Income Statement and Balance Sheet Effects of Variation in Misstatement Quantification

Abstract

We investigate two sets of concerns raised by securities regulators regarding auditors’ materiality decisions surrounding misstatements identified during an audit. Using misstatements disclosed under SEC Staff Accounting Bulletin No. 108 (SAB 108), we first examine whether SAB 108 misstatements are consistent with auditors waiving correction of qualitatively material misstatements that increase the odds of meeting or beating earnings targets. Second, we examine whether the level of post-audit misstatement varies between firms whose auditors use different methodologies to quantify misstatements. We find no evidence that SAB 108 firms are more likely to meet qualitatively material earnings targets than firms disclosing no effect at SAB 108. In addition, we identify significant differences in the post-audit level of misstatement between SAB 108 firms that under-stated earnings in prior periods and firms disclosing no effect at SAB 108 adoption, but no corresponding difference between SAB 108 firms that over-stated prior period earnings and other firms. These asymmetric findings are consistent with auditors’ incentives to apply greater scrutiny to misstatements that over-state earnings than misstatements that under-state earnings due to litigation and reputational concerns. Overall, our findings suggest support for the SEC’s regulatory intervention to standardize audit methodology in practice due to significant differences in the post-audit level of balance sheet misstatements across firms and auditors’ asymmetric scrutiny of income over-statements vs. under-statements.

Keywords: Audit Materiality, SAB 108, Securities Regulation, Audit Methodology, Financial Statement Quality

JEL Classification: M41, M42, M48, G38