Does Non-GAAP Reporting Result in Less Conservative Auditor Materiality Judgments? Evidence from the U.K.

Hallman, Nicholas; Schmidt, Jaime J.; Thompson, A. H.

doi:10.2139/ssrn.3018823

Cited by 12 publications

(10 citation statements)

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“…recurring items (e.g., Hallman et al 2018); or (3) used a different base such as revenue or assets; such deviations could be based on a consideration of qualitative factors.…”

Section: Is Quantitative Materiality the Results Of Applying A Rule-ofmentioning

confidence: 99%

“…judgment is guided by authoritative pronouncements and internal audit firm policies, and that materiality decisions are supported by an appropriate base, typically a financial statement line item such as pre-tax income, revenues or assets and a percentage to apply (multiplicatively) to the base. Hallman et al (2018) highlight an additional dimension of variation, adjustments to the base. These studies shed light on how materiality judgments are made in non-US contexts, typically using small samples, and do not typically analyze implications of these judgments.…”

Section: Previous Research On Auditor Materiality Judgmentsmentioning

confidence: 99%

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Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability

Choudhary

Merkley

Schipper

2019

J of Accounting Research

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We analyze data made available through the PCAOB (Public Company Accounting Oversight Board) to provide descriptive evidence on the properties of auditors' actual quantitative materiality judgments and the implications of those judgments for financial reporting. Auditors' quantitative materiality judgments do not appear to result simply from applying conventional rules-of-thumb, (e.g., 5% of pre-tax income), but instead are associated with size-related financial statement outcomes (income, revenues and assets), where the relative importance of the size-related outcomes varies with client characteristics such as financial performance. Using the distribution of actual materiality amounts reported by auditors to the PCAOB as part of the audit-inspection process, we construct a materiality-judgment measure that locates a specific materiality amount within a normal range that is both comparable across varying client characteristics and supported by guidance in audit firm internal policy manuals. We find that looser materiality (an amount closer to the high end of a normal materiality range) is associated with fewer audit hours and lower audit fees, supporting the construct validity of this measure. We also find that looser materiality is associated with lower amounts of proposed audit adjustments and, in extreme cases, with a greater incidence of restatements, highlighting the importance of auditor materiality assessments for financial reporting reliability.

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“…recurring items (e.g., Hallman et al 2018); or (3) used a different base such as revenue or assets; such deviations could be based on a consideration of qualitative factors.…”

Section: Is Quantitative Materiality the Results Of Applying A Rule-ofmentioning

confidence: 99%

Section: Previous Research On Auditor Materiality Judgmentsmentioning

confidence: 99%

Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability

Choudhary

Merkley

Schipper

2019

J of Accounting Research

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“…Although their average results indicate that managers are primarily motivated to disclose non‐GAAP metrics to inform investors, they conclude that context‐specific analyses are appropriate since there are examples of situations where managers make more aggressive exclusions. More recently, Hallman, Schmidt, and Thompson () explore the influence of non‐GAAP reporting in the UK on audit judgments and find that non‐GAAP disclosures lead auditors to make less conservative materiality judgments, which they argue can result in lower‐quality audits.…”

Section: Regulatory Standard Setting and Academic Foundationsmentioning

confidence: 99%

Non‐GAAP reporting: Evidence from academia and current practice

Black

Christensen

Ciesielski

et al. 2018

Business Fin & Account

180

136

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The number of firms reporting earnings on a non-GAAP basis has increased dramatically over the last decade, and non-GAAP reporting is now commonplace in capital markets. This proliferation of non-GAAP reporting has renewed both regulators' and standard setters' interests in these alternative performance metrics. For example, the SEC, FASB, and IASB have all recently questioned what this increasing reporting trend means for IFRS-and US-GAAP-based reporting and whether these measures are misleading to investors. This increasing focus on non-GAAP metrics motivates us to synthesize the nearly two decades of research on non-GAAP reporting to provide insights on what academics have learned to date about this reporting practice. Then, we utilize a novel dataset of detailed non-GAAP disclosures to provide new descriptive evidence on current trends in non-GAAP reporting and its recent proliferation. Finally, we discuss important questions for future researchers to consider in moving the literature forward. K E Y W O R D Snon-GAAP earnings, regulation, standard setting INTRODUCTIONManagers, financial analysts, investors, lenders, compensation committees, and other stakeholders often evaluate a company's earnings performance using metrics other than GAAP-based net income. These stakeholders generally start with GAAP earnings and back out (or exclude) earnings components that they deem to be transitory or noncash. They argue that these excluded items are less relevant for assessing firm performance and that the "non-GAAP" performance number is more appropriate for their intended purposes. The growth in these non-GAAP metrics over the past 20 years reflects a widespread acceptance of non-standard performance metrics as a way to evaluate firm performance.Although skeptics have frequently viewed non-GAAP disclosure as a threat to the traditional GAAP-based income statement, regulators recognize that non-GAAP metrics can be informative to investors and have laid the groundwork for firms to disclose these metrics in a transparent manner. Standard setters and regulators have recently renewed J Bus Fin Acc. 2018;45:259-294. wileyonlinelibrary.com/journal/jbfa

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“…In concurrent auditor materiality studies that take advantage of newly available archival data, Hallman et al (2017) use the new audit report format in the United Kingdom to examine how auditors adjust earnings benchmarks. They find that about half of the sample audits increase the earnings benchmark by adding back special and/or noncash items.…”

mentioning

confidence: 99%

The Materiality of Accounting Errors: Evidence from SEC Comment Letters

Acito

Burks

Johnson

2019

Contemporary Accting Res

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We gain unique insights into materiality judgments about accounting errors by examining SEC comment letter correspondence. We document that managers typically use multiple quantitative benchmarks in their materiality analyses, with earnings being the most common benchmark. In most of the cases we review, managers deem the error immaterial despite its exceeding the traditional “5 percent of earnings” rule of thumb, often in multiple periods and by a large degree. Instead of attempting to conceal these overages, managers tend to forthrightly acknowledge them, often asserting that the benchmark is abnormally low during the violation period. We find that 17–26 percent of these “low benchmark” assertions are suspect (although none of these “low benchmark” assertions are challenged by the SEC). We also document substantial variation in the extent to which qualitative factors are mentioned as considerations. The SEC generally is deferential toward managers' arguments and judgments but is more likely to challenge immateriality claims when managers admit there are qualitative factors that indicate errors are material.

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Does Non-GAAP Reporting Result in Less Conservative Auditor Materiality Judgments? Evidence from the U.K.

Cited by 12 publications

References 49 publications

Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability

Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability

Non‐GAAP reporting: Evidence from academia and current practice

The Materiality of Accounting Errors: Evidence from SEC Comment Letters

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