The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions

• Author: JEREMY B. GRIFFIN
• DOI: http://doi.org/10.1111/1475-679X.12059
• Date: 01 December 2014
• Published date: 01 December 2014

DOI: 10.1111/1475-679X.12059

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

The Effects of Uncertainty and

Disclosure on Auditors’ Fair Value

Materiality Decisions

JEREMY B. GRIFFIN

∗

Received 24 January 2012; accepted 25 June 2014

ABSTRACT

Financial accounting standards increasingly require fair value measurements.

I experimentally examine how uncertainty affects auditors’ adjustment deci-

sions when evaluating fair values. I manipulate two types of uncertainty, input

subjectivity and outcome imprecision, and one reporting choice, supplemental

disclosure. I find that auditors are most likely to require adjustments when

fair values contain both more input subjectivity and more outcome impreci-

sion, but that this likelihood diminishes when clients supplement recognized

fair values with additional disclosure. Thus, consistent with moral licensing,

I find that auditors tolerate greater potential misstatement in the financial

statements when clients provide disclosure, suggesting that the SEC’s pref-

erence for supplemental disclosure may have the unintended consequence

∗Mendoza College of Business, University of Notre Dame.

Accepted by Philip Berger. This paper is based on my dissertation at the University of

Georgia. I am grateful for the contributions of my committee: Linda Bamber, TinaCarpenter,

Jenny Gaver,and especially Michael Bamber (chair) and Jackie Hammersley. Special thanks to

Tim Bell, Karen Braun, and the anonymous audit partners who helped me develop and refine

my experimental materials. I also appreciate helpful comments received from an anonymous

reviewer, Ann Backof, Pennie Bagley, Margaret Christ, Kathryn Kadous, Bill Kinney, David

Koo, Roger Martin, Jason Matthews, Sean McGuire, Bill Messier,Mark Nelson, Dave Ricchiute,

Chad Simon, Karl Wang, and workshop participants at the University of Georgia, University

of Notre Dame, Miami University, University of South Carolina, University of Massachusetts–

Amherst, University of Wisconsin–Madison, University of Mississippi, and Florida State Uni-

versity as well as conference participants at the 2010 Deloitte/University of Kansas Symposium

on Auditing Problems.

1165

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

1166 J.B.GRIFFIN

of affecting fair values recognized in the body of the financial statements. I

also provide evidence that auditors determine adjustment size by comparing

recorded fair value to the nearest bound, rather than the midpoint, of the

auditors’ own range estimate, consistent with strict application of auditing

standards.

JEL codes: M42

Keywords: fair value; materiality; audit adjustments; uncertainty; disclosure;

subjectivity; imprecision

1. Introduction

Standard setters increasingly prefer that assets and liabilities be measured

at fair value (Barth [2006, 2008]), though implementing fair value mea-

surement sparks considerable debate (Laux and Leuz [2009]). Measuring

fair values in the absence of reliable market prices is difficult because the es-

timation process often depends on relatively subjective information inputs

and generates imprecise ranges of possible outcomes. Investor advocates

warn that preparers could use this uncertainty to bias fair value estimates

(Reilly and Scannell [2008]). The Securities and Exchange Commission

(SEC) has responded by encouraging more voluntary disclosures regarding

fair value estimates (SEC [2008a, 2008b]). Meanwhile, auditors must assess

the reasonableness of their clients’ measurements and, when they deem

misstatements material, require their clients to adjust fair value estimates

before reporting them in the financial statements.1Regulators’ efforts to

address the uncertainty associated with fair value estimates may have the un-

intended consequence of changing how auditors view their fiduciary duty

to the investing public, especially in the case of requiring their clients to ad-

just fair value estimates. Whether recent accounting and auditing standards

cause auditors to require their clients to record more or fewer adjustments

to fair value estimates is an open question.

I experimentally examine how two types of uncertainty addressed by reg-

ulators, subjectivity and imprecision, and one reporting choice encouraged

by regulators, supplemental footnote disclosure, influence auditors’ deci-

sions to require fair value adjustments. Subjectivity affects the reliability of

the inputs used to prepare accounting information. In measuring fair val-

ues under SFAS No. 157, Level 1 items involve little subjectivity because

highly reliable inputs (e.g., active market prices) are available, while Level

2 and Level 3 items involve progressively greater levels of subjectivity be-

cause they depend on less reliable inputs (e.g., information from compa-

rable situations or the reporting entity’s own assumptions).2Imprecision,

1Auditors’ adjustment decisions reflect their judgments about the materiality of detected

misstatements at the evaluation stage of the audit (Icerman and Hillison [1991]). Material

misstatements are those that the auditor perceives would affect the judgment of a reasonable

user of the financial statements (FASB [1980], Messier,Glover, and Prawitt [2008]).

2SFAS No. 157 provides a three-level hierarchy of fair value measurement inputs: Level 1

inputs are quoted prices in active markets for identical assets or liabilities, Level 2 inputs are