New Research from the Eller College Shows Immaterial Errors Point to Control Deficiencies
Immaterial error corrections—that is, errors deemed not significant enough to change an investor’s valuation assessment in a company’s previously issued financial statements—have been increasing since about 2004.
Typically, these corrections are associated with negative share returns—though modest—that are more severe when the correction is related to decreased income or that involved multiple issues.
New research from the Eller College of Management’s Dhaliwal-Reidy School of Accountancy at the University of Arizona shows that investors extract value relevant information from immaterial errors and that these errors reliably predict three indicators of poor reporting reliability: future immaterial and material financial reporting errors, future disclosures of material weaknesses in internal controls over financial reporting and future comment letters from the Securities and Exchange Commission (SEC).
Preeti Choudhary, associate professor of accounting and author on the study, says: “Our findings suggest that immaterial errors are an equal or better indicator of potential audit or financial reporting issues than material errors corrected by restatements.”
The research, titled “Immaterial Error Corrections and Financial Reporting Reliability,” is forthcoming in Contemporary Accounting Research and was co-authored with Kenneth Merkely of Indiana University and Katherine Schipper of Duke University
The evidence is based on a broad sample of 3,559 corrections of reporting errors deemed immaterial by managers of firms applying U.S. GAAP between October 2008 and December 2015 and included in the Audit Analytics database. During this period, the frequency of immaterial error corrections more than doubled from 4 percent to more than 10 percent, while the frequency of material error corrections declined from 3.2 percent to 1.5 percent. These trends are consistent with managers identifying and correcting relatively minor reporting problems before they become severe, consistent with post-2008 guidance for the treatment of immaterial errors.
“Our evidence has implications for financial reporting and auditing,” says Choudhary. “Specifically, these findings amplify calls to reconsider materiality guidance in financial reporting that relies heavily on legal reasoning that is unrelated to financial reporting.”
Managers, auditors, audit committees and securities regulators may find it helpful to view detected and corrected immaterial errors as diagnostic cues to strengthen financial reporting processes and systems. More specifically, recent immaterial error corrections may be a useful indicator of undisclosed lower-level control deficiencies. Finally, immaterial errors can also be used as a more subtle measure of financial reporting/audit quality than restatements.