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

  • PCAOB (US Public Company Accounting Oversight Board) (dark gray) Image

Nov 30, 2016

In November 2016, the Public Company Accounting Oversight Board (PCAOB) released the paper "Do Auditors Correctly Identify and Assess Internal Control Deficiencies? Evidence from the PCAOB Data." The paper was presented at the PCOAB’s 2016 Conference on Auditing and Capital Markets on October 20-21, 2016.

Auditors routinely fail to disclose material weaknesses prior to a material error (i.e. restatements). One potential reason is that auditors misclassify the severity of identified internal control deficiencies due to complexity in judging the materiality and likelihood of potential related errors. Another reason is that auditors face disincentives to report a material weakness without a clear indication of an existing error. The authors evaluate these possibilities using a proprietary database on auditor-identified control deficiencies that are not deemed material weaknesses, hence not publicly disclosed. They compared the severity of the control deficiency with the severity of ex-post reporting errors. Even though they found some evidence consistent with auditor and management incentives to misclassify material weaknesses as less serious deficiencies, they generally found that 1) the severity of identified control deficiencies is properly assessed and 2) the auditor is able to provide reasonable assurance about whether financial statements are materially misstated in the presence of identified deficiencies. Their evidence indicated that the inability of auditors to properly identify relevant internal controls is a contributing reason why material weaknesses are not discovered and disclosed prior to material error restatements.

Collectively, their results indicate that misclassification of the severity of internal control deficiencies is unlikely to be the main reason for why material weaknesses do not often precede a material error restatement. Rather, their results indicate that the inability of the auditor to properly identify relevant internal controls is a contributing factor to the lack of timeliness in disclosures of internal control material weaknesses.

Review the study on the PCAOB's website.

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