The Effect of the External Accountant's Review on the Timing of Adjustments to Quarterly Earnings

Abstract

Publicly listed companies must have their quarterly financial data reviewed by an external accountant. A company can have such data reviewed at the end of each quarter (timely review) or in conjunction with the year-end audit (retrospective review). The costs and benefits of each review choice have been debated for decades. The Securities and Exchange Commission (SEC) consistently has indicated a preference for reviews, while many companies have argued that there is no evidence that reviews provide incremental benefits. In January 1999, the Big Five accounting firms jointly announced to the SEC that they will require timely interim reviews of the financial statements of each public client, as a condition of acceptance of the company as a client. In February 1999 the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, created by the New York Stock Exchange and the National Association of Securities Dealers, recommended that the SEC require reviews prior to firms' filings of Forms 10-Q. Our paper assesses whether the timing of the external accountant's review of quarterly financial data (timely versus retrospective) is associated with differences in the timing of recognition of adjustments to quarterly earnings (recognition during the first three quarters versus the fourth quarter). Our results support earlier claims that a disproportionately large number of adjustments are recorded in the fourth quarter. The results also show that, as claimed but not previously documented, the frequency and proportion of adjustments recorded during the first three quarters are greater for companies with reviews, while the frequency and proportion of fourth quarter adjustments are smaller. Controlling for the total of adjustments recorded during the year, the number of adjustments made during the first three quarters is positively related to having a review, and to company size. Under reasonable assumptions, delay in recording adjustments should result in delayed resolution of uncertainty concerning the amounts of annual earnings, and of earnings of the late quarters in the fiscal year. We investigate the effect of deferred adjustments on uncertainty about the amounts of quarterly and annual earnings, using non-directional earnings prediction errors as proxies for uncertainty. Using results from tests referred to above, we divide the sample into high-deferral and low-deferral firms. Results indicate that high-deferral firms generate more uncertainty about third and fourth quarter earnings than do low-deferral firms. Contrary to our expectations, high-deferral firms do not have less uncertainty surrounding their first and second quarter earnings. The delay in resolving uncertainty over the third and fourth quarter earnings of high-deferral firms appears to cause increased uncertainty about their annual earnings for the entire fiscal year, relative to low-deferral firms.