If tensions are rising between a given company and its external auditor, there’s a greater chance the company will be reporting internal control weaknesses.
That’s one of the findings of a recent Audit Analytics study, which sought to identify those factors or conditions at any given company that are likely to precede reporting of problems with disclosure controls or internal control over financial reporting. A change in auditor accompanied with reported issues in dispute increases the probability of a material weakness in the same year by 13 percent, the study found. A significant vote against auditor ratification increases the probability by 24 percent.
Another predictor of a material weakness, says the study, is a critical financial restatement, where the company issues a reissuance restatement. That’s a filing correcting misstatements in an earlier period, but on errors not considered so serious that an investor cannot rely on the earlier statements. The study says those types of restatements are 20 percent more likely to be followed by disclosures of material weaknesses in controls.
The study also look at what factors might be associated with a material weakness finding in the following year. It found some leading indicators of possible material weaknesses include a critical change in CFO, a notable late filing, or a significant late filing.
The probabilities associated with those factors are lower, however. For example, a change in CFO where there are stated issues or quick turnover are 3.7 percent more likely to be associated with subsequent material weakness findings. Late filings, depending on the reasons and whether it’s a repeat occurrence, are 5 percent to 6.3 percent more likely to be followed by a material weakness finding.
The study also finds a number of other factors associated with material weakness findings, including earlier findings of material weakness, size of company, changes in accounting estimates, out-of-period adjustments, a going concern opinion, and a notable change in audit fees. The study finds only about 5.5 percent of accelerated and large accelerated filers disclose material weaknesses in controls in any given year.