The results of this study shed light on the complex interplay between analyst following, the pressure that managers face to manage earnings, the pressure that auditors face to protect their reputations in the post-SOX environment, and the important role that audit committees can play in settings in which managers may act strategically to achieve desired financial reporting outcomes.

Keune, M. B., and K. M. Johnstone. 2012. Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees. Accounting Review 87 (5): 1641-1677.

Auditors detect and inform client managers and audit committees of misstatements, and these agents must reach agreement about whether managers will correct the misstatements prior to issuing the financial statements. Managers may waive correcting misstatements if auditors and audit committees conclude that the misstatements do not render the financial statements materially incorrect. Yet, the Securities and Exchange Commission (SEC) and others have asked the rhetorical question: If a misstatement is immaterial, then why not correct it? Given the absence of bright-line criteria for assessing materiality, judgments about resolving misstatements may be strategic to achieve desired financial reporting outcomes. Analysis of the role of managers, auditors, and audit committees in misstatement materiality judgments is therefore important because it can aid understanding of observed audit and financial reporting outcomes that can affect users.

In this study the authors make use of regulation concerning the resolution of detected misstatements contained in Staff Accounting Bulletin No. 108 (SAB 108). The implementation of SAB 108 provides disclosure data on detected misstatements that were previously judged immaterial and were not corrected in the financial statements until the release of the new guidance. The authors use the SAB 108 disclosures to measure both the qualitative and the quantitative materiality of misstatements during the periods in which they remained uncorrected.

The data-collection period covers 10-Qs filed from November 15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008, and the analyses examine waived misstatements that existed in the financial statements during the period January 1, 2003 to September 30, 2006. To identify these misstatements, the authors read SAB 108 disclosures to find companies that corrected misstatements under SAB 108. 

• The authors find that managers are generally more likely to waive qualitatively material misstatements as analyst following increases, but this effect is primarily present when audit fees are relatively low.
• They find auditors are less likely to allow managers to waive quantitatively material misstatements as audit fees increase.
• The authors also find a negative interaction between audit fees and analyst pressure on the likelihood that auditors will allow managers to waive qualitatively material misstatements.
• Specifically, auditors’ incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive qualitatively material misstatements as audit fees increase.
• The authors find that audit committees with greater financial expertise are less likely to allow managers to waive qualitatively or quantitatively material misstatements than are audit committees with less expertise.

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