Qualitative Characteristics of Financial Reporting Errors Deemed Immaterial by Managers

Abstract

We provide evidence on two qualitative characteristics of financial reporting errors deemed immaterial by management (immaterial errors). The qualitative characteristics we consider are relevance for equity valuation and predictive ability for financial reporting quality, specifically reliability. Our results suggest that investors find immaterial errors relevant, in particular those that are more severe, and that immaterial errors are informative about financial reporting reliability. Specifically, they indicate increased propensities for three outcomes known to be associated with negative economic consequences: future material errors, immaterial errors and material weakness assessments. When we benchmark the qualitative characteristics of immaterial errors against those of material errors corrected by restatements, we find that investor responses to immaterial errors are smaller than responses to restatements disclosed in Form 8-K, and that predictive ability of immaterial errors for reporting quality is not qualitatively different from that of restatements. Viewed in the context of previous research on material errors, our results support the view that immaterial errors are informative about reporting quality, a qualitative characteristic that is not part of the authoritative guidance management applies in assessing materiality of financial reporting errors. Our analysis informs debates about materiality assessments from an investor perspective, including proposals by the Financial Accounting Standards Board to revise the materiality definition in its conceptual framework.

Keywords: materiality, material error, immaterial error, error correction, revision, out-of-period adjustment

JEL Classification: M41, M42