Why Do Auditors Fail to Report Material Weaknesses in Internal Controls? Evidence from the PCAOB Data
69 Pages Posted: 18 Sep 2016 Last revised: 18 Dec 2020
Date Written: December 17, 2020
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. Additional 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: Suggested Citation