Working Paper: The Last Chance to Improve Financial Reporting Reliability: Evidence from Recorded and Waived Audit Adjustments

Paper Authors:  Preeti Choudhary, Kenneth Merkley and Katherine Schipper

Abstract: We provide evidence on auditors’ proposed audit adjustments and management’s disposition of those adjustments using a large sample of audits of SEC registrants by eight large accounting firms and inspected by the PCAOB between 2005-2014. We find that proposed audit adjustments are pervasive, 81% of sample audit engagements receive at least one proposed adjustment, and that managers appear to frequently disagree with auditors about the disposition of these adjustments, at least one adjustment is waived in 72% of sample engagements. We find that firms with earnings management incentives and those with poor quality financial reporting systems are more likely to benefit from financial statement audits because these factors are associated with more proposed and recorded audit adjustments relative to waived adjustments. Finally, we provide evidence consistent with the disposition of audit adjustments having consequences for financial reporting reliability. We find that the decision to waive audit adjustments is associated with a higher likelihood that financial statements are subsequently restated, while recorded audit adjustments either have no effect or improve financial statement reliability.