep
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Quality ◽  
Unintended Consequences ◽  
Unintended Consequence ◽  
Financial Statement ◽  
Material Weakness ◽  
Material Weaknesses ◽  
Licensing Effects ◽  
Potential Remedy

ABSTRACT Regulators are concerned that auditors do not sufficiently identify and report material weaknesses in internal control over financial reporting (ICFR). However, psychological licensing theory suggests reporting material weaknesses could have unintended consequences for acceptance of aggressive client financial reporting. In an experiment, we predict and find auditors accept more aggressive client reporting after they report a material weakness in ICFR than after they report no material weakness. We provide evidence licensing underlies this effect. In a second experiment, we investigate the efficacy of an intervention to reduce the identified licensing effects by prompting an audit quality goal. We find this prompt mitigates the unintended consequence when auditors report a material weakness. While regulators are concerned companies are undeservedly receiving clean ICFR audit opinions, our findings indicate adverse ICFR opinions may lead auditors to give companies undeservedly clean financial statement opinions. We provide a potential remedy to this unintended consequence.

scholarly journals Integration of Internal Control and Financial Statement Audits: Are Two Audits Better than One?

2018 ◽  
Vol 94 (2) ◽  
pp. 53-81 ◽  
Author(s):  
Lori Shefchik Bhaskar ◽  
Joseph H. Schroeder ◽  
Marcy L. Shepardson
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Quality ◽  
Internal Controls ◽  
Data Availability ◽  
Financial Statement ◽  
Auditor Judgment ◽  
Public Company ◽  
Better Than

ABSTRACT The quality of financial statement (FS) audits integrated with audits of internal controls over financial reporting (ICFR) depends upon the quality of ICFR information used in, and its integration into, FS audits. Recent research and PCAOB inspections find auditors underreport existing ICFR weaknesses and perform insufficient testing to address identified risks, suggesting integrated audits—in which substantial ICFR testing is required—may result in lower FS audit quality than FS-only audits. We compare a 2007–2013 sample of small U.S. public company firm-years receiving integrated audits (accelerated filers) to firm-years receiving FS-only audits (non-accelerated filers) and find integrated audits are associated with higher likelihood of material misstatements and discretionary accruals, consistent with lower FS audit quality. We also find evidence of (1) auditor judgment-based integration issues, and (2) low-quality ICFR audits harming FS audit quality. Overall, results suggest an important potential consequence of integrated audits is lower FS audit quality. Data Availability: Data are publicly available from the sources identified in the text.

The Unintended Consequences of Internal Controls Reporting on Tax Decision Making

2019 ◽  
Vol 42 (1) ◽  
pp. 83-102
Author(s):  
Victoria J. Hansen
Keyword(s):  
Decision Making ◽  
Financial Reporting ◽  
Internal Control ◽  
Unintended Consequences ◽  
Internal Controls ◽  
Corporate Tax ◽  
Material Weakness ◽  
Reporting Requirements ◽  
Internal Control Deficiencies ◽  
The Impact

ABSTRACT This study investigates the impact of the internal controls over financial reporting requirements (ICFR) on the decision making of corporate tax executives. I examine tax executives' decisions to disclose an internal control deficiency by amending a prior year return when the internal control deficiency will be classified as either a significant deficiency or a material weakness. I also examine if tax executives' decisions are impacted by whether amending results in a refund or additional tax due. I find tax executives are less likely to disclose (amend) when the internal control deficiency is classified as a material weakness. When facing a material weakness, 16.7 percent choose not to disclose. Tax executives are also less likely to disclose (amend) when amending results in additional tax due. These results indicate the ICFR requirements may have unintended consequences. If executives do not disclose internal control deficiencies, the reliability of financial reporting is limited.

The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality

2013 ◽  
Vol 33 (1) ◽  
pp. 93-116 ◽  
Author(s):  
Emma-Riikka Myllymäki
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Reporting Quality ◽  
Financial Reporting Quality ◽  
Control Problems ◽  
Section 404 ◽  
Material Weakness ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
History Of

SUMMARY This study examines whether Sarbanes-Oxley (SOX) Section 404 material weakness (MW404) disclosures are predictive of future financial reporting quality. I find evidence that for companies with a history of MW404s, the likelihood of misstatements in financial information continues to be significantly higher for two years after the last MW404 report compared to companies without a history of reported MW404s. The magnitude of the effect decreases non-linearly with decreasing speed. The findings further imply that the reason for the misstatement incidences is the unacknowledged pervasiveness of control problems. In particular, it appears that in many cases, the future misstatements are unrelated to the MW types disclosed in the last MW404 report, suggesting that some MW types are unacknowledged and, hence, control problems are even more pervasive than what was identified. Overall, the findings of this study highlight the importance of discovering and disclosing material weaknesses in internal control over financial reporting.

