The Costs of Waiving Audit Adjustments

• Published date: 01 December 2022
• Author: PREETI CHOUDHARY,KENNETH MERKLEY,KATHERINE SCHIPPER
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/1475-679X.12453

DOI: 10.1111/1475-679X.12453

Journal of Accounting Research

Vol. 60 No. 5 December 2022

Printed in U.S.A.

The Costs of Waiving Audit

Adjustments

PREETI CHOUDHARY,∗KENNETH MERKLEY,†

AND KATHERINE SCHIPPER‡

Received 3 August 2020; accepted 16 May 2022

ABSTRACT

We analyze the disposition of auditor-proposed adjustments to financial state-

ments. Our analyses address concerns, expressed by regulators and others,

that auditors and their clients fixate on quantitative thresholds and over-

look qualitative factors in assessing the materiality of discovered misstate-

ments. Using a large sample of Public Company Accounting Oversight Board

(PCAOB)-inspected audits, we examine the frequency with which man-

agement records versus waives auditor-proposed adjustments and whether

∗University of Arizona; †Indiana University; ‡Duke University.

Accepted by Rodrigo Verdi.This paper was written while Preeti Choudhar y was a senior eco-

nomic research fellow at the PCAOB. The PCAOB as a matter of policy disclaims responsibility

for any private publication or statement by any of its economic research fellows, consultants,

and employees. The views expressed in this paper are the views of the authors and do not

necessarily reflect the views of the PCAOB Board, individual Board members, or PCAOB staff.

We thank Michael Gurbutt, Jay Brown, Jacob Jaggi, Steven Kachelmeier, Patricia Ledesma,

Melissa Lewis-Western, Christian Leuz, Paul Michas, Conrad Naegle, Shiva Rajgopal, Saman-

tha Ross, Roy Schmardebeck, Jaimie Schmidt, Joseph Schroeder, Dan Sunderland, Luigi Zin-

gales, PCAOB staff, and seminar participants at the PCAOB, Arizona State University,Brigham

Young University, University of Arizona, University of Iowa, University of Melbourne, Univer-

sity of Minnesota, University of Oklahoma, Stanford University, University of Texas at Dallas,

and participants at the 2018 Accounting Research Conference at the University of Illinois at

Chicago, the 2018 PCAOB-Journal of Accounting Research Conference, the 2019 FARS Confer-

ence, and 2022 Penn State Accounting Research Conference for helpful discussions. We thank

Eric He for his excellent research assistance. We also thank an anonymous associate editor

and referee for their helpful comments and suggestions. This paper was formerly titled “The

Last Chance to Improve Financial Reporting Reliability: Evidence from Recorded and Waived

Audit Adjustments.”

1813

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

Business.

1814 p. choudhary, k. merkley, and k. schipper

waiving-proposed adjustments ha consequences for reporting reliability and

the audit process. We find waived adjustments are linked to lower finan-

cial reporting quality measured by material misstatements, to incentives to

meet/beat earnings targets, and to the audit process, as measured by higher

next-period audit effort and fees and higher next-period proposed adjust-

ments. These effects on the audit process are consistent with auditors re-

sponding to the increased risk associated with waived adjustments. In an ex-

ploratory analysis, we find that controlling for the amount of proposed adjust-

ments, auditor resignations are negatively associated with waived adjustments.

JEL codes: M40, M41, M42, M43, M49

Keywords: financial reporting reliability; audit adjustments; restatements;

audit fees; audit effort; recorded adjustments; waived adjustments

1. Introduction

This paper provides large-sample archival evidence on decisions to record

versus waive auditor-proposed adjustments to a client’s financial statements

and related financial reporting and auditing outcomes.1The disposition of

audit adjustments is a crucial step in the financial reporting process that

is poorly documented in archival accounting research largely because dis-

position decisions and the process leading to them are typically not visi-

ble to researchers. After auditors conduct tests, gather audit evidence, and

present client management with proposed adjustments, auditors and man-

agement discuss the basis for and materiality of those adjustments. Sub-

ject to audit committee/board oversight and auditor consultation, manage-

ment evaluates the proposed adjustments and decides to record or waive

them. Recorded adjustments change preaudit financial statement values

to those proposed by the auditor and constitute auditor-manager agree-

ments. Waived (unrecorded) adjustments result in no change and consti-

tute auditor-manager disagreements that do not rise to the level of a modi-

fied audit opinion.

