Auditor’s decision to waive proposed audit adjustments

Research that investigates auditors’ decision to book or waive proposed adjustments can shed light on which variables have an impact in auditor-client negotiations over accounting issues, even though these studies do not only investigate accounting issues that are negotiated for the following reasons: first, these studies do not distinguish between proposed adjustments that are negotiated and proposed adjustments that are not (clients do not necessarily disagree with the auditor on the correct accounting of proposed adjustments). Secondly, many proposed adjustments can be relatively small and consequently be waived due to immateriality reasons and not due to the client being successful in persuading the auditor. Issues that auditors negotiate with their clients are, by contrast, typically material and take more time and several people to solve. An overview of the waive-adjust-studies is given in Table 2. An overview of the independent variables that are found significant is given in Table 4.

Prior research on auditors’ decisions to book or waive proposed adjustments show that the size (absolute and relative) and the type (objective vs. subjective) of the proposed adjustment, are factors that explain why these adjustments are corrected or not (Houghton and Fogarty 1991; Icerman and Hillison 1991; Wright and Wright 1997 and Braun 2001).

Table 2 - Auditor’s decision to book or waive proposed adjustments

Author Research question Research method Main findings

Icerman and Hillison

Author Research question Research method Main findings

Houghton and Fogarty (1991) study a sample of 3060 proposed adjustments and find that the waived misstatements in this sample are significantly smaller than the misstatements that are booked, i.e. the absolute size of proposed adjustments has an effect.

Icerman and Hillison (1991) study 1424 proposed adjustments from 49 manufacturing companies in the period 1979-1981 and find that the more proposed adjustments are booked the larger the ratio proposed adjustment size to net revenue. Clients that are audited by a structured audit firm (a firm that uses a more structured audit approach) also book more proposed adjustments than clients that are audited by more unstructured firms (firms that use a less structured audit approach).

Wright and Wright (1997) examine a sample of 368 misstatements from 186 audit engagements and find that the more proposed adjustments are corrected the larger the ratio proposed adjustment to planning materiality. Proposed adjustments that are objective (regulated by unambiguous GAAP) are corrected more often than proposed adjustments that are subjective (open for judgment/more ambiguous GAAP) in nature. Adjustments that will increase income if implemented are corrected more often than adjustments that have an income decreasing potential. More proposed adjustments are also corrected if the client is small as opposed to large (suggesting that incentives related to client retention have an impact

on auditors’ decisions to waive or adjust proposed adjustments). Industry affiliation is found to be insignificant (financial institutions vs. other industries).

Braun (2001) builds on the findings in Wright and Wright (1997) and conducts an experimental study (155 managers and partners participate) to investigate the effect of risk and reward factors on auditors’ adjustment decisions. The findings indicate that reward factors (fee size) do not have an effect on their decision whereas factors related to auditors’

risk are found to impact significantly auditors’ adjustment decisions (objective adjustments are corrected more often than subjective adjustments, adjustments are corrected more often if the clients’ financial health is bad, and adjustments that increase income are corrected more often than adjustments that decrease income).

Two recent experimental studies investigate the effect of different types of decision aids/

regulation on auditor’s adjustment decisions. Nelson et al (2005) provide experimental participants with either a current-period format (the format compares misstatements added in the current period to net income) or a cumulative format (the format compares cumulative misstatements to net income) as a decision aid when judging whether a client should be required to book a proposed adjustment. Findings indicate that the format of the decision aid has an effect (the auditors are more likely to book the proposed adjustment under the format that makes it look more material), and the researchers suggest that auditors be required to consider both formats when making book/waive decisions. Ng (2007) investigates which earnings thresholds seem to be most important in affecting auditors to book audit differences and find that auditors are most likely to book audit differences which have a effect on the client’s ability to report positive earnings. Ng suggests that differences in importance for different thresholds may be caused by the auditors’ awareness of the thresholds and find that availability of materiality guidance will have an effect on auditors’ booking of audit differences. Ng and Tan (2007) investigate whether the salience of qualitative factors has an effect on auditors’ book and waive decisions and whether the effect of salience is moderated by cognitive factors (the auditor’s mental model of the appropriate materiality threshold) and incentive factors (client concern about not booking the proposed adjustment).

Findings suggest that salience has an effect but only for auditors with low materiality thresholds and if client concern is not communicated.

Joe et al. (2011) study 458 proposed adjustments from 163 audit engagements in a Big 4 firm conducted in 2002. Proposed audit adjustments are more likely to be waived if auditor tenure is long (but auditors are not more likely to waive income increasing adjustments) or if the adjustment was also proposed the previous year. The strength of the client’s internal control is not found to have an effect on the decision to book or waive proposed adjustments.