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

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  • PREETI CHOUDHARY
  • KENNETH MERKLEY
  • KATHERINE SCHIPPER

Abstract

We analyze data made available through the PCAOB (Public Company Accounting Oversight Board) to provide descriptive evidence on the properties 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 characteristics such as financial performance. Using the distribution of actual materiality 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 proposed audit adjustments and, in extreme cases, with a greater incidence of restatements, highlighting the importance of auditor materiality assessments for financial reporting reliability.

Suggested Citation

  • Preeti Choudhary & Kenneth Merkley & Katherine Schipper, 2019. "Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability," Journal of Accounting Research, Wiley Blackwell, vol. 57(5), pages 1303-1351, December.
    • Handle: RePEc:bla:joares:v:57:y:2019:i:5:p:1303-1351
    DOI: 10.1111/1475-679X.12286
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    References listed on IDEAS

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    1. Christensen, Brant & Schmardebeck, Roy & Seidel, Timothy, 2022. "Do auditors’ incentives affect materiality assessments of prior-period misstatements?," Accounting, Organizations and Society, Elsevier, vol. 101(C).
    2. Nicholas J. Hallman & Jaime J. Schmidt & Anne M. Thompson, 2022. "Audit Implications of Non‐GAAP Reporting," Journal of Accounting Research, Wiley Blackwell, vol. 60(5), pages 1947-1989, December.
    3. Preeti Choudhary & Kenneth Merkley & Katherine Schipper, 2022. "The Costs of Waiving Audit Adjustments," Journal of Accounting Research, Wiley Blackwell, vol. 60(5), pages 1813-1857, December.
    4. Cassandra Estep & Emily E. Griffith & Nikki L. MacKenzie, 2024. "How do financial executives respond to the use of artificial intelligence in financial reporting and auditing?," Review of Accounting Studies, Springer, vol. 29(3), pages 2798-2831, September.
    5. Chen, Dong & Li, Yi & Lu, Jiani & Li, Chenming, 2024. "Do international tax treaties govern financial report quality?," Research in International Business and Finance, Elsevier, vol. 69(C).
    6. Elsayed, Mohamed & Elshandidy, Tamer & Ahmed, Yousry, 2023. "Is expanded auditor reporting meaningful? UK evidence," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 53(C).
    7. Raul David & Indra Abeysekera, 2021. "Auditor Judgements after Withdrawal of the Materiality Accounting Standard in Australia," JRFM, MDPI, vol. 14(6), pages 1-20, June.
    8. Christensen, Brant E. & Eilifsen, Aasmund & Glover, Steven M. & Messier, William F., 2020. "The effect of audit materiality disclosures on investors’ decision making," Accounting, Organizations and Society, Elsevier, vol. 87(C).
    9. Aleksandra “Ally” B. Zimmerman & Dereck Barr‐Pulliam & Joon‐Suk Lee & Miguel Minutti‐Meza, 2023. "Auditors’ Use of In‐House Specialists," Journal of Accounting Research, Wiley Blackwell, vol. 61(4), pages 1363-1418, September.
    10. Karen‐Ann M. Dwyer & Niamh M. Brennan & Collette E. Kirwan, 2023. "Auditor Materiality in Expanded Audit Reports: More (Disclosure) is Less," Australian Accounting Review, CPA Australia, vol. 33(1), pages 31-45, March.
    11. Ege, Matthew S. & Stuber, Sarah B., 2022. "Are auditors rewarded for low audit quality? The case of auditor lenience in the insurance industry," Journal of Accounting and Economics, Elsevier, vol. 73(1).

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