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AUDITING: A JOURNAL OF PRACTICE & THEORYVol. 24, No. 2November 2005pp. 153187

A Review and Integration ofEmpirical Research on Materiality:

Two Decades LaterWilliam F. Messier, Jr., Nonna Martinov-Bennie,

and Aasmund Eilifsen

SUMMARY: There has been a renewed interest in the concept of materiality motivatedby concerns at the Securities and Exchange Commission, the Sarbanes-Oxley Act,and the Auditing Standards Board and International Auditing and Assurance StandardsBoard issuance of proposed standards on materiality. This paper: (1) reviews and in-tegrates the empirical research on materiality since 1982, and (2) suggests some im-plications of this research for audit practice and research. The review indicates thatwhile many issues related to materiality have been addressed by prior research, anumber of new and important areas are in need of further examination.

Keywords: materiality; materiality bases; quantitative; qualitative materiality factors.

INTRODUCTION

Materiality has been and continues to be a topic of importance for auditors. Themost recent controversy started when Securities and Exchange Chairman ArthurLevitt expressed concern over the concept of materiality in financial reportingand auditing in his Numbers Game speech (Levitt 1998). He argued that companies andtheir auditors were abusing the concept of materiality in order to manage earnings.Commissioner Levitt stated that:

some companies misuse the concept of materiality. They intentionally record errors withina defined percentage ceiling. They then try to excuse that fib by arguing that the effect onthe bottom line is too small to matter. If thats the case, why do they work so hard to createthese errors? Maybe because the effect can matter, especially if it picks up that last pennyof the consensus estimate. When either management or the outside auditors are questionedabout these clear violations of GAAP, they answer sheepishly ... It doesnt matter. Itsimmaterial.

William F. Messier, Jr. is a Professor at Georgia State University and Professor II at theNorwegian School of Economics and Business Administration, Nonna Martinov-Bennie isa Lecturer at The University of New South Wales, and Aasmund Eilifsen is a Professor atthe Norwegian School of Economics and Business Administration.We thank Dick Bernardi, Karen Braun, Joe Carcello, Jeff Cohen, Mike Gibbins, Audrey Gramling, Bill Kinney(Associate Editor), Mark Nelson, Peter Roebuck, and Brad Tuttle for their helpful comments.

Submitted: January 2005Accepted: June 2005

154 Messier, Martinov-Bennie, and Eilifsen

Auditing: A Journal of Practice & Theory, November 2005

In markets where missing an earnings projection by a penny can result in a loss ofmillions of dollars in market capitalization, I have a hard time accepting that some of theseso-called non-events simply dont matter.

Commissioner Levitt instructed the Securities and Exchange Commission (SEC) staff toexamine this problem and develop guidance to consider qualitative factors for determiningmateriality. The SEC (1999) issued Staff Accounting Bulletin (SAB) No. 99, Materiality,which states that strict reliance on quantitative measures to assess materiality is inappro-priate. SAB No. 99 requires auditors to consider qualitative factors (e.g., the effect of theitem on meeting consensus forecasted earnings, trend in earnings) in determining materi-ality.1 To respond to the concerns of the SEC, the largest public accounting firms formedthe Big Five Audit Materiality Task Force and issued a report in October 1998 (Big FiveAudit Materiality Task Force 1998).

The work of the task force resulted in the issuance of Statements on Auditing Standards(SAS) No. 89 and No. 90 (AICPA 2004a) by the Auditing Standards Board (ASB). SASNo. 89 requires that the auditor have management sign-off on waived adjustments whileSAS No. 90 requires that the auditor present any waived adjustments to the companysaudit committee. The intent of these standards is to require management and audit com-mittees to take responsibility for misstatements detected that are not booked.

