Determinants of Prior Period Error Reporting Types : Focusing on Characteristics of Auditors and Managers

The existing Financial Accounting Standards allow both of error reporting practices: error adjustment to the current period's income statement as non-operating gains and losses and error correction by restating financial statements. In the latter case, fundamental error corrections shall be reported in the beginning balance of unappropriated retained earnings and adjusted to relevant account balances. This study investigates the potential factors that may affect the managements' materiality judgments to report the prior period error corrections, partitioning those factors into qualitative materiality, the managers' and auditors' characteristics. As for auditors’ characteristics, auditor size, audit tenure and initial audit engagements are used to investigate whether these factors affect the reporting types of prior period error corrections and as for managers’ features, income smoothing incentive and conservatism are employed. The contribution of this study lies in the initial attempt to examine interaction effect between magnitude of error and the other factors simultaneously. We find that in the case of Big 4 auditors, the larger the magnitude of net error, the more are the auditors inclined to report an error correction in income statements. Moreover, auditors whose audit tenures are greater than 2 years prefer to make restatements when magnitude of net error is large. In addition, the higher the magnitude of net error, the more likely it is for the auditors in their initial engagements to report error in the current net income. Our results suggest that auditors consider their reputation on their audit quality and even the possibility of getting supervised by the regulatory bodies as well as the interests of others in their determination process of prior period error correction types. As for the results related to managers’ features, we find that if there is income smoothing effect stemming from adjusting errors as profit or loss, managers tend to report prior errors in the income statements, whereas in the case of higher magnitude of net error, managers prefer restatements. In addition, if managers prefer conservative accounting, a high magnitude of net errors is a likely cause for managers to report erroneous accounting in the income statements. This study contributes to the literature on reporting types of prior period error corrections by considering the magnitude of net error and influencing factors simultaneously expanding previous studies. Building on the relationship between the material judgments and the qualitative factors, we predict that firms' materiality assessments are associated with the managers' and auditors' characteristics. This setting enables us to test conjectures on the unfolding sequences of materiality judgments and error correction decisions.