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  • The Auditing Section
    A Review and Integration of Empirical Research on...
    research summary posted April 13, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    A Review and Integration of Empirical Research on Materiality: Two Decades Later
    Practical Implications:

    The results of the studies documented in this review suggest that there is a great deal of variability in the approaches taken by firms for establishing materiality. Such differences in materiality methods can affect both the effectiveness and efficiency of audits. For example, if firms differ in how they allocate materiality to financial statement accounts, then the scope of the work could differ across audits with similar characteristics. Auditors also appear to differ in terms of the factors they consider for determining the materiality of internal control weaknesses, suggesting that auditors may need more structured criteria to make materiality judgments about internal control weaknesses. Materiality judgments are influenced by authoritative guidance, suggesting that standard setters and audit firms have the ability to influence auditors’ materiality judgments by providing auditors with specific guidance.

    Citation:

    Messier, Jr., W.F., N. Martinov-Bennie, and A. Eilifsen. 2005. A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory 24 (2): 153-187.

    Keywords:
    Materiality, materiality bases, quantitative, qualitative materiality factors
    Purpose of the Study:

    Materiality has been and continues to be a topic of importance for auditors. There has recently been renewed interest in the concept of materiality, motivated by concerns at the Securities and Exchange Commission, and the Auditing Standards Board and as evidenced by the Sarbanes-Oxley Act and the issuance of proposed standards on materiality by the International Auditing and Assurance Standards Board. Additionally, new guidance has been issued recently in response to some of the materiality concerns, including Staff Accounting Bulletin (SAB) No. 99, Statements on Auditing Standards (SAS) No. 89, and SAS No. 90.  Due to the continued importance of understanding the concept of materiality, this paper reviews and integrates the empirical research on materiality since 1982. Based on the review of the literature, the authors suggest some implications of this research for audit practice and research.

    Design/Method/ Approach:

    This paper reviews the literature related to materiality that has been published since 1982. The authors divide their discussion of the research into archival studies and experimental studies. Archival studies use audit firm manuals, data from auditor working papers, or published financial statement data and auditor reports to examine materiality decisions. Experimental studies examine materiality judgments and decision-making of financial statement users, auditors and others (e.g., judges/lawyers).

    Findings:

    Archival Studies: The primary findings from archival studies are categorized based on whether they were obtained from auditor-related sources (e.g., auditor working papers) or public sources (e.g., financial statements).  

         Auditor Related Sources (i.e., firm manuals and working papers)

    • There appear to be differences in the way firms establish planning materiality as well as differences in the extent of guidance provided by firms for setting planning materiality and tolerable misstatement.
    • Auditor judgment plays a significant role in setting planning materiality
    • Some version of income continues to be the major factor in determining the materiality of a misstatement (e.g., misstatement as a percent of net revenue). 

         Public Sources (i.e., financial statements, disclosures, and auditors’ reports)

    • Public sources also indicate that income continues to be the most significant factor in auditors’ materiality and disclosure decisions. This is the case regardless of the type of reporting item or disclosure in question.
    • Similarly, the choice to modify the auditor’s report seems consistent with traditional effects of the item on income. 

         Experimental Studies:

    • Experimental studies find that net income continues to be the most important factor in determining the materiality of misstatements, consistent with the findings of archival research. A number of studies find that the second most important materiality factor is the effect of the misstatement on a company’s earnings trend.
    • A number of qualitative factors were found to affect materiality decisions, including the auditors’ perceptions of management
      and management’s integrity, audit committee effectiveness, audit firm culture and whether a misstatement will be recognized in the financial statements or the footnotes.
    • Materiality judgments vary by experience and firm type. Experience appears to lead to greater consensus in materiality judgments and greater scrutiny of materiality judgments relating to discretionary, non-routine transactions.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
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  • The Auditing Section
    Accountability and auditors’ materiality judgments: The e...
    research summary posted May 3, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.02 Documentation Specificity, 09.11 Auditor judgment in the workpaper review process, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions, 10.03 Interaction among Team Members 
    Title:
    Accountability and auditors’ materiality judgments: The effects of differential pressure strength on conservatism, variability, and effort.
    Practical Implications:

    Firms should consider the levels of accountability pressure and situations where they use them and consider how different levels of pressure may impact performance.  Higher levels of accountability pressure may increase effectiveness and increase the likelihood of finding material misstatements. 

