This study examines whether the volatility of interim estimates of the annual effective tax rate (ETR) provides ex ante information about the quality of firms' internal control environments. Recent research suggests that some firms selectively disclose internal control weaknesses (ICWs). Given the negative consequences associated with ICWs, it is important for capital market participants to be able to identify firms with ineffective internal controls in a timely manner. We find that firms with more volatile annual ETR estimates are more likely to report both tax‐ and nontax‐related ICWs in the current year. Our results also indicate that the volatility of annual ETR estimates declines following the remediation of tax‐related ICWs, but not following the remediation of nontax‐related ICWs. In addition, we find that ETR volatility in the current year is associated with the likelihood that a firm will report an ICW in the following year. Finally, we provide evidence that the volatility of annual ETR estimates is associated with the likelihood that a firm has an undisclosed ICW. In combination, our results suggest that the volatility of interim estimates of the annual ETR provides an ex ante signal of the likelihood that a firm's internal controls are ineffective.

This study provides evidence that binary signals in audit reports are unable to fully communicate underlying risks that are inherently continuous in nature. Specifically, we find that companies whose audit reports signal an improvement in internal control effectiveness relative to the prior year are still more likely to subsequently restate the current year's financial statements than companies with no material weaknesses in either year. Similarly, companies deemed to no longer have substantial doubt of continuing as a going concern are still more likely to declare bankruptcy than companies with no going concern opinion in either year. Results in both settings suggest the presence of residual risk that cannot be communicated through a binary audit report, despite the fact that auditors recognize the risk, as evidenced by higher audit fees and longer audit report lags. Our findings are strongest when the reported improvement is more pronounced, and our results hold in matched samples. Our study provides empirical evidence that supports recent regulatory efforts to improve the content of the audit report and offers suggestions for future research.

How do auditors behave during periods of market euphoria? To address this question, we study auditor going-concern opinions around the time of the wave of stressed Internet companies filing to go public on Nasdaq, a period many characterize as the ‘dot com bubble’. We focus on the day the auditor signs the opinion that appears in a stressed, Internet registrants’ IPO filing and document a sharp increase in the number of opinions with dates between January 1999 and April 2000. Contemporaneous with this jump in transaction volume, and for the duration of these 16-months, Big 5 firms were less likely to render going-concern opinions to their stressed, Internet IPO registrant clients. Upon conducting tests for determinants that could lead auditors to shift their decision criteria during this euphoric audit market, we find the presence of a going-concern opinion varies with variables that proxy for client reasons (financial distress, company age, venture backing, IPO cash burn) and for less auditor independence/skepticism (recent fees for clients without venture backing and a rush-to-market for clients with venture backing) by the Big 5 firms. These findings suggest a mixed conclusion regarding the Big 5's behavior; as the presence of a going-concern opinion varies inversely with variables that proxy for both client viability and auditor self interest. As for consequences to investors, our analysis of two, three and four-year post-IPO stock delisting provides some evidence of a decrease in the predictive content (early-warning value) of Big 5 opinions signed during the Internet IPO bubble.