The Importance of Quantifying Uncertainty: An Examination of Audit Materiality and Sensitivity Analysis Disclosures on Investors’ Judgments and Decisions

• In Event: Specialists, Audit Materiality & Complex Estimates

Abstract

At present, items containing extreme levels of estimation uncertainty may be obscured from investors given that they are reported using precise point estimates within financial statements that receive a clean opinion from the auditors. However, uncertain and imprecise items are likely to become much more salient to financial statement users as more audit reports begin to include the disclosure of critical audit matters, which often highlight uncertain and subjective items. The way in which investors perceive these highly subjective estimates may depend on how transparently the level of uncertainty underlying the estimate is disclosed. Our study examines two disclosures that should help quantify the amount of uncertainty contained within a highly subjective fair value estimate: a quantitative sensitivity analysis and the auditors’ materiality threshold. Using an experiment with nonprofessional investors, we predict and find that participants who receive both a quantitative sensitivity analysis and a materiality disclosure are able to differentiate between an estimate with relatively low measurement uncertainty (i.e., low sensitivity) and one containing extreme estimation uncertainty (i.e., high sensitivity). When one or both of these disclosures is absent, however, investors fail to recognize differences in reliability between the two levels of sensitivity, despite the fact that the amount of imprecision in the low sensitivity condition represents a fraction of materiality, while in the high sensitivity condition, this amount exceeds audit materiality multiple times over.

Authors

• Aasmund Eilifsen, Norwegian School of Economics

• Erin L Hamilton, University of Nevada-Las Vegas

• William F Messier, University of Nevada-Las Vegas