Additional concerns related to materiality have resulted from the Public Company Ac-counting Oversight Boards (PCAOB 2004) Auditing Standard No. 2 (AS No. 2) on re-porting on internal control. This standard requires management and their auditors to con-sider materiality when deciding which controls to test. More importantly, it requiresmanagement and their auditors to consider materiality when assessing whether a controldeficiency is a significant deficiency or a material weakness. (See A Framework for Eval-uating Control Exceptions and Deficiencies, Version 3, [AICPA 2004b].) Finally, the ASBand International Auditing and Assurance Standards Board (IAASB) have issued exposuredrafts that will revise existing guidance on materiality (AICPA 2005a; IAASB 2004).2

With this renewed interest in materiality by regulators and standard setters, we believethat it is appropriate to examine the state of research on materiality. Therefore, this paperhas two objectives: (1) to review and integrate the empirical research on materiality sincethe Holstrum and Messier (1982) review3 and (2) to identify the implications of this researchfor audit practice and research.

The remainder of the paper is as follows. In the next section, we provide a backgrounddiscussion on the concept of materiality and its application by auditors. This is followedby a brief summary of materiality research conducted prior to 1982 and reviewed byHolstrum and Messier (1982). Our review of materiality research subsequent to 1982 fol-lows that section. The next section presents a summary of this research and suggests areasfor future research. The last section contains some concluding comments.

1 Note that intentional immaterial misstatements by management have always been prohibited by the securitiesacts.

2 Since April 2003, the PCAOB has the authority to issue auditing standards for registered (public) companies.Thus, the ASBs standards apply only to private companies. At the current time, the PCAOB does not havemateriality listed as a current agenda item.

3 The literature review is limited to published scholarly research papers. We provide no coverage of professionaland practitioner articles.

A Review and Integration of Empirical Research on Materiality: Two Decades Later 155


BACKGROUNDMateriality Defined

Materiality is a key concept in both the theory and practice of accounting and auditing.The importance of this issue is summarized in Financial Accounting Standards BoardsDiscussion Memorandum (FASB 1975, 3):

The concept of materiality pervades the financial accounting and reporting process. It influ-ences decisions regarding the collection, classification, measurement, and summarization ofdata concerning the results of an enterprises economic activities. It also bears on decisionsconcerning the presentation of that data and the related disclosures in financial statements.As applied by preparers and auditors, the concept of materiality is generally understoodultimately to involve determination of the importance of a matter for financial reportingpurposes.

The concept of materiality has been defined by the FASB in Statement of Financial Ac-counting Concepts No. 2 (FASB 1980, 132) (and included in SAS No. 47, AU 312.10)as:

The omission or misstatement of an item is material in a financial report, if, in light ofsurrounding circumstances, the magnitude of the item is such that it is probable that thejudgment of a reasonable person relying upon the report would have been changed or influ-enced by the inclusion or correction of an item.

The SECs definition of materiality is very similar with the user defined as an averageprudent investor [who] ought to reasonably be informed about before purchasing the se-curity registered.

The IAASBs exposure draft on materiality (IAASB 2004) relies on the InternationalAccounting Standards Boards (IASB) definition:

Omissions or misstatements of items are material if they could, individually or collectively,influence the economic decisions of users taken on the basis of the financial statements.Materiality depends on the size and nature of the omission or misstatement judged in thesurrounding circumstances. The size or nature of the item, or a combination of both, couldbe the determining factor.

An important difference between the two definitions is that the FASB definition relies onwhether the magnitude of the item is probable in affecting the users judgment while theIASB definition uses the term could influence the users judgment. U.S. standard settershave expressed concern that the use of the word could without a modifier such as rea-sonably, establishes a very low threshold of materiality in light of the fact that the wordcould implies a potentially endless number of possibilities. If the auditor is to design anaudit to detect what could influence the economic decisions of users, this may impose anunreasonable and impractical instruction to the auditor, especially when dealing with theneeds of users of general purpose financial statements (AICPA 2005b, emphasis added).The AICPAs concern is likely the result of the legal environment in the U.S.

Holstrum and Messier (1982, 48) pointed out three main problems with a user approachto materiality. First, little is known about how financial statement information is utilized byusers in investment and credit decision making. Second, materiality decisions are madeby preparers, auditors, and users; these heterogeneous groups are likely to have dissimilarviews of materiality because of their different incentives. Third, there is little informationon how materiality judgments made by preparers and auditors affect users decisions. Thesesame problems with a user perspective continue to be relevant after two decades.



