May 24, 2023

Internal Controls: Audit Partners Punished for Negative Opinions?

Earlier this month, Meredith blogged about a surge in the number of material weaknesses disclosed in Form 10-K filings.  According to a new study, that may be bad news for the careers of the audit partners who called out those weaknesses.  Here’s the abstract:

We investigate how audit firms balance the tension between client service and professional responsibility by examining how engagement partners are treated after they issue adverse internal control opinions (ICOs). We find that among 404(b) clients, audit firms are significantly more likely to remove a partner from a continuing engagement when the partner issued an adverse ICO to any of their clients in the previous year. More importantly, we find that individual partners issuing adverse ICOs experience unfavorable changes in their client portfolios in the form of lower fees and less prestigious client assignments.

We also find that partner consequences are greatest when adverse ICOs are likely to be more subjective and when they are issued to more important clients. Our results are consistent with audit partners experiencing negative consequences when they issue opinions that strain auditor-client relations, even though these opinions provide valuable information to capital market participants and are not likely to reflect lower audit quality.

I guess I’m too cynical to be particularly shocked by this, but I think it’s a safe bet that the SEC’s accounting staff is likely to find the study’s conclusions very disturbing. Moreover, in an era where the SEC is stressing the shared responsibility of audit firms and audit committees for ensuring independence, the potential impact of a negative internal controls opinion on an audit partner’s career is a topic that audit committees should be prepared to ask their auditors some tough questions about when evaluating a firm’s independence.

John Jenkins