Material Weakness Discovery Lag and Misstatement Risk in a Constrained Control Testing Environment

Abstract

In this study, I explore whether archival evidence is consistent with auditors conforming to auditing standards when discovering and responding to internal control weaknesses, and whether conforming has adverse consequences for financial misstatement risk. My study is motivated by two sources: The first is Public Company Accounting Oversight Board member Jeanette Franzel, who in 2015 tasked academics with exploring whether all material weaknesses in internal controls over financial reporting are being properly discovered and disclosed by auditors, as trends in financial misstatement and internal control opinion data suggested otherwise. The second is prior research which suggests that auditors fail to discover most material weaknesses in internal controls; and when auditors do discover a material weakness in internal controls, they often fail to sufficiently adjust their audit procedures over financial statement assertions to negate the misstatement risk resulting from the discovered weakness. An inference from this research is that auditors do not behave in accordance with auditing standards with respect to the discovery of and response to material control weaknesses.I propose and infer from my findings that the combined effect of auditor time constraints, auditor resource constraints, and auditing standards that require the auditor to exercise professional judgment regarding whether and how to perform unplanned control testing procedures leads to a temporal lag in auditors’ discovery of material weaknesses in internal controls, and that the discovery lag results in increased financial misstatement risk. While my results are consistent with auditors failing to discover most material weaknesses in the first year of existence, they also suggest that the discovery failure may be a joint result of auditors following auditing standards while also being constrained by the environment in which they operate.