Disposition decisions have been subjected to scrutiny, criticism, and

multiple changes in authoritative guidance, based mostly on anecdotal

evidence as opposed to a substantial body of empirical findings. For

example, based on anecdotal evidence and the suspicion that auditors were

mechanically applying quantitative materiality thresholds to evaluate ad-

justments, the staff of the Securities and Exchange Commission (SEC) is-

sued SAB 99 in 1999. SAB 99 clarifies that quantitatively small amounts

1In this paper, we refer to auditor-proposed adjustments to the financial statements as ei-

ther “misstatements” or “audit adjustments.” These terms refer to “a proposed correction of

the financial statements that, in the auditor’s judgment, may not have been detected except

through the auditing procedures performed” (para .09, AU 380, Communication with Audit

Committees, superseded by AS 16, codified as AS 1301, Communications with Audit Committees).

As discussed in section 2, our reading of the authoritative guidance suggests the PCAOB has

replaced “audit adjustments” with “misstatements,” retaining the idea that client management

may or may not record the correction (adjustment) proposed by the auditor.

the costs of waiving audit adjustments 1815

can be material and provides qualitative factors to be considered in mak-

ing materiality judgments. In 2006, the SEC staff issued SAB 108 to address

diversity in practice with regard to how to consider the cumulative effect

of prior-period uncorrected immaterial errors in evaluating current-period

misstatements.2In 2010, the Public Company Accounting Oversight Board

(PCAOB) issued AS 2810 to clarify how the auditor evaluates misstatement

risk from audit adjustments. In 2012, the PCAOB issued AS 1301 to formal-

ize the audit committee’s oversight of disposition decisions. These changes

suggest ongoing concerns about the disposition process. We aim to provide

recent, large sample evidence as to whether these concerns are warranted

in the current auditing and reporting environment.

We analyze adjustments from 3,144 audit-year observations (1,681 dis-

tinct clients) chosen for inspection by the PCAOB during 2005–2014. We

provide evidence on disposition decisions and their associations with: (1)

financial statement reliability and (2) the audit process, including next-

period audit effort, audit fees, and proposed adjustments. We complement

the analysis of financial statement reliability with an exploratory analysis of

earnings management incentives for waiving adjustments. We complement

the analysis of the next-period audit process, which presumes a continuing

auditor-client relationship, with an exploratory analysis of auditor turnover,

representing a termination of that relationship.

We believe our analyses represent a significant advance with respect to

providing archival evidence on dispositions of audit adjustments, especially

waive decisions and their consequences, subject to certain limitations. First,

audits selected for PCAOB inspection are not a random sample of audits

of U.S. SEC registrants. Section 4.5 reports analyses to address and miti-

gate selection bias concerns.3Second, PCAOB inspection documents are

an incomplete record of adjustments. The documents provide unsigned

magnitudes of net adjustments to seven financial statement categories (rev-

enue, operating income, pretax income, net income, assets, working cap-

ital, and equity). The data do not include adjustments to disclosures or

cash flows and combine known and projected misstatements (AU 312; AU

9312). Third, the absence of time-series data for individual client-auditor

pairs precludes analyses to support causal inferences.

Relative to previous research on adjustments and disposition decisions,

our data offer several advantages. First, our data include both recorded and

waived adjustments, allowing us to provide new, large sample evidence on

2SAB 108 states, in part, that it is intended “to address diversity in practice in quantifying

financial statement misstatements and the potential … for the buildup of improper amounts

on the balance sheet.” Bryan, Carmichael, and Lilien [2007] describe anecdotal evidence sup-

porting SAB 108 issuance, specifically, Arthur Andersen’s materiality assessment of reporting

errors related to restructuring and other reserves at Sunbeam Corporation.

3To our knowledge, all U.S. academic research that analyzes audit adjustments is subject to

selection issues of varying severity. Our sample is broader (more clients and more years) and

deeper (the largest eight audit firms) than samples used in prior U.S. research, and robust to

several analyses of potential selection-bias effects.