Materiality and the Audit ProcessThe concept of materiality is important throughout the audit process, but is particularly

relevant to planning the audit and in evaluating the results of audit testing.4 The assessmentof what is material at each of these phases of the audit is a matter of professional judgment.At the planning phase, the auditor determines an overall magnitude of materiality (forfinancial statements as a whole) that is used to develop the scope of the audit. This mate-riality amount is typically referred to as planning or audit materiality (Big Five AuditMateriality Task Force 1998; Holstrum and Messier 1982). Generally, auditors allocatea portion of the planning materiality to account balances or classes of transactions. Thisallocated amount is referred to as tolerable misstatement, and represents the amount bywhich the account or class of transactions can be misstated and not be considered material.5At the completion of the audit, detected misstatements are compared to tolerable misstate-ment in order to determine if these misstatements are material enough to require adjustmentof the clients books. This part of the process is typically referred to as evaluationmateriality (Big Five Audit Materiality Task Force 1998). Auditing standards indicate that,theoretically, planning materiality should be similar to evaluation materiality if it was basedon the same information available at the planning stage (AU 312.22).

The Big Five Audit Materiality Task Force concluded that the practice issues relatedto materiality, for the most part, involved evaluation materiality and not planning materiality.Thus, the task force believed that it is the application of appropriate audit judgment to theevaluation of the significance of detected misstatements that is the problem and notthe level of materiality used to plan the scope of audits. A good example of this issueis the $51 million adjustment that was waived by Arthur Andersen on Enrons 1997 audit.Andersen argued that this amount was not material, using an average of annual reportedearnings (Berardino 2001). While various government sources were critical of this mate-riality judgment, Brody et al. (2003) show that much of the professional materiality guid-ance supports Andersens decision to waive the adjustment as immaterial.

MATERIALITY RESEARCH PRIOR TO 1982A significant amount of research was conducted in the 1970s that addressed different

aspects of the materiality concept. Interest in materiality was intensified by the FASBsdecision in 1975 to examine this issue (FASB 1975). Holstrum and Messier (1982) pre-sented a detailed review of the materiality literature prior to 1982. They summarized theirfindings under four areas: (1) the nature of the item, (2) the structural form of the decisionmodel, (3) the relative importance of factors used to determine materiality, and (4) mate-riality thresholds.

The Nature of the ItemBecause of the diversity of items examined in prior research (e.g., extraordinary items,

change in depreciation and tax method, and qualified audit reports), Holstrum and Messier(1982) concluded that it was difficult to integrate the results of the reviewed research. Thisfinding is significant because there is evidence that the nature of the item is an important

4 The process outlined here would be applicable to an integrated audit conducted under PCAOB standards thatincludes reporting on internal control over financial reporting.

5 There are a number of ways in which firms convert planning materiality to tolerable misstatement (see AICPA2001; Messier et al. 2006, Chapter 3). For example, the AICPA (2001) suggests applying a multiplier in therange of 5075 percent to the overall materiality amount.



determinant of materiality, and it is likely that the relative importance of such items variessignificantly.

The Structural Form of the Decision ModelA considerable amount of behavioral research on materiality has found that auditors

judgments can be modeled using an additive (linear) model. For example, Messier (1983)found that a linear model accounted for most of the variance in audit partners materialityjudgments. However, there was some evidence that configural (nonlinear) processing oc-curred in the audit partners materiality judgments.Relative Importance of Factors in Judging Materiality

The percentage effect of the item on income was the single most important quantitativefactor in determining materiality. A distant second in importance was the effect of the itemon earnings trend. Results for total assets or net assets were mixed. While Holstrum andMessier (1982) pointed out that the measurement of relative importance of a particularfactor is dependent upon the range of experimental manipulation used by the researchers,the result on relative importance of income appears to be very consistent with audit practiceguidance.

