Comparing Auditors’ and Users’ Materiality Judgments

Materiality is a ubiquitous concept in accounting and auditing. Accounting and disclosure rules, with few exceptions, are bounded by materiality, meaning that if a matter is immaterial, it is often exempted from the accounting rules. In respect to audits, the auditors’ opinion speaks to whether financial statements are presented fairly in all “material” respects in accordance with an accounting framework. The SEC indicates that a matter is material if there is a “substantial likelihood that a reasonable person would consider it important (SAB No. 99).” Therefore, materiality is fundamentally user-defined, meaning that auditors and accountants have the unenviable task of predicting what various user groups will consider important and unimportant. Yet, this judgment is critical; if auditors’ materiality judgments do not align with investors’, information that is useful in making decisions could be withheld or misstated, and information that is not useful could be exploited to unduly influence users’ perceptions.

There is a long history of research and case law around the concept of materiality with respect to corporate financial disclosures, and generally speaking, we have a good understanding of how auditors, and to a lesser extent financial statement users, judge quantitative financial materiality. However, with the recent rise of corporate ESG disclosures, a sea change is coming that could challenge our understanding of disclosure materiality.

In a recent study, we use a controlled experiment to better understand how assurance level (limited-review vs. reasonable-audit), disclosure valence (information conveying positive vs. negative outcomes), and disclosure form (qualitative vs. quantitative disclosures) influence professional assurance providers’ and users’ materiality assessments of ESG disclosures relative to traditional financial disclosures. We develop our theoretical expectations from research suggesting that task effort increases the perceived value of task outcomes, that individuals weight negative information more heavily than positive information, and that individuals tend to view qualitative information as more subjective and less credible than quantitative information.

Regulators around the world are creating ESG (environmental, social, and governance) disclosure mandates that would require independent, third-party assurance of ESG information. Auditors have traditionally assured that financial statements disclose material and materially correct information to users, but ESG disclosures present new and unique challenges for assurance professionals.

ESG disclosures differ markedly from traditional financial disclosures in at least four ways. First, in contrast to traditional financial disclosures, ESG disclosures are intended to provide information for evaluating both a company’s financial and social impact. For audit professionals, who have extensive experience assuring the accuracy and validity of financial information, this relatively unfamiliar context makes understanding what is and is not useful to users particularly challenging. Second, although over half of companies issuing ESG reports voluntarily obtain some form of third-party assurance, most assured ESG reports are subject to limited (rather than reasonable) assurance and contain broad scope limitations. In contrast, public companies are required to have their financial disclosures comprehensively audited (reasonable assurance). This creates an important difference in the general level of assurance provided and the audit effort required to provide that assurance. Third, at the time of writing, ESG reporting is largely voluntary, so companies are free to choose what and how they report. This has led to companies reporting a higher proportion of positive information in ESG reports compared with the  mix of positive and negative information generally reported in financial statements. Fourth, financial disclosures can generally be quantified in a common unit – currency, such as dollars or euros. Many ESG disclosures may not be quantifiable at all, let alone in a single common unit, which necessitates relatively more qualitative (versus quantitative) ESG disclosures. Unfortunately, little is known about materiality decisions involving these types of non-financial disclosures, which prompted the AICPA to issue a call for research on non-financial and qualitative disclosure materiality.

In our study, we document an auditor-user “materiality gap” in which users rate all disclosures as more material than auditors do, and within this overarching pattern, both users and auditors rate traditional financial disclosures as more material than ESG disclosures. The materiality gap that we document is concerning because it suggests that auditors are not accurate in their materiality judgments and may identify omissions and errors as immaterial when they are in fact material to users.

Importantly, our results provide interesting insights into this materiality gap for ESG disclosures relative to traditional disclosures. First, we find that the materiality gap is larger for ESG disclosures than traditional disclosures, suggesting that  the use of ESG information to understand social outcomes (as opposed to financial outcomes) hinders auditors’ ability to predict users’ ESG materiality assessments. Second, we find that auditors – but not users – judge quantitative disclosures as more material than qualitative disclosures, further widening the materiality gap. Third, while auditors and users rate negative disclosures as more material than positive disclosures, the auditor-user materiality gap is significantly larger for positive than for negative disclosures. When considering these disclosure factors across traditional and ESG disclosures, we find that quantitative and negative disclosures reduce the materiality gap for traditional disclosures but not for ESG disclosures. Finally, in contrast to users’ materiality assessments, we find that auditors view disclosures receiving limited assurance (and therefore requiring less work to verify) as less material than the same disclosures receiving reasonable assurance, further widening the materiality gap for the assurance level most often applied to ESG reports.

Taken together, our results indicate that the  social context associated with ESG disclosures as well as the relatively high proportion of positive and qualitative information in ESG reports all contribute to less accurate auditor materiality assessments. While no single study is definitive, auditors who provide ESG assurance should scrutinize their own materiality judgments more closely and be aware that users may give substantial weight to information that auditors are inclined to discount. With this in mind, auditors should carefully consider their materiality judgments for information in an ESG context, particularly when that information is presented qualitatively or sends positive signals about the company. Since an engagement’s assurance level should not influence auditors’ materiality assessments, auditors should also consider whether the lower effort required for limited assurance engagements may be unduly influencing their materiality assessments and widening the materiality gap with users. Regulators should be aware that forthcoming regulation requiring ESG disclosure and assurance may actually exacerbate the auditor-user materiality gap, and that increasing quantitative and negative ESG disclosures may not reduce the auditor-user materiality gap as it does for financial information. Our findings can help regulators and the accounting profession begin to understand ESG materiality in a way that goes beyond the current topical checklist approach to provide stakeholders with more precise and useful information.

This post comes to us from professors Marcus Doxey and Chez Sealy at the University of Alabama. It is based on their recent article, “Comparing Auditors’ and Users’ Materiality Judgments for ESG and Traditional Financial Disclosures: The Roles of Disclosure Form, Valence, and Assurance Level,” available here.