Does Non-GAAP Reporting Result in Less Conservative Auditor Materiality Judgments? Evidence from the U.K

We investigate whether non-GAAP reporting results in less conservative auditor materiality judgments, as measured by auditors' determination of quantitative materiality thresholds. Using a sample of audit reports for Premium Listed companies on the London Stock Exchange for the 2013-2014 fiscal year, we find that more than 50 percent of auditors who rely on “profit-before-tax” as their materiality benchmark use non-GAAP profit before tax, which results in a less conservative audit (via a higher materiality threshold) 92 percent of the time. We find that auditors are significantly more likely to rely on a non-GAAP profit-before-tax materiality benchmark when management discloses non-GAAP profit before tax in their annual report. The GAAP items that auditors' exclude from the materiality benchmark are highly persistent, suggesting that the exclusions are not typically one-time items as is often claimed. We also find that auditors are significantly more likely to rely on a non-GAAP materiality benchmark when doing so reduces the extent of required audit procedures performed on complex estimates. Finally, we find that auditor turnover is higher when the auditor's materiality benchmark is smaller than non-GAAP earnings disclosed by management. In sum, our results suggest that managers' non-GAAP reporting could indirectly affect investors by lowering the rigor of the financial statement audit