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

66 Pages Posted: 18 Sep 2016 Last revised: 5 May 2018

Date Written: April 19, 2018

Abstract

Using proprietary data from PCAOB inspections, we evaluate why auditors often fail to report material weaknesses in internal controls (ICMW) prior to a material restatement. Despite our evidence that managers and auditors have disincentives to report an ICMW, we fail to find systematic evidence that internal control severity is assessed as less severe than it should be; lower level deficiencies only predict immaterial errors, but do not predict material restatements. We use PCAOB inspection findings to evaluate additional reasons auditors may fail to report an ICMW prior to a material restatement. We find that failing to identify the proper controls to evaluate is not only quite prevalent in our sample, but is also predictive of a material restatement. We also find some evidence that when the auditor failed to properly test the severity of lower level deficiencies, lower level deficiencies predict material restatements. Our evidence suggests that often auditors do not discover and disclose ICMWs prior to material restatements because of incompetency in executing the internal control audit.

Keywords: Internal Controls, Auditing, Material Weakness, Restatements, Audit Deficiencies

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

Suggested Citation

Aobdia, Daniel and Choudhary, Preeti and Sadka, Gil, Do Auditors Correctly Identify and Assess Internal Control Deficiencies? Evidence from the PCAOB Data (April 19, 2018). Georgetown McDonough School of Business Research Paper. 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 )

Department of History
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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