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

Research focus: This study investigates the effectiveness of audits of internal control over financial reporting (ICFR) and examines why material weakness disclosures warning investors of problems in a company’s system of internal control don’t occur more frequently. In earlier studies, researchers have found that less than a third of all restatements are preceded by a material weakness disclosure.

Initial results suggest that managers and auditors both face incentives to misclassify material weaknesses as lower level deficiencies. The data shows, for example, that while CFOs are more likely to lose their job following disclosure of a material weakness, discovery of deficiencies or significant deficiencies do not appear to influence CFO switches. The authors conclude that CFOs' concerns for their own careers could lead them to pressure auditors to underestimate the severity level of identified material weaknesses, particularly in the absence of financial reporting errors. The authors also provide evidence consistent with auditors having incentives to underestimate the severity of identified material weaknesses to preserve the short-term profitability of their audits.

Despite these incentives, the data suggests that auditors generally correctly assess the severity of identified internal control problems. The data shows that material weaknesses are associated with material errors, but deficiencies and significant deficiencies are not. The authors provide evidence that significant deficiencies are nevertheless informative about financial reporting reliability in that they provide predictive power over immaterial errors.

Finally, the authors evaluate what additional factors explain why material weakness disclosures often do not precede a material error in financial reporting and find evidence that auditors struggle to properly identify what controls to test.