The Relationship Between Assessments of Internal Control Strength and Error Occurrence, Impact and Cause

Abstract Planning judgments concerning the nature, extent and timing of evidence are critical to an audit's effectiveness and efficiency. The auditing literature suggests that knowledge of the strength of a client's internal controls in various cycles is an important consideration in such judgments, since the controls' strength is expected to affect the likelihood and nature of financial statement errors. This study examines the occurrence, financial impact and cause of detected misstatements as related to the assessed strength of internal controls. Data on detected errors were gathered from a random, cross-sectional sample of 186 audit agreements. Auditors reported detailed information on 368 audit adjustments, representing 731 misstatements to individual accounts. The results indicated that as assessed internal controls weakened, the frequency of adjustments increased and adjustments were more likely to have an effect on income. However, error magnitude did not differ across control strength settings. Errors were more likely to reflect understatement of assets and liabilities when controls deteriorated, while when controls were strong, assets and liabilities were more frequently overstated. Finally, the causes of adjustments reflect a greater frequency of ‘routine’ errors as controls deteriorate, although cut-off errors were relatively common across all control settings. These results suggest that different audit strategies are appropriate in response to variations in controls.