Working Paper: Why do Auditors Fail to Report Material Weaknesses in Internal Controls? Evidence from the PCAOB Data

Paper Author: Daniel Aobdia, Preeti Choudhary, and Gil Sadka

Abstract:  This paper investigates why material weaknesses in internal controls are often not reported in audited financial statements issued before restatements. To address this question, we analyze Public Company Accounting Oversight Board (PCAOB) proprietary data on audit clients’ internal control deficiencies (both material weaknesses and less-severe deficiencies) and PCAOB-inspector-documented deficiencies in the audits of internal controls. We find that the auditor’s failure to identify the relevant internal controls to evaluate is a significant, yet overlooked explanation. Exploratory analyses suggest that factors linked to auditor incentives and competence explain undetected internal control weaknesses. Collectively, our results suggest that academics, as well as regulators and practitioners, should consider auditor failures to detect internal control deficiencies as an important reason why restatements are not preceded by disclosures of material weaknesses in internal controls.