The Costs of Waiving Audit Adjustments

Abstract

We analyze the disposition of auditor-proposed adjustments to financial statements. Our analyses address concerns, expressed by regulators and others, that auditors and their clients fixate on quantitative thresholds and overlook qualitative factors in assessing the materiality of discovered misstatements. Using a large sample of PCAOB-inspected audits, we examine the frequency with which management records vs. waives auditor-proposed adjustments and whether waiving proposed adjustments has consequences for reporting reliability and the audit process. We find waived adjustments are linked to lower financial 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 adjustments. These effects on the audit process are consistent with auditors responding to the increased risk associated with waived adjustments. In an exploratory analysis we find that controlling for the amount of proposed adjustments, auditor resignations are negatively associated with waived adjustments.

Keywords: Financial reporting reliability, audit adjustments, restatements, waive versus record, earnings management

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