How Do Investor and Auditor Materiality Judgments Compare? Free

Materiality is a critical part of the audit process, yet it remains a challenging concept for auditors to manage in practice. Securities and Exchange Commission (SEC) Acting Chief Accountant Paul Munter recently issued a statement highlighting concerns that registrants and auditors may not be adequately assessing materiality according to existing rules and regulations (Securities and Exchange Commission (SEC) 2022). He specifically noted that his office is routinely presented with arguments as to why omitted items are irrelevant to investors. He further reiterates the importance “for registrants, auditors, and audit committees to carefully assess whether the error is material by applying a well-reasoned, holistic, objective approach from a reasonable investor’s perspective based on the total mix of information” (SEC 2022).

The challenges underlying the materiality determination are compounded by the fact that materiality is typically defined from an investor’s (rather than an auditor’s) perspective. Thus, auditors must consider the judgment and decision-making activities of nonexperts in the accounting domain (i.e., investors). Unfortunately, although the prior research literature includes a number of materiality studies, very little is known about investors’ materiality judgments, the specific factors underlying their materiality judgments, and how their judgments compare to auditors’ judgments. This article summarizes a study by DeZoort, Holt, and Stanley (2019) designed to help address this problem.

The U.S. Supreme Court has held repeatedly that materiality should be defined from the perspective of the “reasonable investor.”¹ In Basic Inc. v. Levinson (U.S. Supreme Court 1988), the Court ruled that materiality is achieved when there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.”² From an accounting and auditing perspective, the Financial Accounting Standards Board (Financial Accounting Standards Board (FASB) 2018), the International Accounting Standards Board (International Accounting Standards Board (IASB) 2017), and the Public Company Accounting Oversight Board (PCAOB) (Public Company Accounting Oversight Board (PCAOB) 2017) recently updated guidance on materiality that highlights the importance of taking an investor-based perspective.

Although the Supreme Court indicated (and the Public Company Accounting Oversight Board (PCAOB) (2010a) reiterated) that materiality assessments require “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts” (U.S. Supreme Court 1976, 426 U.S. at 450), little is known about investors’ materiality judgments and the factors affecting those judgments. Black (2013, 1495) reviews the case law and concludes that “courts hold investors to a high standard of rationality that may not comport with observed reality.”

DeZoort et al. (2019) evaluate investor and auditor materiality judgments using policy-capturing techniques that model actual judgments and the information used to make those judgments. Social judgment theory, the Brunswik Lens Model (Brunswik 1952), and expertise theory provide a basis for the study’s hypotheses focused on judgment consensus and cue usage. The expertise literature is used to predict judgment differences among auditors (i.e., experts), unsophisticated investors, and sophisticated investors.

Judgment consensus refers to the amount of agreement among individuals’ judgments given identical information in a similar environment. Consensus has long been used in behavioral accounting research as a surrogate for judgment accuracy and expertise in situations where true right answers are not available (e.g., judgments related to internal control quality, fraud risk, going concern, etc.). The study of materiality judgment agreement among investors should help auditors better understand the challenge of calibrating their own materiality judgments.

Unsophisticated investors are a relatively diverse group with a wide variety of educational and work backgrounds that are not typically focused on making formal assessments of materiality when evaluating a company’s financial reporting. Accordingly, unsophisticated investors should have greater random variation in information processing that leads to less agreement in their materiality assessments compared to sophisticated investors and auditors. Sophisticated investors also generally lack formal training and experience making materiality assessments; however, they should have greater domain knowledge and task-specific experience related to evaluating financial reporting than unsophisticated investors. Given their training and experience using decision aids that structure and guide decision making regarding materiality, auditors should have the highest level of judgment consensus in this area. Stated formally:

Analysis of cue utilization helps reveal the determinants of investors’ materiality judgments. Cue utilization relates to the absolute and relative importance of specific information cues in explaining individual judgments. The judgment-analysis literature (e.g., Ettenson, Shanteau, and Krogstad 1987; Messier 1983) has operationalized cue utilization by evaluating the amount of variation explained by information cues provided in a judgment task.

