Katherine Schipper, Financial Distress in Private Colleges, Journal of Accounting Research, Vol. 15, Studies on Measurement and Evaluation of the Economic Efficiency of Public and Private Nonprofit Institutions (1977), pp. 1-40

Katherine Schipper, [Discussion of Financial Distress in Private Colleges]: A Reply, Journal of Accounting Research, Vol. 15, Studies on Measurement and Evaluation of the Economic Efficiency of Public and Private Nonprofit Institutions (1977), pp. 52-53

Preface

Methodology, Exact distributions of test statistics

Business combinations, Regulatory changes, Net benefits of estimated future acquisition activity, Regulation

Financial reporting, Value relevance, Usefulness, Information environment

Disclosures, Litigation risk, Rule 10b-5, Discretionary disclosures

We analyze the disposition of auditor‐proposed adjustments to financial statements. Our analyses address concerns, expressed by regulators and others, that auditors and their clients fixate on quantitative thresholds and overlook qualitative factors in assessing the materiality of discovered misstatements. Using a large sample of Public Company Accounting Oversight Board (PCAOB)‐inspected audits, we examine the frequency with which management records versus waives auditor‐proposed adjustments and whether waiving‐proposed adjustments ha consequences for reporting reliability and the audit process. We find waived adjustments are linked to lower financial reporting quality measured by material misstatements, to incentives to meet/beat earnings targets, and to the audit process, as measured by higher next‐period audit effort and fees and higher next‐period proposed adjustments. These effects on the audit process are consistent with auditors responding to the increased risk associated with waived adjustments. In an exploratory analysis, we find that controlling for the amount of proposed adjustments, auditor resignations are negatively associated with waived adjustments.

We analyze data made available through the PCAOB (Public Company Accounting Oversight Board) to provide descriptive evidence on the properties of auditors’ actual quantitative materiality judgments and the implications of those judgments for financial reporting. Auditors’ quantitative materiality judgments do not appear to result simply from applying conventional rules of thumb (e.g., 5% of pretax income), but instead are associated with size‐related financial statement outcomes (income, revenues, and assets), where the relative importance of the size‐related outcomes varies with client characteristics such as financial performance. Using the distribution of actual materiality amounts reported by auditors to the PCAOB as part of the audit‐inspection process, we construct a materiality‐judgment measure that locates a specific materiality amount within a normal range that is both comparable across varying client characteristics and supported by guidance in audit firm internal policy manuals. We find that looser materiality (an amount closer to the high end of a normal materiality range) is associated with fewer audit hours and lower audit fees, supporting the construct validity of this measure. We also find that looser materiality is associated with lower amounts of proposed audit adjustments and, in extreme cases, with a greater incidence of restatements, highlighting the importance of auditor materiality assessments for financial reporting reliability.

We examine uniform and discretionary regimes for reporting information about firm performance from the perspective of a standard setter, in a setting where the precision of reported information is difficult to verify and the reported information can help coordinate decisions by users of the information. The standard setter's task is to choose a reporting regime to maximize the expected decision value of reported information for all users at all firms. The uniform regime requires all firms to report using the same set of reporting methods regardless of the precision of their information, and the discretionary regime allows firms to freely condition their sets of reporting methods on the precision of their information. We show that when unverifiable information precision varies across firms and users' decisions based on reported information have strong strategic complementarities, a uniform regime can have a beneficial social effect as compared to a discretionary reporting regime. Our analysis generates both normative and positive implications for evaluating the necessity and effectiveness of reporting under standards.