Internal Control Weaknesses and Client Risk Management

55 Pages Posted: 8 Dec 2008 Last revised: 16 Dec 2009

See all articles by Randal J. Elder

Randal J. Elder

Syracuse University

Yan Zhang

State University of New York at Binghamton - School of Management

Jian Zhou

University of Hawaii at Manoa

Nan Zhou

University of Cincinnati - Lindner College of Business

Date Written: December 8, 2008

Abstract

We study auditors' client risk management in the first year of SOX 404 implementation, and find that there exists a pecking order among auditors' strategies to manage control risk resulting from internal control weaknesses. We first examine the relations between internal control weaknesses and audit fee, audit fee increase, modified opinion, and auditor resignation, respectively, and establish that these are viable strategies to manage control risk on a stand-alone basis. When we investigate these strategies simultaneously, descriptive evidence suggests that there exists a pecking order among auditors' client risk management strategies. Our ordered logit analyses document that, as the clients' control risk increases, auditors are likely to respond in the order of audit fee adjustments, modified opinions, and auditor resignations. We further create an index based on the severity of auditors' responses, and find that the degree of control risk is positively correlated with this auditor response index. Our comprehensive evidence suggests that auditors use an array of ordered strategies to manage client-related control risk.

Keywords: Internal control weaknesses, Client risk management, Audit fee and audit opinion, Auditor resignation

JEL Classification: M49, G38

Suggested Citation

Elder, Randy and Zhang, Yan and Zhou, Jian and Zhou, Nan, Internal Control Weaknesses and Client Risk Management (December 8, 2008). Journal of Accounting, Auditing and Finance, Vol. 24, No. 4, pp. 543-579, 2009. Available at SSRN: https://ssrn.com/abstract=1312990

Randy Elder

Syracuse University ( email )

900 S. Crouse Avenue
School of Management Department of Accounting
Syracuse, NY 13244
United States
315-443-3359 (Phone)
315-443-5457 (Fax)

Yan Zhang (Contact Author)

State University of New York at Binghamton - School of Management ( email )

P.O. Box 6015
Binghamton, NY 13902-6015
United States
607-777-6195 (Phone)
607-777-4422 (Fax)

Jian Zhou

University of Hawaii at Manoa ( email )

Honolulu, HI 96822
United States

Nan Zhou

University of Cincinnati - Lindner College of Business ( email )

P.O. Box 210211
Cincinnati, OH 45221-0211
United States

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