Expertise theory suggests that the amount of variation explained by cues will differ across expertise levels (Einhorn 1974). Consequently, the amount of judgment variation explained by cue-level manipulation should increase as the level of expertise increases, and the extant judgment-analysis literature provides support for this prediction. Accordingly, auditors with more training and experience making materiality judgments are expected to use available information cues in a materiality-judgment task more than unsophisticated and sophisticated investors who have less training and experience in the area. Similarly, sophisticated investors with more general domain knowledge and experience evaluating financial information are expected to use available information cues more than unsophisticated investors. Stated formally:

Finally, professional guidance explicitly warns about the risks of overreliance on quantitative materiality thresholds and requires auditors to carefully consider qualitative factors that can make small dollar misstatements very material (e.g., SEC 1999; Public Company Accounting Oversight Board (PCAOB) 2010b). Investors lack this type of formal guidance to direct their attention when evaluating the materiality of uncorrected misstatements. Accordingly, auditors are expected to consider qualitative factors more than unsophisticated and sophisticated investors. Stated formally:

The study’s participants include 51 unsophisticated investors, 51 sophisticated investors, and 40 external auditors.³ The unsophisticated investors represent all regions of the United States, a variety of ages (76 percent were in their 20s and 30s), and occupations (e.g., attorneys, doctors, homemakers, plumbers, and retirees). The sophisticated investors represent all regions of the United States, multiple age categories (e.g., 35 percent in their 30s and 40s and 44 percent over 50 years old), and substantial professional investment experience (mean = 12.86 years). The unsophisticated investors reported having taken 1.16 accounting and 1.09 finance courses on average, which was significantly fewer than the 3.71 and 3.45 courses taken, respectively, by sophisticated investors. The unsophisticated investors (mean = 5.39, Std. Dev. = 2.63) report significantly less knowledge than the sophisticated investors (mean = 7.41, Std. Dev. = 1.89) (p < 0.001) based on a self-assessment of how much they know about analyzing company financial statements with “Nothing at all” coded as 0 and “A Great Deal” coded as 10. Based on these combined factors, DeZoort et al. (2019) conclude that both investor groups fall within the legal description of a “reasonable investor.” The auditor sample was obtained through firm contacts and includes 22 partners and 18 managers from two Big 4 public accounting firms. The auditors average 16.67 years of audit experience.

The research instrument was administered online using Qualtrics online research software. Case-background information described a hypothetical manufacturing company, its current financial results, and its industry. Summary financial information provided preaudit account balances and performance results. The case indicated that the company had been profitable and growing for five years, although the current year’s performance lags the prior year, leaving management concerned about meeting expectations. Participants were told that management and the external auditor are discussing the materiality (i.e., importance) of a set of proposed adjustments identified during the audit.

After considering the case background, the participants provided 16 materiality judgments after systematic random variation of five information cues related to the misstatements, which were used to test the study’s hypotheses. Specifically, the participants assessed the fairness of the company’s financial reporting if the identified misstatements are not corrected using a scale anchored at 0 = “Not at all fair” and 10 = “Completely fair.” The five materiality cues manipulated within-subjects include whether the misstatements:

1. Represent 3 percent (7 percent) of pretax income,

2. Are in accounting areas that are (are not) capable of precise measurement,

3. Affect (do not affect) management’s bonus-based compensation,

4. Impact (do not impact) the company’s ability to meet earnings expectations, and

5. Are in a company that is publicly traded (privately held).

The first cue quantifies the dollar magnitude of the misstatement. A misstatement representing 7 percent (3 percent) of pretax income should be more (less) material, holding all else equal. The next three factors provide qualitative information about the circumstances surrounding the misstatements and management incentives to bias the reports. Misstatements in accounting areas that are capable of precise management, affect management’s bonus-based compensation, and/or impact the company’s ability to meet earnings expectations should be deemed more material (Securities and Exchange Commission (SEC) 1999; PCAOB 2010a). Finally, the fifth cue manipulates the company’s ownership structure. Misstatements by a public (private) company can often have a more (less) far-reaching impact.

Figure 1 summarizes the results across the 16 cases. Lower (higher) case numbers along the horizontal axis represent cases where the five cue combinations indicate lower (higher) financial reporting risk.⁴ Overall, the auditors provided the most extreme judgments across the 16 cases (i.e., the highest fairness judgments were made by auditors (Cases 1 and 3), and the lowest fairness judgments were made by auditors (Case 16)). Interestingly, the unsophisticated investors tended to judge financial reporting as less fair than the sophisticated investors. Nevertheless, as the cue combinations indicated increased (decreased) financial reporting risk, the three groups perceived management’s financial reporting to be less (more) fair.

Figure 2 summarizes the judgment consensus results used to test H1. Judgment consensus was measured based on the correlation of judgments, which reflects the amount of judgment agreement within each of the three subject groups. As predicted, the results show that the unsophisticated investors exhibited the lowest level of judgment agreement (mean correlation= 0.11), followed by sophisticated investors (mean correlation = 0.16) and auditors (mean correlation = 0.49, which was significantly higher than both investor groups).