Materiality ThresholdsThere were considerable differences between users, preparers, and auditors with respect

to materiality thresholds. In general, users demonstrated lower materiality thresholds thanpreparers or auditors; the materiality thresholds for auditors tended to be between those ofpreparers and users. Additionally, auditors from large national firms had higher materialitythresholds than auditors from small firms. Last, differences were also found among auditorsfrom different large firms and even among the auditors within the same firm.

SummaryHolstrum and Messier (1982) concluded that the results of research up to 1982 did not

provide any definite comprehensive implications for audit practice or policy formulation.Since that time there have been numerous changes in both the regulatory and professionalenvironments.

MATERIALITY RESEARCH SUBSEQUENT TO 1982Based on our review of the materiality research conducted subsequent to Holstrum and

Messier (1982), relatively little research on materiality was published in the mid-1980s.There was renewed interest in materiality in the late-1980s, most likely due to the adoptionof the audit-risk model into auditing standards and its integration by public accountingfirms into their audit methodologies. We discuss this research under two research methods:archival studies and behavioral studies. In discussing the results, we focus our discussionon the most representative research. The tables that accompany each section outline allpapers reviewed.

Archival StudiesArchival studies use audit firm manuals, data from auditor working papers, or published

financial statement data and auditor reports to examine materiality decisions. We discussthese studies based on the source of the underlying data: auditor-related sources and publicsources.



Auditor-Related SourcesAudit firms manuals and working papers containing auditor-detected misstatements

have provided substantial evidence of auditors materiality judgments. Table 1 summarizeseach of these studies by source of the information or data.

Audit manuals. Steinbart (1987) relied on the manuals of ten audit firms and extensiveinteraction with expert auditors to construct a rule-based expert system for making mate-riality decisions. The construction of the expert systems knowledge base involved learninghow various quantitative and qualitative factors entered into auditors planning materialityjudgments. Steinbart (1987) found that the planning materiality judgments involved twoseparate sub-decisions: (1) the choice of an appropriate base (quantitative factor) for cal-culating materiality and (2) selection of a percentage rate for multiplying the base. Thechoice of the percentage to apply to the base was much more subjective and depended oninformation about intended use of the clients financial statements and the nature of theaudit engagement (i.e., specific situations representing increased business risk and the au-ditors preferred response to that risk). Finally, the prior years materiality level was usedto modify the resulting materiality amount.

Friedberg et al. (1989) examined audit manuals to determine and compare the guidanceprovided by the firms for establishing materiality. They obtained the relevant sections ofthe audit manuals from six of then Big 8 U.S. public accounting firms. Consistent withprevious research, the relationship of a misstatement to net income and the effect of amisstatement on earnings trends were consistently included in the firms manuals as factorsthat should be considered in making materiality judgments. However, the detailed quanti-tative guidelines and qualitative factors included in their guidance differed substantiallybetween firms.

Martinov and Roebuck (1998) performed a similar analysis nearly a decade later usingthe materiality and audit-risk guidance from the Big 6 public accounting firms in Australia.They corroborated their analysis through interviews with a senior representative from eachof the participating firms. Their findings are generally consistent with Friedberg et al.(1989). The individual firms approaches to determining overall planning materiality dif-fered significantly. For five of the firms, a considerable amount of judgment was involvedin setting planning materiality, although guidance was provided as to the appropriate baseand percentage range. Five of the firms also either implicitly or explicitly differentiatedbetween planning materiality and reporting materiality. All firms gave consideration tomateriality at the individual account and/or class of transactions level, normally as a func-tion of the planning materiality. The level of judgment exercised by individual auditors insetting tolerable misstatement at the account level varied significantly, with three of thefirms providing very little or no guidance and the other three prescribing a specific per-centage of the overall materiality. The results of Martinov and Roebuck (1998) are relativelyconsistent with Steinbart (1987).

