Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability

Abstract

We analyze data made available through the PCAOB (Public Company Accounting Oversight Board) to provide descriptive evidence on the properties of auditors' actual quantitative materiality judgments and the implications of those judgments for financial reporting. Auditors' quantitative materiality judgments do not appear to result simply from applying conventional rules-of-thumb, (e.g., 5% of pre-tax income), but instead are associated with size-related financial statement outcomes (income, revenues and assets), where the relative importance of the size-related outcomes varies with client characteristics such as financial performance. Using the distribution of actual materiality amounts reported by auditors to the PCAOB as part of the audit-inspection process, we construct a materiality-judgment measure that locates a specific materiality amount within a normal range that is both comparable across varying client characteristics and supported by guidance in audit firm internal policy manuals. We find that looser materiality (an amount closer to the high end of a normal materiality range) is associated with fewer audit hours and lower audit fees, supporting the construct validity of this measure. We also find that looser materiality is associated with lower amounts of proposed audit adjustments and, in extreme cases, with a greater incidence of restatements, highlighting the importance of auditor materiality assessments for financial reporting reliability.

Influence of auditor's gender, experience, rule observance attitudes and critical thinking disposition on materiality judgements

“…It is the most popular benchmark applied in finalising materiality judgements (Carpenter & Dirsmith, 1992; Messier et al, 2005). Choudhary et al (2019) find pretax income to be the most common benchmark used in materiality assessments followed by revenues and net income. Similarly, Keune and Johnstone (2012) also find pretax income to be the most commonly applied quantitative criteria in materiality judgements.…”

“…However, the study indicates that auditors are concerned about jeopardising the auditor–client relationship in considering QMFs in their judgements. Choudhary et al (2019) demonstrate that financial performance linked qualitative factors affect the quantitative materiality base auditors consider in making materiality judgements. Sunderland and Trompeter (2017) opine that both quantitative and qualitative considerations need to be included when assessing materiality for multinational companies.…”

“…This affects the quality of materiality judgements made as well as overall audit quality. This is because the effective use of qualitative factors, along with quantitative benchmarks, in resolving materiality decisions leads to improved audit quality of financial reporting (Choudhary, Merkley, & Schipper, 2019; Montoya‐del‐Corte et al, 2010).…”

“…Auditors prefer to emphasise the numerical thresholds as they are easier to comply with and easier to justify when faced with litigation and inspections (Donelson, McInnis, & Mergenthaler, 2012). However, the quality of the audit decision is compromised when quantitative percentages dominate the decision with little or no emphasis on qualitative considerations (Choudhary et al, 2019; Shaub, 2005). Principle‐based standards, including the ISA 450, have reiterated the need to include qualitative considerations in assessing materiality judgements, moving away from a primary reliance on quantitative benchmarks.…”

Public interest entities in the context of accounting and auditing legislation in the wake of the globalization process

“…The purpose of the financial statements is to provide information about the financial position, performance and changes in the financial position of the entity [16]. Each entity must also prepare its financial statements taking into account the requirements of business ethics, which assess the economic activities of the company on the basis of moral values, where the primary objective is not profit maximization but focus on long-term development and prosperity [1,4,12]. Entities prepare their financial statements either under Slovak legislation, depending on the type of entity, or under supranational legislation.…”