Listen to Your Auditor or Pay the Price Later

By Daniel L Goelzer

Audits often uncover financial reporting mistakes. When a misstatement is detected, the auditor proposes to company management an adjustment to correct the error. However, in the case of adjustments that are below the materiality threshold, management has discretion whether to record the adjustments or whether to ignore, or waive, them. Any material adjustment must, of course, be made, since the auditor cannot issue a clean opinion on financial statements that are materially inaccurate.

A recent academic paper concludes that management decisions to waive an audit adjustment may be expensive in the long run. In The Costs of Waiving Audit Adjustments, Preeti Choudhary, Kenneth Merkley, and Katherine Schipper find that, although most audits result in the auditor proposing financial statement adjustments, many companies decline to record some or all of these adjustments. The also find that these waivers are associated with a higher risk of future restatements and with increased audit costs.

Choudhary, Merkley, and Schipper had access to PCAOB inspections data and analyzed audit adjustment decisions in 3,144 audits involving 1,681 companies from audit engagements inspected by the Board between 2005 and 2014. They found that:

• Approximately 81 percent of these engagements involved at least one proposed audit adjustment. (As the authors recognize, the PCAOB does not select engagements for inspection solely on a random basis; higher risk audits are more likely to be inspected. Accordingly, this and other study finding are not necessarily representative of all public company audits.)
• In audits with proposed adjustments, management waived all adjustments in 50.5 percent of the engagements. In 11.6 percent of the audits, management recorded all proposed adjustments. In the remaining 37.9 percent of engagements, management recorded some of the auditor’s proposed adjustments and waived others, which the authors refer to as “selective recording”.
• Decisions on how to deal with a proposed adjustment (“dispositions”), seem in some cases to be tied to the potential impact of the adjustment on whether the company’s reported earnings would meet analysts’ expectations. The authors observe, “This analysis provides some confirmation of suspicions * * * that disposition decisions can be an earnings-management tool.”

But waiver of audit adjustments comes at price for the company, both in terms of the reliability of its financial reporting and in terms of audit costs. As to financial reporting reliability, recording audit adjustments “improves financial statement reliability as measured by the propensity to restate financial reports, while waiving detracts from it.” Companies that waive adjustments with magnitudes above the median, were 1.4 to 2.1 percent more likely subsequently restate. In addition, there were “substantial overlaps” between the subjects of proposed audit adjustments and the aspects of the financial statements that were eventually restated.

As to audit costs, the study finds that waived adjustments above the sample median are associated with an increase in current-period audit hours of between 8.6 percent to 10.7 percent and a 6 percent to 7.3 percent increase in audit fees. The study also found that waived adjustments in the current reporting period were associated with greater proposed audit adjustments and increased hours and fees in the subsequent year.

The authors conclude that “errors below quantitative materiality are consequential, even if they do not lead to a modified audit opinion” and that:

“Viewed as a whole, the results of our analyses document costly financial reporting and auditing consequences to waiving auditor-proposed adjustments and provide evidence on an earnings-management motivation for this behavior.” * * * [W]e believe we provide important new evidence on the costs of waiving misstatements that should be of interest to academics, investors, regulators, practitioners and audit committees.”

Public company audit committees should indeed consider these findings. The auditor must communicate all misstatements discovered — both those that are corrected and those that are waived — to the audit committee. Under the PCAOB’s auditing standards, the auditor (or management) should discuss with the audit committee the basis for the determination that any uncorrected misstatements were immaterial, The auditor should also communicate that uncorrected misstatements “could potentially cause future-period financial statements to be materially misstated, even if the auditor has concluded that the uncorrected misstatements are immaterial to the financial statements under audit.” The auditor is also required to discuss with the committee the implications that corrected misstatements might have on the company’s financial reporting process.

The review of the schedule of unadjusted audit differences, or “passed adjustments” required by the auditing standards is a normal part of the post-audit discussion between the audit committee and the auditor. The Choudhary, Merkley, and Schipper paper underscores that this topic should not be treated as routine. Management decisions to waive adjustments, particularly those that begin to approach the frontier of materiality, may have unfortunate consequences and could be indicators of more serious problems. Audit committees should make sure they understand how earnings would be affected if all audit adjustments were accepted and consider the possibility that analyst earnings expectations might be an unarticulated factor in management’s decision-making on whether to waive particular adjustments.