Working Paper: Do Auditors Correctly Identify and Assess Internal Control Deficiencies? Evidence from the PCAOB Data

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

Abstract:  We analyze the 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 to investigate why material weaknesses in internal controls are often not reported in audited financial statements issued before restatements (material-error corrections). We explore detection and disclosure as two possible explanations and find that the disclosure explanation is less frequent in our sample than detection, with the latter generally due to the auditor’s failure to identify the relevant internal controls to evaluate. Exploratory analyses suggest that factors linked to auditor incentives and competence help 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.