Auditor scrutiny of unaudited client disclosure outlets: Recognized vs. disclosed financial statement items also appearing in the MD&A

Securities and Exchange Commission standards require disclosure of material non-recurring or unusual items affecting earnings in the Management's Discussion and Analysis (MD&A) section of annual 10Ks. Extraordinary items and LIFO liquidations represent unusual and non-recurring items. When material, both issues theoretically should be highlighted in management's discussion of current operations in the MD&A. Extraordinary items are recognized on the face of the income statement, while LIFO liquidations are disclosed in the footnotes. Libby, Nelson, and Hunton (2006) found that auditors permit more misstatement in disclosed, as opposed to recognized, amounts in annual reports. In this paper we test empirically whether these audit tendencies also apply in secondary disclosure venues such as the MD&A. For public companies reporting between 2001 and 2011, significantly higher MD&A disclosure rates are noted for recognized items, as opposed to disclosed items. Also, contrary to what Attribution Theory would predict, our results did not show a significant tendency to disclose negative-income-effect extraordinary items more often in the MD&A.