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    Auditors’ Decisions on Audit Differences that Affect S...
    research summary posted April 16, 2012 by The Auditing Section, last edited May 25, 2012, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.08 Evaluation of Errors – Statistical and Non-statistical, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
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    Title:
    Auditors’ Decisions on Audit Differences that Affect Significant Earnings Thresholds
    Practical Implications:

    The results of this study are important for auditors to consider when making materiality judgments.  The evidence indicates that auditors are more likely to overlook the qualitative importance of adjustments that affect a client’s ability to meet or beat analysts’ forecasts.  Furthermore, findings suggest that auditors are more lenient with subjective audit differences.  The study suggests that providing auditors with guidance on qualitative materiality may improve materiality judgments, but it does not completely alleviate the differences among the earnings benchmarks. 

    Citation:

    Ng, T.B. 2007. Auditors’ Decisions on Audit Differences that Affect Significant Earnings Thresholds. Auditing: A Journal of Practice and Theory 26 (1): 71-89.

    Keywords:
    materiality, audit adjustments, earnings management, thresholds, auditor judgments, guidance
    Purpose of the Study:

    Companies have economic incentives to meet or beat certain earnings benchmarks such as the prior year’s earnings, analysts’ forecasts, and positive earnings.  As a result, even small audit differences may be qualitatively material if they allow the client to meet or beat one or more of those benchmarks. However, the SEC and the IAASB both recently recognized that auditors may need further guidance on dealing with small but qualitatively material misstatements, and the SEC issued the Staff Accounting Bulletin 99 in response.  This paper provides evidence on this issue by investigating whether auditors’ propensity to book an adjustment is influenced by: client earnings benchmarks; subjectivity of the audit difference; and the availability of authoritative guidance.

    Design/Method/ Approach:

    The research evidence was collected prior to January 2005.  The author uses a sample of senior and manager auditors from the Singapore offices of the Big 4 firms to complete a simulated task involving the decision to waive or book an audit adjustment.  Participants were each assigned to two scenarios, both involving an audit adjustment that would cause the client to miss one of three earnings benchmarks.  One of the scenarios involved a subjective audit adjustment while the other involved an objective audit adjustment.  In a follow-up experiment, the author used the same methodology, but provided the auditors with materiality guidance from SAB 99.

    Findings:
    • The authors find that among the three earnings benchmarks, auditors are most likely to require an adjustment for differences that cause positive unadjusted earnings to become negative (profitability benchmark). 
    • Auditors are least likely to require adjustments that prevent clients from meeting analysts’ forecasts. 
    • The authors find that when auditors are more likely to require an adjustment when the audit difference is objective versus subjective, regardless of any earnings benchmark effect.
    • The authors also find that providing auditors with SAB 99 materiality guidance increases the likelihood that auditors will require small but qualitatively material items to be booked.  However, auditors are still more likely to require adjustments for audit differences that affect the profitability benchmark than the other two benchmarks.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Evaluation of Errors - Statistical and Non-statistical, Materiality & Scope Decisions
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