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

• Author: PREETI CHOUDHARY,KENNETH MERKLEY,KATHERINE SCHIPPER
• DOI: http://doi.org/10.1111/1475-679X.12286
• Date: 01 December 2019
• Published date: 01 December 2019

DOI: 10.1111/1475-679X.12286

Journal of Accounting Research

Vol. 57 No. 5 December 2019

Printed in U.S.A.

Auditors’ Quantitative Materiality

Judgments: Properties and

Implications for Financial

Reporting Reliability

PREETI CHOUDHARY ,∗KENNETH MERKLEY ,†

AND KATHERINE SCHIPPER ‡

Received 22 March 2018; accepted 20 June 2019

ABSTRACT

We analyze data made available through the PCAOB (Public Company Ac-

counting Oversight Board) to provide descriptive evidence on the properties

∗University of Arizona; †Indiana University; ‡Duke University.

Accepted by Douglas Skinner. This paper was written while Preeti Choudhary was a Se-

nior Economic Research Fellow at the PCAOB. The PCAOB as a matter of policy disclaims

responsibility for any private publication or statement by any of its economic research fel-

lows, consultants, and employees. The views expressed in this paper are the views of the au-

thors and do not necessarily reflect the views of the Board, individual Board members, or

staff of the PCAOB. We thank Michael Gurbutt, Patrick Kastein, Jayanthi Krishnan (discus-

sant), Christian Leuz, Gary Previts, Dana Smith, Jessica Watts, Keith Wilson, Luigi Zingales,

PCAOB staff, and seminar participants at the PCAOB, University of Arizona, ESSEC Busi-

ness School, University of Florida, George Mason University, HEC Paris, Rutgers University,

Stanford University, University of Rochester, University of Wisconsin, Indiana University, and

The Center for Audit Quality Research Advisory Board for helpful discussions. Previous ver-

sions of this paper were titled “Determinants and Consequences of Quantitative Materiality

Judgments” and “Direct Measures of Auditors’ Quantitative Materiality Judgments: Proper-

ties, Determinants and Consequences for Audit Characteristics and Financial Reporting Re-

liability.” We have also benefited from discussions about selection bias with Jonathan Cook

and research assistance provided by Noah Newberger. We would like to give a special thank

you to Jim Doty, Patricia Ledesma, Samantha Ross, and Gordon Seymour for their support

in making this research possible. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1303

CUniversity of Chicago on behalf of the Accounting Research Center, 2019

1304 P.CHOUDHARY,K.MERKLEY,AND K.SCHIPPER

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 pretax 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 charac-

teristics such as financial performance. Using the distribution of actual ma-

teriality 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 pro-

posed audit adjustments and, in extreme cases, with a greater incidence of

restatements, highlighting the importance of auditor materiality assessments

for financial reporting reliability.

JEL codes: C80; M41; M42; M48

Keywords: financial reporting; materiality; auditing; reporting quality

1. Introduction

We provide descriptive evidence on a key component of the financial re-

porting assurance process, auditors’ overall quantitative materiality assess-

ments made to support the planning and execution of a financial statement

audit.1Materiality assessments, including those made by auditors as part of

the assurance process and those made by management in the preparation

of financial statements, are both pervasive and essential to achieving finan-

cial reporting reliability. Despite their importance, these assessments are

rarely directly observable in the U.S. environment outside the reporting en-

tity; as a result, little is known about either their properties or their links to

reporting outcomes. We provide broad-sample archival evidence on both.

Our evidence is based on actual materiality amounts for a broad sam-

ple of audits using inspection documents that the eight largest public

accounting firms submitted to the PCAOB (Public Company Account-

ing Oversight Board). As discussed later, most previous research on ma-

teriality judgments has, of necessity, relied on inferences from report-

ing error-correction disclosures that reflect joint auditor–management

1Para. 5, 6 of Accounting Standard No. 2105, Consideration of Materiality in Planning and Per-

forming an Audit, (AS 2105), effective for fiscal years beginning on or after December 15, 2010.

These initial materiality assessments are distinct from, but related to, other auditor materiality

judgments such as determining component materiality for specific accounts, transactions, or

segments; evaluating proposed audit adjustments; and evaluating financial statement errors,

because initial materiality forms the foundation for the other assessments.

AUDITORS’QUANTITATIVE MATERIALITY JUDGMENTS 1305

materiality assessments (e.g., Acito, Burks, and Johnson [2009], Keune and

Johnstone [2012], Choudhary, Merkley, and Schipper [2017]) or on other

indirect sources such as audit firm policy manuals (e.g., Eilifsen and Messier

[2015]). We provide descriptive evidence that is both derived from actual

auditor materiality amounts (as opposed to inferred thresholds) and spe-

cific to auditors, not reflective of a joint auditor–management assessment.

Our sample includes U.S. audits inspected by the PCAOB during 2005–

2015, comprising 2,150 clients (4,284 client-year observations). Inspected

audits are selected based on expert judgments of ex post audit risk, that is,

the risk the audit contains audit deficiencies (Hansen [2012]); this sample

construction gives rise to the possibility that materiality assessments from

PCAOB-inspected audits might not generalize to the population of audits.

While we believe our analyses of selection bias, reported in the section IV

of the online appendix, alleviate concerns about the generalizability of our

results, the potential for limited generalizability cannot be entirely ruled

out.

Our analysis proceeds in three steps. We first document the properties

(amounts and supporting calculations) of materiality values to provide ev-

idence that auditors’ materiality assessments are not simply based on rules

of thumb, such as 5% of pretax income. This analysis is motivated by the

near-complete lack of broad-sample, recent-period archival evidence about

auditors’ actual materiality assessments and by recurring concerns, some-

times rising to the level of suspicion, that in making these assessments audi-

tors underemphasize qualitative and contextual factors such as those spec-

ified in AU 9312 and Staff Accounting Bulletin 99 (SAB 99), Materiality,

(e.g., the potential for misstatements to affect earnings trends, earnings

volatility or whether a client reports a profit vs. loss or earnings increase vs.

decrease) and overemphasize quantitative factors (in the extreme case, re-

flexive application of numerical rules-of-thumb). We graph the frequency

of sample quantitative materiality expressed as a percentage of pretax in-

come for various subsamples of our data, providing visual evidence of sub-

stantial variation around the most common materiality benchmark, 5% of

pretax income.2We find that reported materiality amounts vary with re-

spect to bases (i.e., size-related financial reporting line items), adjustments

to those bases, and percentages applied to those bases.

Approximately 90% of the variation in dollar materiality is explained by

variation in absolute pretax income, revenues, and assets; the regression

weights on these size-related bases vary in predictable ways with contex-

tual factors such as those specified in SAB 99. We infer that the choice of

size-related measure(s) is an important element of auditors’ overall ma-

teriality assessments, and in making those assessments auditors combine

2As discussed later, quantitative materiality is a monetary amount, often reported as a per-

centage, for example, 1% applied to a materiality base, for example, total assets. Reporting

quantitative materiality as a percentage of a base does not mean that the judgment was arrived

at by multiplying a single percentage times a single base.