Audit partners who issue adverse internal control opinions are often replaced and experience unfavorable changes in their client portfolios, according to a research study forthcoming in the Journal of Accounting Research.
For large, publicly traded companies, their financial statement auditor issues an opinion on their internal controls over financial reporting. These controls include the separation of duties involving the accounting for assets like cash and inventory, credit checks for sales on account, and approved vendor listings. Like a financial statement audit, the auditor’s opinion on a company’s internal controls is provided annually to the public.
When the auditor determines that a material or substantial weakness in internal control exists, the auditor can issue a negative or adverse opinion on a company’s internal controls. Prior research has demonstrated that adverse opinions can lead to negative market responses and the audit firm is sometimes replaced. But when the audit firm is not replaced, are there consequences for the audit partner who issued the adverse opinion?
In a study titled “What Happens to Partners Who Issue Adverse Internal Control Opinions?” researchers examined 10,979 audit opinions on companies’ internal controls between 2017 and 2023. Roughly 6% of the opinions examined in the study involved partners who issued an adverse opinion for at least one publicly traded client that year. The article is authored by Ashleigh Bakke from Oklahoma State University, Elizabeth Cowle of Colorado State University, Stephen Rowe from the University of Arkansas, and Mike Wilkins of the University of Kansas.
“Audit firms are constantly balancing the tension between incentives to keep clients happy and incentives to maintain a reputation for audit quality. We were specifically interested in how that tension impacts individual audit partners, who are the ones that ultimately make the decisions on an audit. The research team expected that, when faced with the possibility of losing a client entirely, audit firms may be willing to reassign audit partners in an attempt to salvage the relationship,” says Bakke.
The researchers first demonstrate that companies are more likely to switch partners after their audit partner issues an adverse internal control opinion. Next, they focus on the partners’ audit client portfolios, specifically the number of company clients, the size of those clients, and the total audit fee revenue managed by the partner. The research team finds that partners who issue an adverse internal control opinion experience unfavorable changes in their client portfolios.
“While their intention may not be to punish partners, in this particular area, audit firms appear to be prioritizing client relationships to the detriment of audit partners. Adverse internal control opinions are an important channel of communication, but auditors who issue these opinions face negative career consequences that may also have implications for the partners’ own personal wealth. From an audit firm’s perspective, these findings highlight the importance of supporting audit partners who are forced to make difficult decisions that upset the client but protect investors,” notes Bakke.
Bakke concludes, “Investors and other financial reporting stakeholders should continue to demand transparency and encourage the reporting of material weaknesses. Identifying a control weakness is the first step to resolving the weakness, which benefits everyone involved.”