Material weakness disclosures and restatements: value of external auditor attestation

2019 ◽  
Vol 32 (3) ◽  
pp. 362-380
Author(s):  
Binod Guragai ◽  
Paul D. Hutchison
Keyword(s):  
Propensity Score ◽  
Propensity Score Matching ◽  
Financial Reporting ◽  
Internal Control ◽  
Financial Services ◽  
Reporting Quality ◽  
Unintended Consequences ◽  
Financial Reporting Quality ◽  
Material Weakness ◽  
Content Type

Purpose The purpose of this study is to examine the value of auditor attestation in internal control over financial reporting (ICFR) disclosures. The authors argue that internal control material weakness (ICMW) disclosures issued without auditor attestation by non-accelerated filers provide weaker signal to the impaired financial reporting quality compared to those issued with auditor attestation by accelerated filers. Design/methodology/approach This study investigates the differences in the association between ICMW disclosures and impaired financial reporting quality, as proxied by financial statement restatements, for accelerated and non-accelerated filers. The authors use propensity score matching to find control groups for both accelerated and non-accelerated filers. Findings The authors find that ICMW disclosures signal impaired financial reporting quality for both accelerated and non-accelerated filers, but such signaling is weaker for non-accelerated filers compared to accelerated filers. Research limitations/implications Although propensity score matching was used to match firms with and without ICMW disclosures, any unobservable fundamental differences between these groups may affect the results of this study. Originality/value This study shows that auditors’ involvement in the assessment of internal control effectiveness improves the signaling effect of ICMW disclosures on impaired financial reporting quality. As approved by the House Financial Services (HFS) Committee on November 4, 2009, non-accelerated filers are permanently exempt from auditor attestation requirement. This study provides some evidence that the exemption of non-accelerated filers from auditor attestation may have unintended consequences, and these results should be of interest to regulators and investors.

Audit Office Experience with SOX 404(b) Filers and SOX 404 Audit Quality

2018 ◽  
Vol 94 (4) ◽  
pp. 1-43 ◽  
Author(s):  
Divya Anantharaman ◽  
Nader Wans
Keyword(s):  
Internal Control ◽  
Audit Quality ◽  
Two Dimensions ◽  
Financial Statement ◽  
Timely Manner ◽  
Material Weaknesses ◽  
History Of ◽  
Timely Fashion ◽  
Internal Control Weaknesses ◽  
Industry Expertise

ABSTRACT We measure two dimensions of SOX 404 audit quality: (1) whether auditors identify and report material weaknesses (MWs) in a timely fashion, and (2) on identifying MWs, whether auditors identify misstatements arising from MWs in a timely fashion. We find that audit practice-offices with a large base of SOX 404(b) clients and those with a long history of conducting control evaluations for that client are more likely (1) to identify and report MWs in a timely manner (i.e., before resulting restatements come to light), and conditional on identifying MWs, (2) to detect MW-related misstatements in a timely manner (i.e., before the misstatements become restatements). Audit office industry expertise also matters, but only to timely MW reporting. Our results inform on the drivers of variation in SOX 404 audit quality, and highlight the key role that auditors play in identifying internal control weaknesses and assessing their impact on financial statement reliability.

Unexpected Fees and the Prediction of Material Weaknesses in Internal Control Over Financial Reporting

2016 ◽  
Vol 33 (4) ◽  
pp. 485-505 ◽  
Author(s):  
Susan M. Albring ◽  
Randal J. Elder ◽  
Xiaolu Xu
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Audit Fees ◽  
Financial Statement ◽  
Section 404 ◽  
Sarbanes Oxley ◽  
Material Weaknesses ◽  
New Material ◽  
Internal Control Weaknesses ◽  
Section 302

We investigate whether prior year unexpected audit fees help predict new material weaknesses in internal control over financial reporting reported under Section 404 of the Sarbanes–Oxley Act (SOX). Predicting material weaknesses may be useful to investors and other financial statement users because these disclosures have adverse economic impacts on disclosing firms. Unexpected fees are significantly associated with material weaknesses reported under Section 404, even after controlling for Section 302 disclosures and other factors associated with internal control weaknesses. Unexpected fees are associated with company-level weaknesses but are not significantly associated with account-specific weaknesses, consistent with differences in the nature and severity of the two types of material weaknesses. Our results are consistent with unexpected audit fees containing information on unobserved audit costs and client control risks, which help predict future internal control weaknesses.

