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Qualitative audit materiality and earnings management

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Abstract

This study investigates auditors’ propensity to rely on quantitative materiality thresholds to the exclusion of qualitative materiality thresholds. Specifically, we examine whether auditors are more likely to allow earnings management that is less than typical quantitative materiality thresholds but that nonetheless is qualitatively material. We use changes in tax expense as a proxy for earnings management. Our results indicate that companies with pre-managed earnings that would have missed the consensus analyst forecast are more likely to decrease their tax expense when the magnitude of the decrease is less than quantitative audit materiality thresholds. The results also indicate that firms are more likely to meet or beat the forecast when the amount of earnings management necessary to meet the analyst forecast is less than quantitative materiality. These results are consistent with auditors relying on quantitative materiality thresholds to the exclusion of qualitative materiality thresholds, i.e., the importance of meeting or beating the analyst forecast. Finally, we find that the ability to use tax expense reduction within quantitative materiality to meet or beat analysts’ consensus forecasts was significantly reduced by the SEC’s guidance on materiality in SAB-99 and by the passage of the Sarbanes–Oxley Act.

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Notes

  1. Statement of Financial Accounting Standards No. 162 (FASB 2008) describes the hierarchy of Generally Accepted Accounting Principles (GAAP). The FASB’s Concept Statements are not listed in the GAAP hierarchy. Rather, they provide a theoretical structure to evaluate current accounting standards and help in the formulation of future accounting standards. Thus the formal definition of materiality as stated in the FASB’s Concepts Statement No. 2 does not constitute GAAP. Nevertheless, SFAC 2 did have an impact on the how the concept of materiality has developed in both accounting practice and academia.

  2. Under the cumulative approach, the auditor compares the amount of the misstatement at the end of the accounting period to net income, whereas with the current-approach, the auditor compares the amount of the misstatement added in the current period to net income.

  3. For instance, Graham et al. (2005) surveyed more than 400 CFOs and found that the analyst forecast and meeting the prior year's quarterly earnings are the most important benchmarks.

  4. Gleason and Mills (2002) investigate the factors that cause firms to disclose and record contingent liabilities. They find that firms also use the “5 % rule of thumb” as firms tended to not disclose and record contingent liabilities when the amount was greater than 5 % of pre-tax income or 5 % of total assets. Since these firms are SEC filers, they would require an audited financial statement, and thus the “5 % income rule of thumb” used by Gleason and Mills (2002) provides additional support for its use as a quantitative materiality threshold.

  5. Excluding loss firms does not qualitatively change the results.

  6. We use the last consensus forecast from IBES before the annual earnings announcement to measure the forecast error. We examined the forecasts, and, for observations with a third quarter earnings announcement date in IBES, 98 % of the forecasts used in our analyses are after the third quarter earnings are announced. Excluding those observations for which the forecast was prior to the third quarter earnings announcement date and those observations for which the third quarter earnings announcement date was not available does not affect our results.

  7. Dhaliwal et al. (2004) use a sample that excludes firms with a forecast error greater than or less than five cents per share. Our results are robust to excluding these firms. We winsorize the top and bottom 1 % of observations for forecast error.

  8. To measure economic significance, we examine the odds ratio for the coefficient on QUALITATIVE_EM in Table 4, which is 1.32. This implies that, for firms with pre-managed earnings less than quantitative materiality, the odds of decreasing the effective tax rate in the for quarter are 1.32 times greater than the odds of firms with pre-managed earnings greater than quantitative materiality decreasing their effective tax rate. The predicted probability of decreasing the fourth quarter ETR when QUALITATIVE_EM is zero (and all other variables are measured at their mean) is 60.7 %. On the other hand, when QUALITATIVE_EM is one the probability increases to 67.2 %, or a 10.8 % increase in the probability.

  9. To measure economic significance, we examine the odds ratio for the coefficient on QUALITATIVE_EM in Table 5, which is 1.78. Therefore the odds of a firm with pre-managed earnings less than quantitative materiality meeting or just beating the analysts’ forecast is almost two times greater than the odds of a firm with pre-managed earnings greater than quantitative materiality meeting or just beating the analysts’ forecast. The predicted probability of meeting or just beating analysts’ consensus forecast when QUALITATIVE_EM is zero (and all other variables are measured at their mean) is 15.2 %. On the other hand, when QUALITATIVE_EM is one, the probability increases to 24.2 %, or a 59.2 % increase in the probability.

  10. The American Jobs Creation Act of 2004 permitted a one-time dividend repatriation deduction of 85 % but increased effective tax rates. Thus we exclude observation from 2004 and 2005, and our results are unaffected.

  11. SAB 99 was issued by the SEC in 1999 and thus the indicator variable SAB99 is set to one if the year is greater than or equal to 1999 and zero otherwise. Sarbanes–Oxley was passed in 2002, and therefore the indicator variable SOX is coded one if the year is greater than or equal to 2002 and zero otherwise.

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Acknowledgments

The authors would like to express their gratitude to Marsha Keune, Lillian Mills, and workshop participants at Florida State University, Indiana University, Michigan State University, the University of Missouri at Columbia, Louisiana State University, and the Annual Meeting of the American Accounting Association for comments on prior versions of this study.

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Authors and Affiliations

  1. Department of Accounting, Louisiana State University, Business Education Complex, Room 2800, Baton Rouge, LA, 70803, USA

    Joseph Legoria

  2. Department of Accounting & IS, New Mexico State University, MSC 3DH, P.O. Box 30001, Las Cruces, NM, 88003, USA

    Kevin D. Melendrez

  3. Department of Accounting, Florida State University, 408 Rovetta Business Annex, 821 Academic Way, Tallahassee, FL, 32306, USA

    J. Kenneth Reynolds

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  1. Joseph Legoria
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Correspondence to J. Kenneth Reynolds.

Appendix

Appendix

See Table 7.

Table 7 Definition of variables used in the study
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Legoria, J., Melendrez, K.D. & Reynolds, J.K. Qualitative audit materiality and earnings management. Rev Account Stud 18, 414–442 (2013). https://doi.org/10.1007/s11142-012-9218-3

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