Materiality Disclosures and Their Effect on Investors’ Decisions

Auditors consider misstatements or omissions in financial statements to be material if they could influence the economic decisions of financial statement users. Additionally, materiality affects how auditors plan and perform an audit and evaluate identified misstatements. Regulators in the UK (Financial Reporting Council) and the Netherlands (Nederlandse Beroepsorganisatie van Accountants) require auditors to disclose their threshold for materiality in auditors’ reports of listed companies. The International Auditing and Assurance Standards Board does not require disclosure of the materiality threshold in an audit report but does not preclude auditors from voluntarily disclosing that threshold.[1] In the U.S., however, the Public Company Accounting Oversight Board (PCAOB) and the AICPA’s Auditing Standards Board do not discuss such disclosure in their reporting standards, although the PCAOB is tracking the results of the required disclosure of materiality by other countries.

Recent research indicates that little is known regarding how financial statement users respond to materiality disclosures or evaluate the level of materiality used by auditors, and what is deemed to be material to various groups of financial statement users (e.g., creditors, shareholders).[2]

Our study examines the effect of audit materiality disclosures on professional investors’ decision-making. A sample of 246 U.S. and UK professional investors evaluated a company for a hypothetical investment in which auditors’ materiality considerations are disclosed in the entity’s audit report, as they are in the audit reports of UK filers. We find, in an experimental setting, that the disclosure of materiality in the audit report has no effect on users’ decision to increase or decrease current investment levels in a hypothetical company. This result is consistent with research on stock price reaction to expanded UK audit reports.[3] We find some evidence that the level of disclosed materiality (4 percent of income before taxes vs. 10 percent) affects investor decision-making, but in the direction opposite to what audit theory would predict, in that they invest more when materiality is disclosed as 10 percent of income before taxes. This result suggests that participants fail to understand the inherently inverse relationship between audit materiality and the amount of auditor effort. In other words, users do not seem to understand that auditors typically expend greater effort when the materiality threshold is lower.

In a series of debriefing questions, the participants shed further light on our results. In one question, we asked investors what they thought materiality should be for the theoretical company, and responses suggested a preference for materiality levels closer to 10 percent of income before taxes, a level that is higher than materiality typically used in practice.[4] Thus, a potential explanation for the decision not to increase their investment at the 4 percent level is that lower audit materiality signals that the audit client is a riskier investment than is the typical audit client.

In other results, we find no evidence that the type of potential investment (i.e., publicly-traded stock, privately-held shares, or publicly-traded debt) has any significant effect on how materiality is used by investors in their investment decision. Thus, our results suggest that investors view materiality disclosures as either not informative or marginally informative at best, but in a direction opposite to what audit theory would predict. Additionally, we note that investors may be more open to alternative materiality benchmarks than previously thought. While audit firms predominantly use pre-tax income as the materiality benchmark, and even though we also use this threshold in our study, investors’ responses suggest a preference for other financial statement metrics such as EBIT and total assets.

Overall our results suggest that investors may not interpret the relationship between audit materiality and auditor effort in the same way audit professionals and audit theory would predict, providing support for the decision of U.S. regulators not to require its disclosure in an expanded audit report. If such disclosures are considered in the future, our results suggest the importance of clearly communicating the inherent relationship between quantitative materiality and auditor effort. Further, our results provide evidence on users’ expectations of materiality. By better understanding users’ expectations, practitioners can more efficiently plan and execute audits. These findings should enhance the understanding of regulators, firms, and academics of how users view materiality and inform regulators about the effect of appropriate disclosure of auditor materiality considerations in the audit report.

ENDNOTES

[1] For example, PwC has elected to do so for audits of financial statements in Finland (e.g., Tieto and Ferratum Oyj) and Sweden (e.g., Betsson AB).

[2] See Church, B. K., Davis, S. M., & McCracken, S. A. (2008). The auditor’s reporting model: A literature overview and research synthesis. Accounting Horizons, 22(1), 69-90. Also, Mock, T. J., Bédard, J., Coram, P. J., Davis, S. M., Espahbodi, R., & Warne, R. C. (2012). The audit reporting model: Current research synthesis and implications. Auditing: A Journal of Practice & Theory, 32(sp1), 323-351.

[3] For example, see Gutierrez, E. F., Minutti-Meza, M., Tatum, K., and Vulcheva, M. (2017). Consequences of Adopting an Expanded Auditor’s Report in the United Kingdom. Available at SSRN: https://ssrn.com/abstract=2741174. Also, Lennox, C. S., Schmidt, J. J., and Thompson, A. (2017). Is the Expanded Model of Audit Reporting Informative to Investors? Evidence from the UK. Available at SSRN: https://ssrn.com/abstract=2619785.

[4] See Eilifsen, A. and Messier Jr, W.F., 2014. Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.

This post comes to us from Professor Brant E. Christensen at the University of Missouri, Professor Aasmund Eilifsen at the Norwegian School of Economics, Professor Steven M. Glover at Brigham Young University, and Professor William F. Messier, Jr. at the University of Nevada, Las Vegas and the Norwegian School of Economics. It is based on their recent article, “The Effect of Materiality Disclosures on Investors’ Decision Making,” available here.

1 Comment

  1. Sun Rui

    Could the disclosure of materiality level improve the market efficiency ? Maybe it is an important issue to address.

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