Why Do Auditors Fail to Report Material Weaknesses in Internal Controls? Evidence from the PCAOB Data

68 Pages Posted: 18 Sep 2016 Last revised: 5 May 2020

Date Written: October 1, 2019

Abstract

In this paper we investigate why auditors fail to report material weaknesses in internal controls (ICMWs) in advance of misstated audited financial statements. 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 deficiencies in the audits of internal controls documented by PCAOB inspectors. We find evidence using both audit and control deficiencies that detection failure is a significant yet overlooked explanation for unreported ICMWs. Exploratory analyses suggest that factors linked to auditor incentives and expertise explain undetected internal control weaknesses. Collectively, our results suggest that academics, as well as regulators and practitioners, should consider detection as an important reason why misstated financial statements are not preceded by ICMW disclosures.

Keywords: Internal Controls, Auditing, Material Weakness, Restatements, Audit Deficiencies, Detection Failure, Disclosure Failure

JEL Classification: M40, M41, M42, M48, M12

Suggested Citation

Aobdia, Daniel and Choudhary, Preeti and Sadka, Gil, Why Do Auditors Fail to Report Material Weaknesses in Internal Controls? Evidence from the PCAOB Data (October 1, 2019). Available at SSRN: https://ssrn.com/abstract=2838896 or http://dx.doi.org/10.2139/ssrn.2838896

Daniel Aobdia

Northwestern University - Kellogg School of Management ( email )

2211 Campus Drive
Evanston, IL 60208
United States

Preeti Choudhary (Contact Author)

University of Arizona, Eller College of Management ( email )

School of Accountancy
Tucson, AZ 85721
United States

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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