Auditors Tend to Correct Overstatements but Ignore Understatements on Financial Statements

Auditors are often caught between the proverbial "rock and a hard place." In order to protect themselves from litigation, they are more likely to detect and correct overstatements than understatements on financial statements.

"On one hand, undetected overstatements can lead to out-of-pocket losses to investors that can be recouped through litigation," says Orie Barron, assistant professor of accounting in Penn State's Smeal College of Business Administration. "On the other hand, favoring the correction of overstatement errors at the expense of understatement errors also can lead to financial statements that impose costs on certain financial statement users. Consider a banker who refuses a profitable loan on the basis of understated financial performance."

Financial statement audits are performed annually after the fiscal year end for all publicly traded companies in the U.S. Their purpose is to provide investors with assurance that the financial statements contain no "material misstatements," says Barron. Material misstatements are those that could influence the decisions of foreseeable users of the financial statements.

Favoring the detection and correction of overstatements over understatements, in settings where they are equally likely, results in audit outcomes that are inconsistent with the industry's ethical standards, says Barron. He recently co-authored a paper examining the topic, "Misstatement Direction, Litigation Risk and Planned Audit Investment," which has been accepted for publication in the Journal of Accounting Research . He co-authored the paper with Jamie Pratt, professor of accounting at Indiana University, and James D. Stice, professor of accounting at Brigham Young University.

In an experiment using audit partners and managers, where the risk of material errors is controlled, the researchers found the unintentional overstatement errors give rises to higher assessments of litigation risk and larger audit investments than do unintentional understatement errors. The result was much stronger in the presence of high levels of litigation risk in the client's industry.

"These results suggest that in industries where litigation risk is high, audited financial statements may contain more unintentional material understatement errors than overstatement errors," says Barron. "Thus, litigation risk-through its effect on auditors-may be encouraging financial statements that understate firm performance and creating an incentive for auditors to focus more attention on detecting unintentional errors that overstate financial performance."

This is significant, Barron explains, because this practice is inconsistent with the expressed goal of the Securities and Exchange Commission to encourage full disclosure and accounting practices that result in "true and fair" measurement.

Understatements also create the type of hidden-or "cookie jar"-reserves that the SEC feels should be eliminated because they make it difficult for investors to fairly value companies, making it easier for manager to "dim the signals" when business turns down, says Barron.