Materiality Uncertainty and Earnings Misstatement

46 Pages Posted: 23 May 2003

See all articles by Evelyn Patterson

Evelyn Patterson

Indiana University-Kelley School of Business

Reed Smith

Kelley School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: March 2003

Abstract

The concept of materiality provides a basis for auditors to ignore small misstatements, but the definition of small in this context is ambiguous. The issue of "materiality-standard-setting" has been raised recently by Arthur Levitt, former chairman of the Security and Exchange Commission. We examine how materiality uncertainty affects the auditor's evaluation of audit evidence and a manager's choice of earnings overstatement in a strategic auditing model where earnings misstatements also include unintentional system error. We find that when the expected cost of accepting financial statements that are materially misstated, which we refer to as an audit failure, is relatively large, an increase in materiality uncertainty results in a more conservative auditor evaluation of the audit evidence and a decrease in the amount of intentional overstatement. Alternatively, if the auditor's expected cost of extending audit procedures is relatively high, then an increase in materiality uncertainty results in a less conservative auditor evaluation of the audit evidence and an increase in the manager's earnings overstatement. The auditor also becomes increasingly conservative as the report increases when the information system is sufficiently noisy. Finally, when the expected cost of audit failure is large, the equilibrium audit risk can increase or decrease in materiality uncertainty despite the corresponding increase in auditor conservatism and decrease in intentional overstatement. Audit risk is the average probability of audit failure across all possible evidence outcomes.

Keywords: strategic audit, materiality, intentional overstatement, system of internal control

JEL Classification: M49, C72, G34

Suggested Citation

Patterson, Evelyn and Smith, J. Reed, Materiality Uncertainty and Earnings Misstatement (March 2003). Available at SSRN: https://ssrn.com/abstract=386562 or http://dx.doi.org/10.2139/ssrn.386562

Evelyn Patterson (Contact Author)

Indiana University-Kelley School of Business ( email )

801 West Michigan
Indianapolis, IN 46202
United States
317-278-7843 (Phone)

HOME PAGE: http://kelley.iupui.edu/faculty/FacultyProfile.cfm?netid=evpatter

J. Reed Smith

Kelley School of Business ( email )

801 W Michigan Street
BS 4002
Indianapolis, IN 46202
United States
317-274-0867 (Phone)
317-274-3312 (Fax)

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