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    The Effects of Uncertainty and Disclosure on Auditors'...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
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    Title:
    The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions.
    Practical Implications:

    The findings suggest that auditors view disclosure as lessening their responsibility for the possible misstatement of recognized amounts, and that they are less likely to require adjustment to the body of the financial statements when preparers supplement recognized fair values with footnote disclosure. Auditors respond to uncertainty differently in the fair value setting than in earlier research on nonfair value materiality decisions. The author contributes to the understanding of how professional standards are implemented as auditors decide whether to adjust fair value measurements.

    Citation:

    Griffin, J. B. 2014. The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions. Journal Of Accounting Research 52 (5): 1165-1193.

    Keywords:
    audit adjustments, disclosure, fair value, materiality, uncertainty, subjectivity, imprecision
    Purpose of the Study:

    Standard setters increasingly prefer that assets and liabilities be measured at fair value, though implementing fair value measurement sparks considerable debate. Measuring fair values in the absence of reliable market prices is difficult because the estimation process often depends on relatively subjective information inputs and generates imprecise ranges of possible outcomes. Investor advocates warn that preparers could use this uncertainty to bias fair value estimates. Auditors must assess the reasonableness of their clients’ measurements and, when they deem misstatements material, require their clients to adjust fair value estimates before reporting them in the financial statements. Regulators’ efforts to address the uncertainty associated with fair value estimates may have the unintended consequence of changing how auditors view their fiduciary duty to the investing public, especially in the case of requiring their clients to adjust fair value estimates.

    The author experimentally examines how two types of uncertainty addressed by regulators, subjectivity and imprecision, and one reporting choice encouraged by regulators, supplemental footnote disclosure, influence auditors’ decisions to require fair value adjustments. Subjectivity affects the reliability of the inputs used to prepare accounting information. In measuring fair values under SFAS No. 157, Level 1 items involve little subjectivity because highly reliable inputs (e.g., active market prices) are available, while Level 2 and Level 3 items involve progressively greater levels of subjectivity because they depend on less reliable inputs (e.g., information from comparable situations or the reporting entity’s own assumptions). Imprecision reflects the degree of variability in possible future outcomes.

    Design/Method/ Approach:

    The author conducts a 2 x 2 x 2 between-participants experiment to examine how subjectivity, imprecision, and supplemental footnote disclosure affect auditors’ adjustment decisions in a fair value measurement setting. Participants from Big Four firms were chosen randomly; 106 practicing auditors with an average of 8.9 years of experience participated in the experiment. The experiment takes participants approximately 15 minutes to complete. The evidence was gathered prior to January 2012.

    Findings:

    Subjectivity and imprecision interact to increase the likelihood that auditors will require their clients to adjust recognized fair value estimates. Increasing the imprecision of possible fair value outcomes amplifies the likelihood that auditors will require adjustment of estimates that rely on more subjective information inputs. Auditors are most likely to require clients to adjust fair value estimates when subjectivity and imprecision are both high. Auditors are most likely to require adjustments when uncertainty is highest and their clients’ discretion is greatest.

    The supplemental footnote disclosure negates this interaction. Although subjectivity and imprecision interact to increase the likelihood that auditors will require an adjustment when supplemental disclosure is absent, the dollar amount of the adjustment depends on imprecision alone. Consistent with standards, auditors use the lower boundrather than the midpointof the range of possible misstatement outcomes to calculate the size of their required adjustments.

    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements