Do Client Managers Strategically Manage Earnings in Response to Auditors’ Quantitative Materiality Threshold Disclosures?

Abstract

SYNOPSIS Expanded audit report regulation in the United Kingdom requires auditor disclosure of client-specific quantitative materiality thresholds (QMTs). The United States decided against requiring this disclosure, concerned that providing clients with visibility into this important audit input could enhance managers’ ability to manage earnings without detection. Using the U.K. setting, we investigate whether clients strategically leverage their auditors’ QMTs to increase income through undetected earnings management. We examine the association between auditor QMT and client earnings management generally and in client settings where a material qualitative factor in the form of heightened earnings management incentives exists. In our general setting, we find a positive relation between auditors’ lagged and current QMTs and clients’ current-year accruals-based earnings management. We do not find a relation in our heightened earnings management settings, however, suggesting that auditors consider qualitative materiality factors and constrain clients’ auditor QMT-based earnings management. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M41; M42; M48.