Audit Implications of Non‐GAAP Reporting

• Published date: 01 December 2022
• Author: NICHOLAS J. HALLMAN,JAIME J. SCHMIDT,ANNE M. THOMPSON
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/1475-679X.12433

DOI: 10.1111/1475-679X.12433

Journal of Accounting Research

Vol. 60 No. 5 December 2022

Printed in U.S.A.

Audit Implications of Non-GAAP

Reporting

NICHOLAS J. HALLMAN ,∗JAIME J. SCHMIDT,∗

AND ANNE M. THOMPSON†

Received 22 March 2018; accepted 5 December 2021

ABSTRACT

We investigate whether non-GAAP reporting affects the audit process and

thereby the quality of the related financial statements. First, we provide ev-

idence that auditors in numerous countries, including the United States and

the United Kingdom, rely to varying degrees on non-GAAP profit before

tax as a benchmark for determining quantitative materiality. Then, using

Premium Listed companies on the London Stock Exchange, we document

that U.K. auditor reliance on non-GAAP materiality benchmarks often re-

∗Accounting Department, University of Texasat Austin; †Department of Accountancy, Uni-

versity of Illinois at Urbana-Champaign.

Accepted by Christian Leuz. We thank a Big 4 audit firm (who requested anonymity) for

providing us access to partners willing to discuss how materiality decisions are made in the

United States. We thank two anonymous reviewers, Dorsey Baskin, Nerissa Brown, Ted Chris-

tensen, Alex Johanns, Jeff Johanns, Bill Kinney, Clive Lennox, Mark Peecher, Sam Ranzilla,

Dan Sunderland, and workshop participants at the International Symposium on Audit Re-

search, Ohio State University, Oklahoma State University, the PCAOB/JAR Conference on

Auditing and Capital Markets, Texas Christian University, the University of Massachusetts-

Amherst, the University of Washington, Wichita State University,and the University of Illinois

at Urbana-Champaign for helpful comments. We are grateful for research funding from the

McCombs Undergraduate Research Assistant Program. We thank Jonathan Bouwhuis, Jing

Cui, Joel Garcia, Minjae Kim, Kayla Kimrey, Shelby Krummel, Yuxi Li, Sabrina Lim, Madi-

son Macica, Alejandra Oseguera, Yitong Pan, Parth Patel, Bitian Qi, Sharmin Sharif, Nick

Williams, Annie Xue, Hongshuo Zhang, and Boyan Zhu for research assistance. Jaime Schmidt

acknowledges financial support from the KPMG Centennial Fellowship in Accounting and

Anne Thompson acknowledges financial support from the Arthur Andersen Faculty Fellow-

ship. An online appendix to this paper can be downloaded at https://research.chicagobooth.

edu/arc/journal-of-accounting- research/online-supplements.

1947

© 2022 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

1948 n. j. hallman, j. j. schmidt, and a. m. thompson

sults in a higher quantitative materiality amount and can lower audit quality.

Although U.K. auditors appear skeptical of managers’ more aggressive non-

GAAP adjustments, auditors adopt more of management’s low-quality adjust-

ments when auditor independence is weaker. In sum, our results suggest that

non-GAAP reporting can indirectly affect investors by reducing the rigor of

the financial statement audit.

JEL codes: M40, M41, M42, M48, N20

Keywords: non-GAAP earnings; auditor materiality; audit quality; auditor

retention/turnover

1. Introduction

Non-GAAP reporting is prevalent in capital markets worldwide (PwC

[2007], Black et al. [2017]).1Prior research has examined whether non-

GAAP reporting is useful to investors for evaluating firm performance (see

Black et al. [2017] and Marques [2017] for reviews of this literature). Yet,

to the best of our knowledge, neither regulators nor the academic litera-

ture has considered the possibility that non-GAAP reporting could affect

investors indirectly as an input to the financial statement audit process. To

plan the nature, timing, and extent of auditing procedures and to evalu-

ate errors, auditors determine a quantitative materiality amount, typically

by applying a percentage (e.g., 5%) to a financial benchmark (e.g., profit

before tax [PBT]). Given the proliferation of non-GAAP reporting world-

wide, we investigate how often and under what circumstances auditors rely

on an adjusted, or non-GAAP,benchmark for determining quantitative ma-

teriality (for brevity, we will refer to this practice as “auditor non-GAAP re-

liance”). We then investigate whether auditor non-GAAP reliance impacts

audit quality.

