Working Paper: Direct Measures of Auditors’ Quantitative Materiality Judgments: Properties, Determinants and Consequences for Audit Characteristics and Financial Reporting Reliability

Paper Authors: Preeti Choudhary, Kenneth Merkley, and Katherine Schipper

Research Focus: This paper evaluates how auditors set materiality for U.S. audits by analyzing judgments made on audit engagements inspected by the PCAOB between 2005 and 2015 for the eight largest U.S. audit firms.

The most common approach auditors use to measure quantitative materiality is 5 percent of pretax income, however, there is significant variation in terms of percentages and financial statement line items chosen in this calculation. Three financial statement line items — revenue, net income, and assets — explain over 90 percent of auditors’ quantitative materiality judgments, indicating these judgments nearly exclusively are explained by measures of client size. The selection of which size measure auditors weight most heavily varies with company performance. For example, clients near breakeven or with a loss are less likely to have their materiality judgement based upon income.

The authors transform materiality judgments into a scale of how strict or loose materiality is based upon common thresholds used across audit firms and time periods that are supported by internal audit firm guidance. The study finds that auditors tend to select on the stricter end of the spectrum, on average.

The paper then evaluates the consequences of the looseness of materiality values for the audit and finds that looser materiality values correspond with fewer audit hours, lower fees, and lower magnitudes of detected audit adjustments. Finally, the authors evaluate whether loose materiality values have any implication for financial statement reliability and find that the two loosest materiality deciles have a higher incidence of restatements, suggesting that very loose materiality can increase the likelihood that auditors will miss material misstatements.