Materiality and the Length of Misstatement Detection Periods

• In Event: Timeliness of Reporting Bad News and Misstatements

Abstract

In this paper, I examine if misstatement materiality motivates managers to shorten misstatement detection periods, the length of time between the end of the misstated period and the misstatement disclosure date. Using Form 8-K item 4.02 filing (big R) as a proxy for management self-evaluated materiality of misstatement, I find it is negatively associated with the length of detection periods. Put in economic terms, management accelerates announcements of material misstatements by about 116 days compared to immaterial misstatements. The impact of materiality is even more evident for the disclosure of serious (fraud/SEC investigated) than non-serious (error-related) misstatements. Additional tests using misstatement severity and cumulative income effect in non-BigR firms as alternative measures of materiality alleviate the concern that the observed negative association is mechanical due to the regulatory requirement on disclosure. Further test shows that non-earnings related components of materiality contribute to shorter detection periods as well. Finally, even though material misstatement firms are more likely to be sued than immaterial misstatement firms are, I provide evidence that among material-misstating firms the litigation risk is lower for earlier disclosers than for the later. This finding explains why management would like to shorten the detection period of material misstatement.

Author

• Yongtao Hong, North Dakota State University