    On the other hand, increased effectiveness and time spent due to higher levels of accountability pressure may cause inefficiencies and result in unnecessary effort.  Firms should evaluate the costs and benefits for their situations. 

    The authors note that this study only looks at the effect of accountability pressure from an unknown partner.  In the real world, auditors have accountability pressures from many levels such as other superiors, clients, regulators, and audit committees. 
    Further, the auditor may have assessed things differently if they knew the partner that was performing their review.

    Citation:

    DeZoort, T., P. Harrison, and M. Taylor. 2006.  Accountability and auditors’ materiality judgments: The effects of differential pressure strength on conservatism, variability, and effort.  Accounting, Organizations, and Society 31 (4-5):  373-390. 

    Keywords:
    Audit Judgment; Audit Materiality; accountability pressure; materiality judgment
    Purpose of the Study:

    The purpose of this study is to look at how four different levels of accountability pressure (i.e. how their decisions would be reviewed) affect auditor conservatism, variability, and effort in tasks related to materiality.

    Design/Method/ Approach:

     The authors performed a computerized experiment using a final sample of auditors from five public accounting firms.  Participants were managers, staff and senior associates.   Participants were asked to review client background information, financial information, and a proposed audit adjustment for the Allowance for Doubtful Accounts balance.  Participants were asked to provide a planning materiality amount for the engagement and a materiality judgment regarding the proposed audit adjustment.  The auditors were put into one of four levels of accountability pressure:

    • Anonymity –judgment decision and responses were anonymous
    • Review –audit partner review but no feedback provided
    • Justification – participants provide written justification, which was reviewed but no comments provided
    • Feedback –formal feedback from partner about performance provided  

    In addition, about half of the participants received a “planning materiality decision aid,” which provided a range of planning materiality values.

    Findings:
    • For higher levels of accountability pressure strength (i.e. justification and feedback) judgments regarding planning materiality and proposed audit adjustments were more conservative and less variable.  In addition, higher level participants spent more time on the tasks, provided longer explanations and included more qualitative factors than those in lower levels, which suggest a higher level of effort.
    • Planning materiality decision aids reduced planning materiality variation across the various pressure levels, particularly for those in the lower accountability pressure groups.  
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Documentation Specificity, Auditor judgment in the workpaper review process, Materiality & Scope Decisions, Interaction among Team Members
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  • Jennifer M Mueller-Phillips
    Auditor Independence in Fact: Research, Regulatory, and...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Auditor Independence in Fact: Research, Regulatory, and Practice Implications Drawn from Experimental and Archival Research.
    Practical Implications:

    The analysis suggests that a holistic synthesis of the independence literature requires one to carefully consider methodological choices underlying a given study. Such an understanding is necessary to appreciate the context and meaning of the reported findings in relation to the greater body of literature and ongoing concerns of regulators.

    Citation:

    Church, B. K., Jenkins, J. G., McCracken, S. A., Roush, P. B., & Stanley, J. D. 2015. Auditor Independence in Fact: Research, Regulatory, and Practice Implications Drawn from Experimental and Archival Research. Accounting Horizons 29 (1): 217-238.

    Keywords:
    auditor independence, independence in fact, independence regulation, auditor judgment
    Purpose of the Study:

    The essence of factual independence encompasses the auditor’s ability and willingness to suppress bias and report honestly. A lack of independence can lead to biased judgments, indicating a failure in the audit process, but such failures do not necessarily reduce the quality of audit outputs. Process failures increase the likelihood that the quality of audit outputs is lowered; however, this relationship is by no means one-to-one. Notwithstanding various safeguards intended to enhance auditor independence in fact, regulators including the PCAOB have continued to express concerns that auditors, at times, are failing to maintain an appropriate level of independence. In this paper, the authors provide an analysis of selected academic studies related to auditor independence to offer readers a foundation on which to evaluate the substantial body of research in the area and to understand the mixed findings reported in experimental and archival studies. The authors discuss issues surrounding the research designs and methods used in prior work, highlighting challenges that face researchers. 

    Design/Method/ Approach:

    This paper analyzes information from selected academic studies related to auditor independence. 

