Does Company Reporting of Non-GAAP Earnings Result in Less Conservative Auditor Materiality Judgments? Evidence from the U.K.

• In Event: Auditor Report Change, Auditor Materiality

Abstract

Does company reporting of non-GAAP earnings result in less conservative auditor materiality judgements, as measured by auditors’ determination of quantitative materiality thresholds? Using a sample of audit reports issued to Premium Listed companies on the London Stock Exchange for FY 2013-2014, we find that more than 50 percent of auditors relying on a profit-before-tax materiality benchmark use adjusted (non-GAAP) profit-before-tax as their benchmark and these non-GAAP adjustments result in a less conservative audit (i.e., higher materiality amount) 92 percent of the time. We find that auditors’ adjustments are significantly more persistent than managers’ adjustments, suggesting that (1) the adjustments are not “one-off” as often described by the client and its auditor, and (2) auditor materiality thresholds are not always based on true underlying earnings. Finally, we find that auditors’ reliance on non-GAAP rather than GAAP earnings keeps estimation uncertainty in complex estimates below materiality 23 percent of the time which likely reduces the extent of procedures auditors perform over complex estimates. In sum, our findings suggest that company reporting of non-GAAP earnings results in less conservative auditor materiality judgments which could negatively impact audit quality.

Authors

• Nicholas Jennings Hallman, University of Texas at Austin

• Jaime J Schmidt, University of Texas at Austin

• Anne Margaret Thompson, University of Illinois-Urbana-Champaign