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AS5:
An Audit of Internal Control over Financial Reporting that Is Integrated with an
Audit of Financial Statements
(PCAOB, 2007). AS5 uses a principle-based, fraud-
awareness focus and adopts a top-down, risk-based approach, which allows auditors to use
their professional judgment and refer to the work of others, including management and
internal auditors. By eliminating unnecessary and detailed procedures required by AS2,
AS5 is less prescriptive and encourages auditors to focus on the critical risks of
misstatements and related controls. The aim of AS5 is to alleviate the compliance burden
while still preserving the benefits of ICFR audits.
2.2 The Disclosure Quality of ICFR Reports
ICFR-disclosure quality cannot either be observed or directly measured. In this study,
we develop an approach to measure ICFR-disclosure quality based on the likelihood of
making Type I or Type II errors
4
in ICFR reports. Knechel and Vanstraelen (2007) have
used a sample of stressed bankrupt companies and stressed nonbankrupt companies to
measure audit quality as the likelihood of an auditor issuing a going concern opinion. An
indicator of Type II errors is presumed as a decrease in the likelihood of issuing a going
concern opinion when a firm subsequently goes bankrupt. Likewise, an indicator of Type I
errors is presumed as an increase in the likelihood of issuing a going concern opinion
when a firm subsequently does not go bankrupt.
We adapt the rationale and method developed by Knechel and Vanstraelen (2007) to
our context of ICFR-disclosure errors. We presume that internal control weaknesses are
more likely to exist in misstated periods of restatement companies. Prior literature has
supported the notion that misstatements are indicative of internal control problems
(Kinney and McDaniel, 1989; DeFond and Jiambalvo, 1991; McMullen et al., 1996;
Eilifsen and Messier, 2000; Leone, 2007; Rice and Weber, 2012). Practitioners and the
PCAOB also argue that a company’s need to correct a misstatement can demonstrate a
breach in its internal control system (Turner and Weirich, 2006; PCAOB, 2004).
Therefore, restatement (non-restatement) companies in this study are viewed as those that
are
more (less) likely
to have material weaknesses and
more (less) likely
to receive adverse
4 According to the definition used in statistics, a Type I error is committed when a true null hypothesis is
rejected. In addition, a Type II error is committed by failing to reject a false null hypothesis. The
probabilities of committing either Type I or Type II errors are conditional.