    Findings:

    In this paper, the authors explore specific experimental and archival research relevant to the effects of independence on (1) auditors’ judgments and decisions that underlie the audit process and (2) observable audit outputs. The examination of experimental studies suggests that cognitive and motivational biases have the potential to impair independence and, consequently, weaken the audit process. By comparison, the examination of archival studies fails to definitively link test variables (i.e., auditor fees and lengthy auditor tenure) with evidence of compromised independence. Taken as a whole, the findings suggest that, although judgmental biases may hinder the audit process, such biases do not necessarily degrade audit outputs. 

    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Scope & Materiality Judgements
  • The Auditing Section
    Auditors’ Decisions on Audit Differences that Affect S...
    research summary posted April 16, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.08 Evaluation of Errors – Statistical and Non-statistical, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    Auditors’ Decisions on Audit Differences that Affect Significant Earnings Thresholds
    Practical Implications:

    The results of this study are important for auditors to consider when making materiality judgments.  The evidence indicates that auditors are more likely to overlook the qualitative importance of adjustments that affect a client’s ability to meet or beat analysts’ forecasts.  Furthermore, findings suggest that auditors are more lenient with subjective audit differences.  The study suggests that providing auditors with guidance on qualitative materiality may improve materiality judgments, but it does not completely alleviate the differences among the earnings benchmarks. 

    Citation:

    Ng, T.B. 2007. Auditors’ Decisions on Audit Differences that Affect Significant Earnings Thresholds. Auditing: A Journal of Practice and Theory 26 (1): 71-89.

    Keywords:
    materiality, audit adjustments, earnings management, thresholds, auditor judgments, guidance
    Purpose of the Study:

    Companies have economic incentives to meet or beat certain earnings benchmarks such as the prior year’s earnings, analysts’ forecasts, and positive earnings.  As a result, even small audit differences may be qualitatively material if they allow the client to meet or beat one or more of those benchmarks. However, the SEC and the IAASB both recently recognized that auditors may need further guidance on dealing with small but qualitatively material misstatements, and the SEC issued the Staff Accounting Bulletin 99 in response.  This paper provides evidence on this issue by investigating whether auditors’ propensity to book an adjustment is influenced by: client earnings benchmarks; subjectivity of the audit difference; and the availability of authoritative guidance.

    Design/Method/ Approach:

    The research evidence was collected prior to January 2005.  The author uses a sample of senior and manager auditors from the Singapore offices of the Big 4 firms to complete a simulated task involving the decision to waive or book an audit adjustment.  Participants were each assigned to two scenarios, both involving an audit adjustment that would cause the client to miss one of three earnings benchmarks.  One of the scenarios involved a subjective audit adjustment while the other involved an objective audit adjustment.  In a follow-up experiment, the author used the same methodology, but provided the auditors with materiality guidance from SAB 99.

    Findings:
    • The authors find that among the three earnings benchmarks, auditors are most likely to require an adjustment for differences that cause positive unadjusted earnings to become negative (profitability benchmark). 
    • Auditors are least likely to require adjustments that prevent clients from meeting analysts’ forecasts. 
    • The authors find that when auditors are more likely to require an adjustment when the audit difference is objective versus subjective, regardless of any earnings benchmark effect.
    • The authors also find that providing auditors with SAB 99 materiality guidance increases the likelihood that auditors will require small but qualitatively material items to be booked.  However, auditors are still more likely to require adjustments for audit differences that affect the profitability benchmark than the other two benchmarks.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Evaluation of Errors - Statistical and Non-statistical, Materiality & Scope Decisions
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  • Jennifer M Mueller-Phillips
    Commentary on Auditing High-Uncertainty Fair Value...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.06 Adequacy of Disclosure 
    Title:
    Commentary on Auditing High-Uncertainty Fair Value Estimates.
    Practical Implications:

    PCAOB Chairman James Doty recently announced plans to convene a task force on audits of fair value measurements, as well as plans to change the auditor’s report to provide more useful, relevant, and timely information to users of public company financial statements. The authors hope their commentary is helpful to standard-setters’ deliberations, and the authors believe it should be useful to auditing scholars, both as a supplemental reading in auditing courses and a source of ideas to help guide future research designs on auditor and user judgment and decision making for high uncertainty FVA estimates.

