Where's the risk? Material weakness detection in advance of financial misstatement discovery

Abstract

This study uses material weakness (MW) disclosures to explore whether auditors systematically assign greater risk to specific financial statements and account types. Auditing Standard 2201 mandates auditors adjust their levels of material weakness detection in response to the risk associated with each control being tested. Using a sample of firm years with financial misstatements, I show that auditors are most likely to detect material weaknesses in advance of misstatement discovery when they relate to the income statement, followed by the balance sheet, and to revenues and assets, relative to other income statement and balance sheet accounts. These results suggest that auditors, on average, assign the greatest level of associated control risk to the income statement, then the balance sheet, and that revenues and assets are the drivers of that assignment.