Direct Measures of Auditors’ Quantitative Materiality Judgments: Properties, Determinants and Consequences for Audit Characteristics and Financial Reporting Reliability.

• In Event: Auditor Report Change, Auditor Materiality

Abstract

For a large sample of audits carried out during 2005-2015 by eight large accounting firms and inspected by the PCAOB, we provide evidence on the properties of auditors’ quantitative materiality judgments and the consequences of those judgments for financial reporting. We find that auditors’ quantitative materiality judgments do not appear to result only from applying conventional rules-of-thumb, specifically, 5% of pre-tax income, but instead are associated with qualitative factors suggested by authoritative guidance and with size-related financial statement outcomes (income, revenues and assets); weights placed by auditors on these outcomes vary with client characteristics such as financial performance. Using non-authoritative guidance in audit-firm policy manuals, we construct a materiality measure (materiality looseness) that is comparable across varying client sizes. We find that looser materiality is associated with fewer audit hours and lower audit fees, supporting the construct validity of this measure. We also find that looser materiality judgments are associated with lower amounts of detected errors and a greater incidence of restatements, highlighting the importance of these decisions for financial reporting reliability.

Author

• Preeti Choudhary, University of Arizona