    Citation:

    Bell, T. B., and J. B. Griffin. 2012. Commentary on Auditing High-Uncertainty Fair Value Estimates. Auditing: A Journal of Practice & Theory 31 (1): 147-155.

    Keywords:
    disclosure, fair value estimate, inherent measurement uncertainty, materiality
    Purpose of the Study:

    Debate over the relevance and reliability of fair value accounting (FVA) dates back at least seven decades, as evidenced by excerpts presented above from MacNeal’s 1939 accounting classic, Truth in Accounting. In recent years, accounting and auditing standard-setters in the U.S. and abroad have issued a number of authoritative pronouncements that, collectively, indicate institutional embracement of FVA. However, today’s business transactions, terms of contractual arrangements, and structures of financial instruments and other assets and liabilities are more varied and complex. Against this backdrop, continuing controversy over the usefulness and verifiability of high-uncertainty fair value estimates centers primarily on estimates and associated disclosures pertaining to assets and liabilities that are not traded in active markets, i.e., estimates involving the use of Level 2 and Level 3 inputs in the FASB’s fair value hierarchy in Fair Value Measurement.

    This commentary addresses challenges faced by standard-setters, preparers, users, and auditors pertaining to high-uncertainty fair value estimates. The authors briefly describe the financial reporting environment and the difficulty of obtaining reasonable assurance for fair value estimates with high levels of inherent measurement uncertainty. They then discuss some characteristics of an effective accountability framework for fair value accounting.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    The authors discuss interdependencies between FVA disclosures and auditing attributes, within the context of an accountability framework for FVA, and propose a combination of changes to these institutional features whose joint effects should (1) improve transparency to users of the inherent (i.e., irreducible) level of measurement uncertainty in high-uncertainty FVA estimates and disclosures, (2) enhance the value to users of the audit of such estimates and disclosures, and (3) help standard-setters improve the clarity of related auditing standards.

    The authors propose additional disclosures on management’s estimation processes, assumptions, and historical estimation accuracy that they believe provide the best avenues for improving the verifiability of decision-useful information on inherent measurement uncertainty. Also, the authors suggest a modified audit report conveying that only negative assurance has been obtained for high-uncertainty FVA estimates, reasons why, and an overview of the procedures performed by the auditor, which should provide a more faithful representation of the true nature and extent of assurance provided to users.

    Category:
    Auditor Judgment
    Sub-category:
    Adequacy of Disclosure, Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Does Charismatic Client Leadership Constrain Auditor...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Does Charismatic Client Leadership Constrain Auditor Objectivity?
    Practical Implications:

    The potential threat of constrained auditor objectivity due to charismatic leadership is one that has not previously been addressed before. Therefore, auditors should be proactive in making sure they are aware of this threat while working on various audit engagements. Additionally, audit firms should pay attention because it is unlikely that there are any mitigating strategies in place to combat the threat within the firm. 

    Citation:

    Svanberg, Jan, and P. Ohman. 2017. “Does Charismatic Client Leadership Constrain Auditor Objectivity?”. Behavioral Research in Accounting. 29.1 (2017): 103.

    Keywords:
    auditing; auditor objectivity; charismatic client leadership; client identification
    Purpose of the Study:

    An auditor’s objectivity can be negatively affected by various financial or social characteristics of the client. This study examines whether or not auditor objectivity is constrained by perceived charismatic leadership of management. The initial assumption is that perceived charismatic client leadership will in fact negatively affect auditor objectivity. This threat is particularly concerning because it can rapidly materialize and is unable to be addressed by auditor rotation. Previous studies have focused on the financial size of clients as an indicator of possible problematic relationships between the auditor and client. If the initial assumption in this study is correct than this will suggest that charismatic leadership plays a role in auditor objectivity along with the financial size of the firm. 

    Design/Method/ Approach:

    The sample consists of 1,000 Swedish auditors randomly selected using a Revisorsnamnden register. There was a 19.9% response rate to a questionnaire that was sent out on September 2013. The majority of respondents were male partners or managers. The questionnaire was a cross-sectional survey where auditors were asked to recall their largest client’s leader, and then to assess the extent to which the leader is charismatic. A regression model was then used to test the hypothesis.

