Study: Audit tensions often precede control weaknesses

Written on Aug 31, 2017

A new study shows that if tensions are rising between a given company and its external auditor, there’s a greater chance the company will be reporting internal control weaknesses.

The Audit Analytics study was designed to identify factors or conditions at any given company that are likely to precede reporting of problems with disclosure controls or internal control over financial reporting. A change in auditor accompanied with reported issues in dispute increases the probability of a material weakness in the same year by 13%, the study found. A significant vote against auditor ratification increases the probability by 24%.

According to the study, another predictor of a material weakness is a critical financial restatement, where the company issues a reissuance restatement. That’s a filing correcting misstatements in an earlier period, but on errors not considered so serious that an investor cannot rely on the earlier statements. The study says those types of restatements are 20% more likely to be followed by disclosures of material weaknesses in controls.

The study also looks at what factors might be associated with a material weakness finding in the following year. It found some leading indicators of possible material weaknesses include a critical change in CFO, a notable late filing or a significant late filing.

The probabilities associated with those factors are lower, however. For example, a change in CFO where there are stated issues or quick turnover are 3.7% more likely to be associated with subsequent material weakness findings. Late filings, depending on the reasons and whether it’s a repeat occurrence, are 5% to 6.3% more likely to be followed by a material weakness finding.

The study also finds a number of other factors associated with material weakness findings, including earlier findings of material weakness, size of company, changes in accounting estimates, out-of-period adjustments, a going concern opinion and a notable change in audit fees. The study finds only about 5.5% of accelerated and large accelerated filers disclose material weaknesses in controls in any given year.

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