Business Strategy, Internal Control over Financial Reporting, and Audit Reporting Quality

2017 ◽  
Vol 36 (4) ◽  
pp. 49-69 ◽  
Author(s):  
Kathleen A. Bentley-Goode ◽  
Nathan J. Newton ◽  
Anne M. Thompson
Keyword(s):  
Quality Improvement ◽  
Financial Reporting ◽  
Internal Control ◽  
Business Strategy ◽  
Audit Quality ◽  
Reporting Quality ◽  
Internal Controls ◽  
Data Availability ◽  
Material Weaknesses ◽  
Jel Classifications

SUMMARY This study examines whether a company's business strategy is an underlying determinant of the strength of its internal control over financial reporting (ICFR) and auditors' internal control reporting quality. Organizational theory suggests that companies following an innovative “prospector” strategy are likely to have weaker internal controls than companies following an efficient “defender” strategy. Consistent with theory, we find that firms with greater prospector-like characteristics are more likely to report and less likely to remediate material weaknesses, incremental to known determinants of material weaknesses. We also find that auditors' internal control reporting quality is lower among clients with greater prospector-like characteristics when measured using the timeliness of reported material weaknesses. Our findings indicate that business strategy is a useful summary indicator for evaluating companies' internal control strength and suggest that internal control reporting is an important area for audit quality improvement among prospector-like clients. JEL Classifications: D21; 21; M41. Data Availability: Data are obtained from public sources as indicated in the text.

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

2021 ◽  
Vol ahead-of-print (ahead-of-print) ◽  
Author(s):  
Hyeesoo (Sally) Chung ◽  
Sudha Krishnan ◽  
John Lauck ◽  
Jinyoung Wynn
Keyword(s):  
Internal Control ◽  
Negative Impact ◽  
Unintended Consequences ◽  
Financial Statement ◽  
Presentation Format ◽  
Market Reactions ◽  
Content Type ◽  
Financial Statement Audit ◽  
Material Weaknesses ◽  
Audit Reports

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.

Adverse Section 404 Opinions and Shareholder Dissatisfaction toward Auditors

2009 ◽  
Vol 23 (4) ◽  
pp. 391-409 ◽  
Author(s):  
Dana R. Hermanson ◽  
Jagan Krishnan ◽  
Zhongxia (Shelly) Ye
Keyword(s):  
Internal Control ◽  
Audit Quality ◽  
First Year ◽  
Section 404 ◽  
Positive Interaction ◽  
Material Weakness ◽  
Accounting Restatements ◽  
Material Weaknesses ◽  
Level Versus

SYNOPSIS: Auditors issuing adverse Section 404 internal control opinions may be viewed as too conservative, or they may be blamed for being partly responsible for the existence of the internal control material weaknesses. Using a sample of 240 companies with adverse internal control opinions and 240 matched “clean” companies in their first year of Section 404 compliance, we examine how shareholder dissatisfaction with the auditors varies depending on material weakness existence/type (company-level versus noncompany-level) and the presence of recent accounting restatements. In the full sample, we find a significant positive interaction between restatement and company-level material weakness—company-level material weaknesses have a greater effect on shareholder dissatisfaction when a restatement has occurred. To provide insight, we partition our sample based on whether test companies have had recent accounting restatements. In the nonrestatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 internal control opinion because of noncompany-level material weaknesses. Shareholders may view the auditor as being too conservative when no company-level material weaknesses are cited and no recent accounting restatements have been issued. In the restatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 opinion with or without company-level material weaknesses cited—but with shareholder dissatisfaction greater for companies with company-level material weaknesses. Hence, in companies with recent accounting restatements, shareholders may blame the auditor for being partly responsible for the existence of material weaknesses (i.e., low audit quality). Overall, the results provide insights into shareholders’ perceptions of auditing and suggest that existing shareholders may sometimes prefer less conservative auditors. We encourage additional research on the role of auditors in protecting current versus prospective shareholders.

Accruals Quality and Internal Control over Financial Reporting

2007 ◽  
Vol 82 (5) ◽  
pp. 1141-1170 ◽  
Author(s):  
Jeffrey T. Doyle ◽  
Weili Ge ◽  
Sarah McVay
Keyword(s):  
Financial Reporting ◽  
Internal Control ◽  
Discretionary Accruals ◽  
Cash Flows ◽  
Internal Controls ◽  
Earnings Persistence ◽  
Firm Characteristics ◽  
Material Weakness ◽  
Material Weaknesses ◽  
Accruals Quality

We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to “audit around.” We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

Sign in / Sign up

Export Citation Format

Share Document