The Effect of the External Accountant's Review on the Timing of Adjustments to Quarterly Earnings

36 Pages Posted: 19 May 1999

See all articles by Michael Ettredge

Michael Ettredge

University of Kansas - Accounting and Information Systems Area

Dan T. Simon

University of Notre Dame - Department of Accountancy

David B. Smith

University of Nebraska

Mary S. Stone

University of Alabama - Culverhouse College of Commerce & Business Administration

Date Written: May 1999

Abstract

Publicly listed companies must have their quarterly financial data reviewed by an external accountant. A company can have such data reviewed at the end of each quarter (timely review) or in conjunction with the year-end audit (retrospective review). The costs and benefits of each review choice have been debated for decades. The Securities and Exchange Commission (SEC) consistently has indicated a preference for timely reviews, while many companies have argued that there is no evidence that timely reviews provide incremental benefits. In January 1999, the Big Five accounting firms jointly announced to the SEC that they will require "timely interim reviews of the financial statements of each public client, as a condition of acceptance of the company as a client." In February 1999 the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, created by the New York Stock Exchange and the National Association of Securities Dealers, recommended that the SEC require timely reviews prior to firms' filings of Forms 10-Q.

Our paper assesses whether the timing of the external accountant's review of quarterly financial data (timely versus retrospective) is associated with differences in the timing of recognition of adjustments to quarterly earnings (recognition during the first three quarters versus the fourth quarter). Our results support earlier claims that a disproportionately large number of adjustments are recorded in the fourth quarter. The results also show that, as claimed but not previously documented, the frequency and proportion of adjustments recorded during the first three quarters are greater for companies with timely reviews, while the frequency and proportion of fourth quarter adjustments are smaller. Controlling for the total of adjustments recorded during the year, the number of adjustments made during the first three quarters is positively related to having a timely review, and to company size.

Under reasonable assumptions, delay in recording adjustments should result in delayed resolution of uncertainty concerning the amounts of annual earnings, and of earnings of the late quarters in the fiscal year. We investigate the effect of deferred adjustments on uncertainty about the amounts of quarterly and annual earnings, using non-directional earnings prediction errors as proxies for uncertainty. Using results from tests referred to above, we divide the sample into high-deferral and low-deferral firms. Results indicate that high-deferral firms generate more uncertainty about third and fourth quarter earnings than do low-deferral firms. Contrary to our expectations, high-deferral firms do not have less uncertainty surrounding their first and second quarter earnings. The delay in resolving uncertainty over the third and fourth quarter earnings of high-deferral firms appears to cause increased uncertainty about their annual earnings for the entire fiscal year, relative to low-deferral firms.

JEL Classification: M41, M49

Suggested Citation

Ettredge, Michael L. and Simon, Daniel T. and Smith, David Brian2 and Stone, Mary S., The Effect of the External Accountant's Review on the Timing of Adjustments to Quarterly Earnings (May 1999). Available at SSRN: https://ssrn.com/abstract=163808 or http://dx.doi.org/10.2139/ssrn.163808

Michael L. Ettredge (Contact Author)

University of Kansas - Accounting and Information Systems Area ( email )

1300 Sunnyside Avenue
Lawrence, KS 66045
United States
785-864-7537 (Phone)
785-864-5328 (Fax)

Daniel T. Simon

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
219-631-8116 (Phone)
219-631-5255 (Fax)

David Brian2 Smith

University of Nebraska ( email )

College of Business Business Administration
Lincoln, NE 68588
United States
402-472-2927 (Phone)
402-472-4100 (Fax)

Mary S. Stone

University of Alabama - Culverhouse College of Commerce & Business Administration ( email )

Box 870223
School of Accountancy 314 Alston Hall
Tuscaloosa, AL 35487-0223
United States
205-348-2915 (Phone)
205-348-8453 (Fax)

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