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Client/Auditor Loyalty, Embeddedness, and Adverse Internal Control Opinions

Linda A. Hall and Valerie L. Bennett

The BRC Academy Journal of Business

Volume 1

Number 1

Print ISSN: 2152-8721 Online ISSN: 2152-873X

Date: March 15, 2010

First Page 1

Last Page 24

Abstract

Section 404 of the Sarbanes Oxley Act requires management and external auditors to report on the adequacy of companies’ internal controls over financial reporting (ICOFR). This aspect of the Act is one of the most costly to implement. This study examines client companies that do not switch auditors when faced with adverse ICOFR opinions and compares them to clients that switch auditors under similar circumstances. We find that clients that stay with existing auditors after receiving an adverse opinion have longer prior engagement relationships with their auditors than clients that switch auditors under similar circumstances. These clients are more likely to experience an increase in audit fees in the year they receive a clean opinion, and are more likely to be larger than clients that switch auditors under similar circumstances. We also find that clients that stay with existing auditors after receiving an adverse opinion are likely to have fewer material weaknesses in ICOFR (both account-specific and entity-level). The results are supported by embeddedness theory, in that over time, clients and auditors develop relationship-specific assets; their relationships exhibit positive duration dependence; and based on this, audit fees may be considered investments in stronger internal controls and future relationships.

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