The Impact of Changes in the Reporting Environment on the Disposition of Proposed Audit Adjustments

We present evidence on the resolution of proposed audit adjustments during a unique period of time immediately following several US financial scandals and surrounding the passage of the Sarbanes-Oxley Act (SOX). During this period auditors and clients both faced increased scrutiny from investors and regulators. In addition, auditors had to contend with changed incentives, annual inspections and a new external regulator (i.e., the PCAOB). In comparison with prior studies we also consider a broader range of factors potentially impacting the resolution of proposed adjustments including the affect of client tenure, strength of internal controls, and repeat adjustments. Data on 458 proposed adjustments are obtained from the working papers of a sample of 163 audit engagements conducted during 2002 by a Big 4 firm. We find a dramatic reduction in the proportion of waived audit adjustments when compared to prior studies, suggesting calls for greater auditor and client responsibilities increased conservatism. Results indicate audit adjustments are more likely to be waived for clients with whom the audit firm has had a longer relationship, although there is no pattern of favoring such clients. We also find that adjustments are more likely to be waived for clients with stronger internal controls, especially larger clients, and for repeat adjustments. Overall, the results suggest that there is increased conservatism in the resolution of proposed adjustments.