An academic study finds that an adverse opinion on the effectiveness of a company’s internal control over financial reporting (ICFR) may not just raise investor concerns about the reliability of the company’s financial reporting. It may also lead to the demotion of the engagement partner.
Section 404(b) of the Sarbanes-Oxley Act requires larger public companies to obtain an opinion from the company’s financial statement auditor on the effectiveness of the company’s ICFR. ICFR is ineffective when there are one or more material weaknesses in the company’s controls. Investor advocates generally assert that ICFR opinions provide valuable information concerning the reliability of a company’s financial reporting. Some critics of the profession have argued that material weaknesses are, however, under-reported because auditors face pressures not to issue adverse ICFR opinions. See Do Audit Committees Shun Accounting Firms That Uncover Material Weaknesses?, August 2019 Update.
How Do Audit Firms Treat Partners Who Issue Adverse Internal Control Opinions?, by Ashleigh L. Bakke (University of Kansas). Elizabeth N. Cowle (Colorado State University), Stephen P. Rowe (University of Arkansas), and Michael S. Wilkins (University of Kansas), seems to lend additional support to these concerns. The authors reviewed audit partners and their publicly traded clients with audit opinions filed from January of 2017 through December of 2020. They find that –
“[A]udit firms are significantly more likely to remove a partner from a continuing engagement when the partner issued an adverse ICO [internal control opinion] to any of their clients in the previous year. More importantly, we find that individual partners issuing adverse ICOs experience unfavorable changes in their client portfolios in the form of lower fees and less prestigious client assignments. * * * Our results are consistent with audit partners experiencing negative consequences when they issue opinions that strain auditor-client relations, even though these opinions provide valuable information to capital market participants and are not likely to reflect lower audit quality.”
The authors conclude with the observation that their “findings suggest a potential ‘root cause’ for why material weaknesses may be underreported.”
It is difficult to gauge the extent to which the possible career impacts this study reports actually affect auditor behavior. However, audit committees may want to bear the study’s findings in mind when they are confronted with situations in which the company’s ICFR contains one of more significant deficiencies that do not, in the view of management and the auditor, rise to the level of material weaknesses. Audit committees should be alert to the possibility that career considerations could influence the auditor’s views regarding control effectiveness.