Prior research finds that auditors often fail to disclose existing material weaknesses in internal controls before they lead to material misstatements. This study aims to investigate whether auditors are aware of such control issues and how they respond by examining subsequent audit-related outcomes of firms with undisclosed control problems (UCPs).
Using a prediction model developed by prior research, the study first identifies firms likely to have UCPs. The study then empirically analyzes how these identified UCPs influence changes in audit fees, audit reporting lags and the likelihood of auditor changes in the subsequent year. The study analysis is based on a large sample of accelerated filers from 2007 to 2019.
The study finds that firms with UCPs are likely to experience higher audit fees and longer reporting lags in the following year, indicating auditors’ awareness of these problems and their proactive responses. However, these increases are smaller than those for firms with formally disclosed material weaknesses, suggesting that auditors perceive UCPs as less severe. In addition, firms with UCPs exhibit a higher likelihood of subsequent auditor dismissal and replacement with higher-quality auditors, which implies that audit committees may be dissatisfied with auditors’ decisions not to publicly report these control deficiencies.
This study contributes new empirical evidence regarding auditor and audit committee reactions to internal control deficiencies that remain undisclosed, addressing a critical yet largely overlooked issue in the auditing literature. This study offers unique insights into auditors’ internal risk assessments, materiality judgments and audit committees’ oversight roles, providing practical implications for regulators, auditors and audit committees in enhancing financial reporting transparency and audit quality.
