The Unintended Consequences of Material Weakness Reporting on Auditors’ Acceptance of Aggressive Client Reporting

• In Event: Auditor-Client Relationships & Interactions

Abstract

The SEC and the PCAOB are concerned that auditors do not sufficiently identify and report material weaknesses in internal controls over financial reporting (ICFR). However, theory on psychological licensing suggests reporting more material weaknesses could have unintended consequences: auditors may be more likely to permit aggressive accounting by their clients when they report a material weakness in ICFR. We conduct an experiment with experienced auditors to investigate this possibility. We predict and find auditors more willingly accept aggressive client accounting preferences after they initially report a material weakness in ICFR versus reporting no material weakness. These results hold whether the material weakness is in the same or different financial statement account as the aggressive accounting, or is at the entity-level. We also examine auditors’ underlying cognitive processes leading to such action. This research is informative to practitioners and regulators because while regulators are concerned companies are undeservedly receiving clean ICFR audit opinions, our findings indicate adverse ICFR opinions may lead auditors to give companies undeservedly clean financial statement opinions.

Authors

• Tim David Bauer, University of Illinois-Urbana-Champaign

• Anthony Bucaro, Case Western Reserve University

• Cassandra Ruth Estep, Emory University