Repeat Offenders: Examining Cases of Multiple Years of Internal Control Weaknesses

• In Event: Internal Control and Fraud Detection

Abstract

This study attempts to identify potential drivers behind the increasing number of companies disclosing material weaknesses in internal controls and receiving adverse opinions on the internal controls over financial reporting (ICFR) audit. Despite the fact that more than a decade has passed since the requirements in SOX were enacted, ICFR continues to be an important and risky area since it includes the processes and procedures pertaining specifically to financial reporting. We focus on whether a subset of public companies with multiple years of adverse opinions (“repeat offenders”) is driving the increase in adverse opinions. Additionally, we investigate two important audit features of ICFR issues in the context of our repeat offender sample: auditor changes and audit fees. We find on average, 40% of reported adverse opinions in ICFR in a given year can be attributed to repeat offenders and that 62% of repeat offenders experience consecutive years of internal control weaknesses. The most commonly reported category of material weakness classifications among these firms is “accounting rule (GAAP/FASB) application failure”. In multivariate analysis, we find that repeat offenders are more likely to have pervasive material weakness issues, as proxied by the number of material weaknesses reported. These firms are also less likely to utilize Big4 auditors, are smaller, are more complex, and are more likely to be incorporated outside the U.S. In terms of the consequences of multiple years of material weakness reporting, we find that the level of audit fees is significantly higher for repeat offenders and the pervasiveness of the material weakness disclosures is positively and significantly associated with audit fees and changes in audit fees. Lastly, we find that repeat offenders are more likely to switch auditors and this switch is more likely to be to smaller audit firms.

Authors

• Kathleen M Bakarich, Hofstra University

• Devon Baranek, Rider University