Only material weaknesses are required to be disclosed under Sections 302 and 404, and they are automatically accompanied by an adverse opinion on internal controls by the auditor.
This procedure yields a total of 765 valid firms, of which 649 remained with their auditor and 116 switched auditors in the year after the adverse opinion.
Table 3 presents the sample distribution based on auditor in the year of the adverse ICOFR opinion (Panel A) and new auditor in the year following the adverse opinion for switcher firms (Panel B).
where Switch is an indicator variable that is equal to one if the firm changes its auditor, and zero otherwise; MaterialWeak is the number of material internal control weaknesses; PctTotalfees is total fees paid to the auditor, including audit and non-audit fees, divided by total assets; Tenure is the log of the length of the relation in months between the firm and the auditor until the end of the year of the adverse ICOFR opinion; BigFourAuditor is equal to one if the audit firm is one of the Big Four, zero otherwise; and AveMCap is the log of the average market capitalization in the year of the adverse opinion and the following year.
Further, H3 predicts that the longer the relation between a firm and its auditor, the less likely that the company will switch auditors when an adverse opinion on internal controls is issued.
Nusbaum, CEO of Grant Thornton, says, "Since no firm has yet issued a 404 opinion, we have no way of knowing how many adverse opinions are likely to result.
Some investors may struggle with understanding the potential for seemingly divergent opinions (a clean opinion on the financial statements, with a concurrent adverse opinion on internal control) and what that may mean.
Bromark, who serves as Americas Theater Leader, Professional, Technical, Risk and Quality, at PricewaterhouseCoopers, offers the following guidance: "Particularly in this first year of the integrated internal control and financial statement audit, the issue that people are going to have to come to grips with, is that the integrity of the current period's financial statements is not necessarily adversely impacted by an adverse opinion on the internal control assessment.
Beier, PricewaterhouseCoopers' Leader, National Technical Services, observes there is the potential for an investor to interpret a material weakness as casting a shadow over a company's entire system of internal control on financial reporting, when it may only be a single aspect of the system that resulted in the adverse opinion.
He explains, "That is, if a company receives an adverse opinion, the investor [may] automatically assume the worst.
He expects that this will result in an adverse opinion
for the holding company, but the operating companies should continue to receive their traditional unqualified opinions.
In addition to the adverse opinion
disclosures, a total of 27 companies (with revenue of more than $75 million) disclosed material weaknesses or significant deficiencies in internal controls during the month of January 2005.