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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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  • 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
    Consequences of Big Data and Formalization on Accounting and...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.01 Changes in Reporting Formats, 01.02 Changes in Audit Standards, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    Consequences of Big Data and Formalization on Accounting and Auditing Standards.
    Practical Implications:

    In light of cost reductions in data generation, storage, retrieval, and transmission, the inherent compromises within the paper paradigm are of little benefit. Users are entitled to more in-depth, granular values that they can manipulate, drilling down and up for more or less detail where needed. Financial reporting standards that govern presentation and arbitrary aggregation must likewise give way to rules regarding the limits and frequency of data transmission, as well as the quality of those data. 

    Audit standards must change as well. Error detection and risk quantification are no longer sufficient targets, but must be seen as small components of an audit of broader scope. The deep analysis of tremendous volumes of data and potentially thousands of exception reports necessitates a different paradigm of reporting and assurance. The role of auditing standards, far from being diminished in the face of increasing automation, must shift from governing sampling procedures to embracing the broader, deeper data availability and analysis of the modern era in an effort to create a better, more thorough audit.

    Citation:

    Krahel, J. P., and W. R. Titera. 2015. Consequences of Big Data and Formalization on Accounting and Auditing Standards. Accounting Horizons 29 (2): 409-422.

    Keywords:
    accounting standards, auditing standards, Big Data, continuous audit, materiality
    Purpose of the Study:

    The level, breadth, and quality of externally presented financial information have always represented a compromise between the preparer’s cost and the user’s benefit. While preparer costs vis-a`-vis data collection and transmission have decreased significantly, the compromises made in the paper-based era have persisted, creating a set of anachronistic accounting practices that, in the authors’ view, unfairly handicaps statement users. A similar effect can be observed in auditing practices. While data availability and standardization have increased, audit standards continue to focus on sampling and other practices indicative of a low-information environment. This paper will address the problems that result from such anachronisms, present a set of axes along which accounting and auditing standards must evolve, describe the avenues through which such changes can be accomplished, and discuss the new paradigm from academic and practical perspectives.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:
    • Accounting and reporting standards must adapt to deal with the frequent (possibly even continuous) transmission of granular data, not only their presentation in the aggregate.
    • Such standards need to consider addressing company-specific data, as well as macro-level data that may be important to the analysis of a company’s financial condition. They also need to consider enhancing historical reporting to include other data elements that may enable predictive analysis by users.
    • Auditing standards must address situations where data are abundant, not only where data are sparse. The concept of materiality in relation to a company’s financial statements, taken as a whole, needs to be reevaluated.
    • Auditing standards must also do more to address the concept of process auditing. When data are available on a continuous basis, the processes generating those data must be continuously assured. Internal and external auditor competencies must be broadened to include more advanced types of data analytics. 
    • All parties along the financial reporting value chain must recognize the latent value in unstructured and semi-structured data.
    • Care must be taken to minimize the expectations gap between users and auditors in the face of increasing data and analytical capacity. A user’s role (and responsibility), which could change, must also be considered.
    Category:
    Engagement Management, Standard Setting
    Sub-category:
    Changes in Audit Standards, Changes in Reporting Formats, Changes in Reporting Formats, Materiality & Scope Decisions
  • 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

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