Conventional wisdom, auditing textbooks, and prior research presume

that financial statement auditors determine quantitative materiality based

on GAAP financial statement metrics such as PBT (Johnstone-Zehms,

Gramling, and Rittenberg [2019]; Messier, Glover, and Prawitt [2019],

IAASB [2009], Chewning and Higgs [2002], Eilifsen and Messier [2015]).

However, Eilifsen and Messier [2015] and Choudhary, Merkley, and Schip-

per [2019] note that auditors at least occasionally calculate quantitative ma-

teriality based on an adjusted or non-GAAP earnings benchmark. Because

non-GAAP earnings are usually higher than GAAP earnings (CFA [2016]),

auditor non-GAAP reliance could result in a higher quantitative materiality

amount, which would thereby reduce the scope of audit procedures, re-

duce the quantity of evidence gathered, and raise the auditor’s threshold

for requiring correction of detected misstatements (ISA 320). Thus, auditor

1For example, 94% of S&P 500 companies include at least one non-GAAP financial measure

in their earnings releases and 95% of UK FTSE 100 companies report alternative performance

metrics (CAQ [2020], CFA [2016]).

audit implications of non-gaap reporting 1949

non-GAAP reliance could pose a risk to audit quality and thereby threaten

financial reporting quality.

We begin by investigating whether and how often auditor non-GAAP re-

liance occurs. Recent U.K. regulation requires auditors to disclose quan-

titative materiality in the audit reports for companies with Premium

Listings on the London Stock Exchange. As a result, the United King-

dom provides a unique opportunity to observe a large sample of au-

ditor materiality decisions that were not previously publicly observable

in any other country. We find that auditor non-GAAP reliance occurs

in 61% of U.K. audit engagements during 2013–2014 that use a PBT

materiality benchmark and that auditor non-GAAP reliance results in a

higher materiality benchmark for 88% of these engagements.2

To determine whether this practice is unique to the United Kingdom, we

survey U.S. audit partners and examine voluntary materiality disclosures

made by PricewaterhouseCoopers (PwC) LLP global affiliates in 11 coun-

tries in 2017. The U.S. partners report adjusting PBT on 46.8% of engage-

ments that use a PBT materiality benchmark. PwC auditors report at least

some non-GAAP reliance in 9 of the 11 countries and the average rate of

auditor non-GAAP reliance among engagements that use a PBT materiality

benchmark is 43%. In sum, auditor non-GAAP reliance is not unique to the

United Kingdom and occurs to varying degrees in other countries.

Next, we use the U.K. setting to examine when and why auditors rely

on non-GAAP benchmarks.3To the extent that assurance standards, au-

dit firm methodologies, and auditor economic incentives are similar across

countries, studying auditor behavior in the United Kingdom can provide

insight into auditor behavior worldwide. We find that management’s deci-

sion to report non-GAAP PBT is a strong predictor of the auditor’s decision

to rely on a non-GAAP materiality benchmark. We then apply two tests de-

veloped in the non-GAAP literature to examine whether auditor non-GAAP

reliance depends on the quality of management’s non-GAAP adjustments

(Black et al. [2018]). The first test examines the persistence of manager

and auditor non-GAAP adjustments. Because adjustments for nonrecurring

(recurring) components of earnings are considered to be more informa-

tive (potentially opportunistic), less (more) persistent adjustments reflect

higher (lower) quality adjustments. We find that auditors’ adjustments are

less persistent than managers’ although both manager and auditor adjust-

ments are persistent, on average.

2Weuse the “non-GAAP” terminology in our paper given it is a familiar term to the account-

ing literature but acknowledge that “non-GAAP” reporting in the United Kingdom would be

more accurately described as “non-IFRS” reporting. We also note that auditors often adopt

managers’ terms for non-GAAP PBT (e.g., “underlying earnings,” “adjusted income”).

3Although some PwC global affiliates disclosed materiality in non-U.K. countries, this dis-

closure was not mandated by regulation and later abandoned. Thus, we cannot study the effect

of auditor reliance on non-GAAP more broadly than the United Kingdom.