Poll: Companies Punish Auditors Who Point Out Internal Control Weaknesses

Chris Gaetano
Published Date:
Aug 13, 2019

A recent study has found that auditors who are good at their jobs can have a negative, not positive, impact on their firm's reputation in the marketplace, at least when it comes to revealing material weaknesses in internal controls. 

The study, conducted by academics at the University of Arkansas, used a sample of audit offices and their clients from 2004 to 2016 consisting of 4,996 office-year observations. The researchers computed client count for each office-year using the Audit Analytics full population of clients, after removing companies identified as asset backed securities, funds or trusts, non-tickered subsidiaries, offices of bank or other holding companies, and real estate investment trusts because these companies are typically associated with one parent company and the study's authors were interested in capturing growth in the number of unique auditor-client relationships within an audit office.

What they found was, on average, for every Internal Controls Material Weakness (ICMW) issued by an audit office, that office experiences 2.2 percent lower client growth and 6.1 percent lower fee growth over the next year. The more visible the client, and the more severe the ICMW, the more this average goes up, The researchers say that this is largely a reputational effect: Namely, audit clients are less likely to select a firm that they think will make them look bad, and so those that issued an ICMW have a diminished ability to attract new clients. This is in line with previous research that found that clients are more likely to switch auditors after an ICMW issuance. 

"This finding suggests that auditors who issue an ICMW are perceived as less attractive in the audit market and indicates that the issuance of an ICMW affects auditor selection decisions even among clients that do not receive an ICMW," said the study. "Together, these results support the notion that the audit market disincentivizes auditors from disclosing internal control information that could make their clients look bad."

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