Adverse Section 404 Opinions and Shareholder Dissatisfaction toward Auditors

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SYNOPSIS: Auditors issuing adverse Section 404 internal control opinions may be viewed as too conservative, or they may be blamed for being partly responsible for the existence of the internal control material weaknesses. Using a sample of 240 companies with adverse internal control opinions and 240 matched “clean” companies in their first year of Section 404 compliance, we examine how shareholder dissatisfaction with the auditors varies depending on material weakness existence/type (company-level versus noncompany-level) and the presence of recent accounting restatements. In the full sample, we find a significant positive interaction between restatement and company-level material weakness—company-level material weaknesses have a greater effect on shareholder dissatisfaction when a restatement has occurred. To provide insight, we partition our sample based on whether test companies have had recent accounting restatements. In the nonrestatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 internal control opinion because of noncompany-level material weaknesses. Shareholders may view the auditor as being too conservative when no company-level material weaknesses are cited and no recent accounting restatements have been issued. In the restatement sample, we find that shareholders are less likely to vote for auditor ratification if the company received an adverse Section 404 opinion with or without company-level material weaknesses cited—but with shareholder dissatisfaction greater for companies with company-level material weaknesses. Hence, in companies with recent accounting restatements, shareholders may blame the auditor for being partly responsible for the existence of material weaknesses (i.e., low audit quality). Overall, the results provide insights into shareholders’ perceptions of auditing and suggest that existing shareholders may sometimes prefer less conservative auditors. We encourage additional research on the role of auditors in protecting current versus prospective shareholders.

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