Figure 3 summarizes the cue-usage results used to test H2 and H3. Judgment models were estimated for each participant. The amount of variation explained by the five cues was then examined. As shown in Panel A, the results indicated that the five cue manipulations explained 59 (61) percent of the variation in fairness judgments made by unsophisticated (sophisticated) investors. The difference between the two investor groups was not statistically significant. In contrast, the results indicated that the cue manipulations explained 74 percent of the variation in fairness judgments made by the auditors (which was significantly higher than the explained judgment variance of the two investor groups).

To test H3, the proportion of variation explained by quantitative (Cue 1) versus qualitative (Cues 2–5) factors was examined. Individual cue-usage results are summarized in Panel B of Figure 3. Contrary to H3, the proportion of judgment variation explained by the qualitative factors was significantly lower for the auditor group compared to both investor groups. Specifically, 66 percent of the judgment variation of the auditor group was explained by Cues 2–5.⁵ In contrast, 81 percent and 84 percent of the judgment variation of the unsophisticated and sophisticated investors, respectively, was explained by Cues 2–5. Thus, the auditors focused significantly more on the dollar magnitude of the misstatement (3 percent versus 7 percent of the company’s pretax income) than the investors. Further analysis of the individual cue-usage results indicates that the investors focused significantly more (less) on the manipulation of whether the misstatements are in accounting areas that are capable of precise measurement (whether the company is publicly traded) compared to the auditors. In addition, the results indicate that auditors focused significantly more on the manipulation of whether the misstatement impacts the company’s ability to meet earnings expectations compared to the unsophisticated investors.

Supplemental tests were performed to provide further insight. For example, participants were asked to indicate the largest misstatement (as a percentage of pretax income) they would accept before concluding that a company’s financial reporting is not presented fairly. Results are summarized in Figure 4, Panel A. Interestingly, the results indicate that the unsophisticated investors have a significantly lower materiality threshold (6 percent of pretax income) than the sophisticated investors (9 percent) and auditors (10 percent). The thresholds of the sophisticated investors and auditors were not significantly different.

Next, participants’ subjective assessments of cue use were compared with objective assessments provided by statistical judgment models. Results summarized in Panel B of Figure 4 indicate that, consistent with expertise theory, the unsophisticated investors had lower self-insight compared to sophisticated investors and auditors (who exhibited similar self-insight).

The participants were asked to indicate the amount of confidence they had in their materiality judgments on an 11-point scale anchored at 0 = “Not at all confident” and 10 = “Completely confident.” The unsophisticated investors’ confidence (mean = 6.45) was significantly lower than that of the sophisticated investors (mean = 7.67) and auditors (mean = 7.18) (which were not significantly different). Finally, when asked what additional information the participants would like in assessing materiality for the cases, the auditors desired significantly more information than unsophisticated and sophisticated investors.

The “reasonable investor” approach currently espoused in the materiality guidance requires auditors to consider the effects of potential misstatements on a relatively broad group of users along a spectrum of investing sophistication. DeZoort et al. (2019) show significant differences in materiality judgments between unsophisticated and sophisticated investors, both of which likely fall within the definition of a “reasonable investor.” The divergent nature of materiality judgments across different levels of investor sophistication suggests the need for auditors to consider the various dimensions of the meaning of “reasonable” investor in planning the audit and applying professional standards. Additionally, regulators and standard-setters should carefully assess whether current materiality guidance appropriately addresses the challenges auditors face when applying the “reasonable investor” standard.

Auditors’ focus on quantitative materiality factors combined with the comparable, quantitative materiality thresholds self-reported by auditors and sophisticated investors bodes favorably on auditors’ ability to meet the demands of sophisticated investors. These results are likely driven by a consistency in firm guidance related to qualitative factors and quantitative benchmarks found in public accounting firms (Eilifsen and Messier 2015). In contrast, the lower materiality thresholds reported by unsophisticated investors raise additional concerns about an expectations gap between the assurance that auditors provide and the assurance sought by some user groups.

Differences in cue usage also call attention to potential qualitative factors that auditors should consider more closely in designing audit plans and evaluating identified misstatements. For example, both investor groups found accounting areas that were capable of precise measurement to be significantly more important in their materiality judgments than auditors. Although some of these judgment differences are likely driven in part by auditors’ business-risk concerns (e.g., auditors focus more on whether the company is publicly traded than investors), these findings complement prior research suggesting the need for improved auditor guidance on evaluating qualitative materiality (e.g., Ng and Tan 2007).