Can Accrual-based Metrics Indicate Material Accounting Misstatements? Evidence on Audit Adjustments

This paper analyses the usefulness of various accrual-based measures in detecting material accounting misstatements. Predicting financial misstatements has been of great interest not only to researchers but also to investors, auditors, financial analysts and regulators. However, since pre-audit financial statements are usually not available, prior research is mainly based only on samples of Securities and Exchange Commission (SEC) enforcement actions. We exploit almost unique institutional framework in which Croatian listed companies are required to publish both pre-audit and audited annual financial statements. Therefore, we are able to investigate which pre-audit financial indicators are significantly related to accounting misstatements detected by independent statutory audit, i.e. audit adjustments. Using a sample of 437 pairs of pre-audit and audited financial statements during 2009-2018, we find that financial statements with high value of absolute residuals from the Dechow-Dichev accrual model modified by McNichols (2002) are more likely to contain material misstatements of net income, working capital or fixed assets.Funding: This work has been partially supported by Croatian Science Foundation under the project IP-2020-02-9372 ?Disentangling Financial Reporting Quality?.