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Adverse audit opinions on ICFR taper off in 2017

Tammy Whitehouse | September 28, 2018

For the first time since 2010, adverse auditor opinions on internal control over financial reporting tapered off in 2017.

In an analysis by Audit Analytics, 4.9 percent of public company annual filings in 2017 contained an adverse opinion from auditors on the effectiveness of internal control over financial reporting to produce financial statements free of material error. That was a drop from 6.7 percent in 2016, a figure that had risen steadily from 3.5 percent in 2010.

The data show adverse audit opinions landed at 15.9 percent in 2004, the early days after the Sarbanes-Oxley Act required companies to make assessments of their internal controls and auditors to issue opinions on those assessments. As companies and auditors gained more experience with the reporting and as regulators issued more guidance, that figure declined steadily to a low of 3.5 percent in 2010.

At about that point in time, however, the Public Company Accounting Oversight Board took a decidedly more aggressive approach to its inspection of audit firms, coinciding with the increase in adverse opinions shown in the Audit Analytics report. Inspectors began issuing reports reflecting growing numbers of audit deficiencies, especially among the largest firms, which are doing the majority of public company audit work.

The PCAOB has come down particularly hard on the audit of internal control, finding increased instances where auditors failed to properly select controls for testing, failed to properly test the design and operating effectiveness of controls, or failed to properly respond to their own identified risks of material misstatement. Although some firms have shown improvement in recent years, some have not, prompting the PCAOB to consider new ways to address a "plateau" in improvements.

The most common cause for adverse internal control findings in 2017 centered on year-end adjustments, whether they were numerous or individually material, followed closely by problems with accounting personnel competency or training. Additional common causes included inadequate disclosure controls, segregation of duties or design of controls, and IT or software issues.

Now that companies are adopting major new accounting standards—for revenue recognition in 2018 and for leases in 2019—accounting experts have indicated the climate is right for increases in restatement or adverse internal control opinions. “My intuition says with a significant change like this, it does increase the risk of companies having material weaknesses and restatements,” says Cullen Walsh, a partner in accounting advisory services at Grant Thornton.

Preliminary data prepared separately by Audit Analytics suggests public companies may see an increase in restatements in 2018, although that projection is based on filings completed in only the first half of this year. In the first half of 2017, 60 public companies gave notice of a restatement, whereas 65 had issued similar notice in the first half of 2018.

“It’s probably too early for issues to be coming out,” as a result of implementing new rules on revenue recognition, says Walsh. “We will probably have more insight about that after 10K season.”

Among smaller public companies that are not required to have their management assessments of internal control audited, adverse management assessments held relatively steady for a third year in a row, hovering just above one-third of all filings. Between 30 and 40 percent of all filings by smaller companies, which typically have smaller, less resourced accounting functions, have reported adverse internal control opinions over the past decade.