    Findings:

    Overall, the authors find that there is a positive relationship between constrained auditor objectivity and the extent to which the auditor perceives the client leaders as charismatic. This suggests that client identification is not necessarily the only social factor leading to constrained objectivity.     

    Additionally, the authors find the following:

    • Stronger levels of professional identification are not associated with more objective judgment.
    • Auditors for Big 4 firms are more objective when compared to auditors in smaller audit firms.
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Prior Dispositions/Biases/Auditor state of mind
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  • The Auditing Section
    Effects of Qualitative Factor Salience, Expressed Client...
    research summary posted May 7, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    Effects of Qualitative Factor Salience, Expressed Client Concern, and Qualitative Materiality Thresholds on Auditors’ Audit Adjustment Decisions
    Practical Implications:

    Individual auditors have wide variations in the materiality thresholds the auditors use to assess qualitative materiality.  Greater clarity in materiality guidance can potentially reduce the variability in auditors’ materiality threshold judgments pertaining to qualitative materiality factors.

    Citation:

    Ng, T. B-P and H. T. Tan. 2007. Effects of qualitative factor salience, expressed client concern, and qualitative materiality thresholds on auditors’ audit adjustment decisions. Contemporary Accounting Research 24 (4): 1171-92.

    Keywords:
    Auditor judgment, audit adjustments, audit materiality
    Purpose of the Study:

    Judgments of materiality are pervasive throughout the financial statement audit.  Accounting standards state both quantitative and qualitative factors must be considered in materiality decisions.  Prior research, however, indicates that auditors traditionally use quantitative rules of thumb in their materiality judgments.  This study examines how the auditor’s qualitative materiality threshold and expressed client concern about booking an audit difference affects the auditors’ propensity to book the audit difference. 

    Design/Method/ Approach:

    In this study, the authors conducted an experiment using audit managers from the Big 4 certified public accountant firms based in Singapore.  These participants were used because at the time the study was conducted, SAB No. 99 or its equivalent had not been implemented in Singapore.  The authors utilized the context of a quantitatively immaterial audit difference that affects the client’s ability to meet analysts’ expectations.  Although not specifically stated, the data appears to have been collected in the early-mid 2000’s, prior to 2007.

    Findings:
    • Auditors with lower qualitative materiality thresholds (but not those with higher qualitative materiality thresholds) have a greater propensity to book a quantitatively immaterial audit difference that affects the client’s ability to meet analysts’ expectations when the qualitative materiality factor is made salient, in spite of the client’s preference not to book it.
      • The lack of attention to the qualitative factors in the absence of an aid that makes them salient may, in part, explain why auditors waive such audit differences
    • Effectiveness of attention-directing mechanisms (e.g., decision aids) that make qualitative materiality factors salient may be undermined if one of the following is true:
      • auditors apply high thresholds to assess qualitative materiality
      • the client expresses concerns about booking the audit difference in question, in which case the auditors’ qualitative materiality threshold will play a role
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
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  • Jennifer M Mueller-Phillips
    Financial Statement Disaggregation Decisions and Auditors’ T...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    Financial Statement Disaggregation Decisions and Auditors’ Tolerance for Misstatement
    Practical Implications:

    The findings of this study are relevant to financial reporting standard-setters and regulators interested in the effects of financial statement presentation standards on the reliability of the information presented, to auditing standard-setters and regulators who have a responsibility to clarify auditors’ responsibility for misstatement in disaggregated numbers, and to audit firms that must provide guidance to ensure consensus in their auditors’ judgments. Standard-setters should also consider the fact that FASB has also been considering issues related to balance sheet aggregation or netting of balances. As a consequence, the importance of the effects of aggregation on auditors’ materiality judgments may be broader than the focus of the current study.

    For more information on this study, please contact Robert Libby.
     

    Citation:

    Libby, R., and T. Brown. 2013. Financial Statement Disaggregation Decisions and Auditors’ Tolerance for Misstatement. The Accounting Review 88 (2).

