Some audit disclosures may prompt companies to manipulate earnings

Auditor disclosures of client-specific quantitative materiality thresholds, which are required in the United Kingdom but not the United States, could be encouraging some businesses to massage their earnings reports, according to a university study.

The study, which appears in the journal Accounting Horizons, examines the relationship between earnings management and auditor materiality threshold disclosures. The researchers, Patricia Wellmeyer and Morton Pincus of the University of California, Irvine, and Lijie Yao of Beijing Jiaotong University, noted that expanded audit report regulations in the U.K. require auditor disclosures of client-specific quantitative materiality thresholds. The Public Company Accounting Oversight Board decided against requiring this disclosure in the U.S. out of concern that providing clients with visibility into this important audit input could give managers more ability to manipulate earnings without detection. 

Using the U.K. environment, the researchers investigated whether clients strategically leverage their auditors' quantitative materiality thresholds to increase income through undetected earnings management. They examined the association between auditor QMT and client earnings management generally and in client settings where a material qualitative factor in the form of heightened earnings management incentives exists. 

"If regulatory concerns are warranted, then mandated auditor QMT disclosures may help clients manage earnings in ways their auditors would fail to catch in light of their QMTs," said the study. "This in turn could lead to more earnings management and more misled investors. Moreover, insights into how auditors respond to clients' attempts to manage earnings around QMTs in cases of heightened earnings management incentives is important for understanding the potential impact of mandatory auditor QMT disclosures on firm earnings management."

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The professors pointed out that earnings management abuses can often be linked to misuse of the materiality concept. Accounting scandals involving HealthSouth Corporation, Waste Management Inc., and U.K.-based Tesco show how clients can exploit auditors' reliance on quantitative materiality thresholds to record many small misstatements that collectively enhance reported financial results. 

"If indeed managers manage earnings with their auditor's expected or disclosed quantitative thresholds for misstatements in mind, then requiring auditors to disclose their client-specific QMTs better informs clients about what auditors consider material," said the paper. "This can enable clients to manage earnings without the auditor detecting it."

Both the PCAOB and the International Auditing and Assurance Standards Board are taking a wait-and-see approach before mandating auditor materiality disclosures, the professors noted, and whether managers use QMT disclosures to manage earnings is an important, relevant question. The IAASB and PCAOB materiality standards require auditors to consider both the qualitative and the quantitative nature of misstatements or omissions in making final materiality determinations. The research suggests auditors should consider qualitative materiality factors and constrain their clients from doing any auditor QMT-based earnings management.