The Effect of Auditors’ Incentives on the Assessed Materiality of Misstatements Identified in Previously Audited Financial Statements

53 Pages Posted: 8 Aug 2019

See all articles by Brant E. Christensen

Brant E. Christensen

University of Oklahoma

Roy Schmardebeck

The University of Tennessee, Knoxville - Haslam College of Business, Accounting and Information Management

Timothy A. Seidel

Brigham Young University

Date Written: August 5, 2019

Abstract

The correction and disclosure prominence of misstatements identified in previously audited financial statements depends largely on preparers’ and auditors’ materiality judgments. Despite being tasked with independent attestation, we posit that auditors’ incentives to avoid reputational and legal damage associated with more prominent misstatement disclosures align their disclosure preferences with those of management. Thus, we investigate the extent to which auditors’ incentives influence materiality judgments inherent in the misstatement disclosure. In this setting, and holding constant the magnitude of the misstatement, we find that auditors strategically assess misstatements as less material (i.e., misstatements are disclosed less prominently) when auditors face greater reputation risk, greater litigation risk, or have greater incentives to please important clients. Importantly, we find that these incentive effects manifest only when the materiality of the misstatement is less certain but not when the misstatement is clearly material. These findings suggest that the risk of litigation and reputational damage arising from the prominent acknowledgement of failed prior period audits aligns auditors’ materiality assessments with management’s preference for less prominent disclosure. These results provide important insights regarding auditors’ incentives.

Keywords: materiality, incentives, litigation risk, reputation risk, misstatement disclosure, audit quality, engagement risk

Suggested Citation

Christensen, Brant E. and Schmardebeck, Roy and Seidel, Timothy A., The Effect of Auditors’ Incentives on the Assessed Materiality of Misstatements Identified in Previously Audited Financial Statements (August 5, 2019). Available at SSRN: https://ssrn.com/abstract=3432547 or http://dx.doi.org/10.2139/ssrn.3432547

Brant E. Christensen

University of Oklahoma ( email )

Norman, OK 73019-4004
United States

Roy Schmardebeck

The University of Tennessee, Knoxville - Haslam College of Business, Accounting and Information Management ( email )

The Boyd Center for Business and Economic Research
Knoxville, TN 37996
United States

Timothy A. Seidel (Contact Author)

Brigham Young University ( email )

Provo, UT 84602
United States

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