    Keywords:
    audit guidance; disaggregation; IFRS vs. U.S. GAAP; materiality; statement vs. note disclosure
    Purpose of the Study:

    Current IFRS requires significant disaggregation of income statement numbers while such disaggregation is voluntary and much less common under U.S. GAAP. This study examines whether voluntary disaggregation of income statement numbers increases the reliability of income statement subtotals because auditors permit less misstatement in the disaggregated numbers. Auditors require managers to correct discovered financial statement errors only when they are deemed material, and recent evidence suggests that reporting managers leave many immaterial errors uncorrected. Possible effects of management behavior and required disaggregation resulting from U.S. adoption of IFRS or the recommendations of the joint FASB/IASB financial statement presentation project are also discussed.

    Design/Method/ Approach:

    A total of 78 experienced U.S. auditors from three Big 4 firms participate in the study. Of the 78, 76 identify their current position as audit manager, two identify as audit seniors. Most of the participants’ experience is with public, commercial (nonfinancial), for-profit companies. The participants are randomly assigned to the experimental conditions. The experiment involves the participating auditors determining the materiality of a single audit difference involving the underaccrual of occupancy expenses. 

    Findings:

    Disaggregating expense items can reduce the allowable error in the disaggregated amounts, increasing the reliability of the disaggregated amounts as well as the resulting statement subtotals and totals.
    There is significant disagreement among practicing auditors on the relevance of line items as materiality benchmarks and that reporting disaggregated in the notes reduces the effect. This suggests that voluntary disaggregation decreases the average amount of error tolerated in the current financial statements, but at the same time decreases the consensus in audit practice.
    The prior effect is substantially reduced if the disaggregated data are presented in the notes. This results from conscious differences in beliefs about the relevance of line items as materiality benchmarks.
     

    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
  • Jennifer M Mueller-Phillips
    Group Audits, Group-Level Controls, and Component...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough?
    Practical Implications:

    The proposed component materiality method helps the group auditor develop and document a rational plan for achieving the group assurance objective that is rooted in applicable auditing standards and decision theory.

    The significant differences in results between the proposed method and the alternatives suggest the need for guidance more definitive than that provided by current auditing standards. Indeed, the authors’ approach could be a useful metric for evaluating the efficacy of methods that do not have as comprehensive a supporting theory.

    Field deployment of the proposed method requires software support. A specific implementation is available as an Excel app at http://raw.rutgers.edu/GUAMcalc.

    For more information on this study, please contact Trevor Stewart at trsny@verizon.net.

    Citation:

    Stewart, Trevor R., and William R. Kinney, Jr. 2013. Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough? The Accounting Review 88 (2): 707-737.

    Keywords:
    Aggregation, audit assurance, Bayes’ rule, component materiality, group audits, group-level controls, ISA 600, auditor judgment, materiality and scope decisions
    Purpose of the Study:

    Auditing standards mandate that group auditors determine and implement appropriate component materiality amounts, which ultimately affect group audit scope, reliability, and value. However, standards are virtually silent about how these amounts should be determined, indicating merely that they should be less than group materiality but may be greater than proportionate. For example, if group materiality is $1 million and there are five equal size components, then component materiality should be between $200K and $1 million for each component; but how to determine the right amount in that range is not indicated. Various methods used in practice vary widely, lack theoretical support, and may either fail to meet the group audit objective or do so at excessive cost. The authors develop a rigorous method, describe its properties, and compare the component materiality amounts thus derived and the resulting relative audit costs and achieved levels of assurance with those of other methods. 

    Design/Method/ Approach:

    The authors’ method determines component materiality as a function of group materiality, the group auditor’s assurance objective, and relative component sizes and audit costs. The method formally incorporates group auditor knowledge of group-level structure, controls, and context as well as component-level constraints imposed by statutory audit or other requirements. Application of the method yields component materiality amounts that achieve the group auditor’s overall assurance objective by finding the minimum cost solution on an efficient materiality frontier. To continue the simple five-equal-size-component example, the proposed method indicates that component materiality amounts should be no greater than $330K in order to achieve reasonable assurance at the group level relative to group materiality of $1 million. But these amounts may be increased significantly depending on additional factors that the method accommodates.

    The authors’ starting point is the group auditor’s overall objective of achieving reasonable assurance about whether the group financial statements as a whole are free from material misstatement. This overall objective is disaggregated down to the component level and component materiality amounts are determined such that component auditors will do enough work to meet those component objectives. Thus, by design, if the component auditors use component materiality as determined by the group auditor and their audits go as planned, then component objectives will be met and, on aggregation, so will the overall group audit objective.

