Does CEO Inside Debt Improve the Quality of Internal Control Audit Opinions? Actual and Suspected Failures

Abstract

This study examines whether CEO inside debt is associated with the quality of internal control audit opinions (ICOPs), focusing on both actual and suspected failures to issue adverse ICOPs when warranted. Motivated by recent findings that CEO inside debt may lower demand for accounting conservatism and increase audit risk, we address the growing concern over clean ICOPs issued to firms that merit adverse opinions. We find that CEO inside debt reduces the likelihood of adverse ICOPs for firms without concurrent misstatements; however, this effect vanishes when a misstatement is present. Auditors are more likely to issue adverse ICOPs to misstated firms with high CEO inside debt, ruling out an increase in Type II audit errors. Further, CEO inside debt is positively associated with adverse ICOPs in firms with high predicted misstatement risk. These findings hold when considering inside debt holdings of non-CEOs and top management teams. Our results have implications for audit committees and regulators, suggesting that executive compensation structure—particularly inside debt—can enhance audit quality and reduce ICOP audit failures.