Quantitative Materiality Perspectives and Auditors' Disposition of Detected Misstatements
Mark W. Nelson
Cornell University - Samuel Curtis Johnson Graduate School of Management
University of Southern California
Steven D. Smith
Brigham Young University
January 30, 2004
Two alternative approaches are used in audit practice to make quantitative materiality assessments about proposed audit adjustments: the cumulative approach compares to net income the total amount of misstatement existing at the end of the current period, while the current-period approach compares to net income the amount of misstatement added in the current period. The Panel on Audit Effectiveness and the SEC have expressed concern that these alternative materiality approaches could affect auditor judgments, but no research has investigated this question. We report the results of an experiment in which 234 audit managers and partners from one Big 4 firm completed eight cases that required them to determine whether the final outcome of an audit would be to book or waive a proposed adjusting journal entry. We manipulated materiality approach between auditors by providing auditors with either the current-period or cumulative formats used at their firm, and also manipulated whether auditors were provided with a prompt to consider their clients' quality of earnings. Results indicate waived adjustments for all cases, and a robust and often unintentional effect of materiality approach on auditors' adjustment decisions, but no effect of the quality of earnings prompt. Results also indicate that auditors' adjustment decisions are affected by misstatement size, subjectivity, current-period income effect, and precision.
Number of Pages in PDF File: 44
Keywords: Materiality, auditing, adjusting entries, iron curtain, rollover, earnings management.
JEL Classification: M41, M44, M49, G14
Date posted: March 8, 2004