    Audit assurance is a probabilistic concept, where probability is a measure of the auditor’s degree of professional belief—a subjective notion embraced by Bayesian probability theory. The key to the authors’ method is a Bayesian group audit model that generalizes and extends the single-component audit risk model to aggregate and disaggregate assurance across multiple components. 

    Findings:
    • A conceptually sound, standards-based planning approach to determining component materiality is developed from the insight that component materiality amounts should be those that result in component assurance that aggregates to the desired overall group assurance. Bayesian probability theory provides the philosophical and mathematical framework.
    • The proposed method yields component materiality amounts and achieved group assurance that, depending on circumstances, may differ substantially from other methods. Those methods may be ineffective in meeting professional standards, inefficient in the use of resources, or both ineffective and inefficient.
    • The auditor’s prior (pre-audit) assurance based on group-level controls can facilitate substantially increased component materiality amounts, thereby reducing component auditor work and cost. Indeed, numerical results suggest group-level controls and structured subgroups of components are central to efficient group audits.
    • Aggregate component audit costs can be reduced by optimizing component materiality to incorporate contextual factors, such as group structure, differing component sizes, component audit costs, and component-level constraints imposed by statutory audit and other requirements.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
  • Jennifer M Mueller-Phillips
    Investors’ Response to Revelations of Prior Uncorrected M...
    research summary posted April 1, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Investors’ Response to Revelations of Prior Uncorrected Misstatements
    Practical Implications:

    The results of this study are important in realizing the investor’s perception of audit quality as it relates to SAB No. 108 disclosures. Investors respond negatively to the quantification of prior period misstatement disclosures. The investor also distinguishes between misstatements that are waived by previous auditors and misstatements waived in the current year. Investors react negatively to misstatements that are disclosed in the current year. The investors also react to the importance of the client as it relates to the misstatements that are waived. Investors understand and react to the correlation between client importance, waived misstatements, and client retention. The results are important to understand that investors react to disclosures made under SAB No. 108.

    Citation:

    Omer, T. C., M. K. Shelley, and A. M. Thompson. 2012. Investors' Response to Revelations of Prior Uncorrected Misstatements. AUDITING: A Journal of Practice & Theory 31 (4):167-192.

    Keywords:
    materiality decisions; Staff Accounting Bulletin No. 108; client importance; audit quality; misstatements.
    Purpose of the Study:

    Staff Accounting Bulletin (SAB) No. 108 requires the disclosure of prior-period waived misstatements as well as the use of multiple methods of quantifying misstatements. The rollover method quantifies misstatement on a current year income statement effect, while the iron curtain method quantifies misstatement based on the balance sheet effect. The two methods can differ in terms of the resulting misstatement amounts. The authors of this study examine:

    • Investor responses to the new disclosures under SAB No. 108. Previously waived misstatements that were deemed immaterial by one quantifying method, but then deemed material by the other must now be disclosed.
    • Investor responses to misstatements waived by a predecessor auditor compared to misstatements waived by a current year auditor.
    • Investor perceptions of audit quality based on the new disclosures.
    • Whether client importance is a factor in relation to SAB No. 108 disclosures. 
    Design/Method/ Approach:

    The authors identified 420 firms that disclosed misstatements under SAB No. 108 using EDGAR and Morningstar Document Research. Of these firms, a sample of 272 firms were chosen to complete market return tests on the data. Multivariate regression analysis was employed on firm disclosures from filings made after November 15, 2006. 

    Findings:
    • The authors find that investors respond negatively to SAB No. 108 disclosures. The findings provide evidence that the information affects how the investor views the financial statement information and biases perceptions of audit quality.
    • The authors find that cumulative abnormal returns exist in relation to misstatements initially waived by current auditors. The findings suggest that investors react negatively to waived misstatements by auditors in the current year. Investors distinguish these misstatements from those of waived misstatements by predecessor auditors.
    • The authors find a negative trend of cumulative abnormal returns associated with the investor’s perception of client importance. The findings suggest that investors react according to the perception that misstatements are waived for important clients in order to retain their business. 
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Judgment, Standard Setting
    Sub-category:
    Audit Scope & Materiality Judgements, Changes in Reporting Formats, Changes in Reporting Formats, Impact of New Accounting Pronouncements

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