Audit working papers. Studies that used audit working papers examined issues thatincluded auditors materiality decisions at the planning stage (Blokdijk et al. 2003) andevaluation stage (Robinson and Fertuck 1985), the effect of materiality on auditors deci-sions to book or waive adjustments (Icerman and Hillison 1991; Wright and Wright 1997),and the effect of materiality on auditors decision to project misstatements (Allen and Elder2005; Elder and Allen 1998).

Blokdijk et al. (2003) examined a sample of 108 Dutch Big 5 and non-Big 5 auditengagements for the years 199899. They found that although planning materiality in-creases with client size, it increases at a decreasing rate (similar to nonlinear relationship

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TABLE 1Summary of Archival Studies on Materiality

Auditor-Related Sources

Studies Scope Research Issue(s) Major FindingsPanel A: Studies Based on Information from Audit ManualsSteinbart (1987) Audit manuals of ten U.S. audit

firms, interviews with four ofthese firms, a number ofinteractive sessions with one auditpartner (involved in theconstruction of the expert system),and responses of six auditors (intesting the expert system on 13clients).

Construction of a rules-basedexpert system for makingplanning-stage materialityjudgments and how various typesof information influence thosejudgments.

The planning-stage materiality judgmentswere seen to involve two separate sub-decisions: (1) choice of an appropriate basefor calculating materiality and (2) selectionof a percentage for multiplying the base.

The base was shown to depend oninformation about the perceived needs of thefinancial statements users and objectivecharacteristics of the client.

The percentage rate depended on informationabout intended use of the clients financialstatements and the nature of the auditengagement.

Friedberg et al.(1989)

Audit manuals obtained from six ofthe then Big 8 firms in U.S.

Guidelines in audit manuals aboutquantitative and qualitativefactors used to judge materiality.

The relationship of a misstatement to netincome and the effect of a misstatement onearnings trends were consistently mentionedas affecting quantitative and qualitativemateriality, respectively.

The quantitative and qualitative guidanceprovided by the firms differed substantially.

Martinov andRoebuck (1998)

Analysis of audit manuals, otherrelevant decision aids, andinterviews with the technicalpartner or manager from each ofthe Big 6 firms in Australia.

Analysis of how materialityassessments are made andintegrated.

Although all the firms set an overallplanning materiality, diversity existed inrelation to level of guidance and judgmentinvolved, the actual guidelines used, and theutilization of additional materiality levelssuch as an account-level materiality.

(continued on next page)

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TABLE 1 (continued)

Studies Scope Research Issue(s) Major FindingsPanel B: Studies Based on Information from Audit Working PapersRobinson and

Fertuck (1985)Data from work papers on 610

materiality decisions for 61Canadian companies that were theprime responsibility of 15 partnersfrom three audit firms.

The study attempts to identifyfactors that determine auditorevaluation materiality judgments.

The effect of the misstatements on netincome was significant in their decisions, butit was not the only relevant factor.

Objectively verifiable misstatements are morelikely to be material, as are misstatements incompanies where the client opposes theadjustments.

Contrary to expectations, misstatements areless likely to be declared material in highdebt-ratio companies.

Icerman andHillison (1991)

1,424 detected misstatements in 147audits of seven U.S. Big 8 firms.The sample consisted of 49manufacturing companies for theyears 19791981.

Materiality judgments as reflectedin the decision to book or waivedetected misstatements.

The decision to book or waive detectedmisstatements was a function of relativemisstatement size (percentage of netrevenues) and audit firm structure.

Wright andWright (1997)

368 misstatements of 186 clients ofPeat, Marwick, Mitchell & Co.(U.S.) for 198485.

Examine variables that may explainthe decision to waive detectedmisstatements.

Materiality (misstatement amount relative toplanning materiality) appeared to be animportant factor in deciding whether towaive detected misstatements.

The decision to book or waive a detectedmisstatement entails multiple factors inaddition to materiality such as impact onincome, nature of the misstatement, and sizeof the client.

Elder and Allen(1998)

235 sampling applications for 64audits by two U.S. Big 6 firmsand one large regional publicaccounting firm for 199394.

Auditors decision to quantifymisstatements by projectingthem to the population.

Auditors decision to project misstatementswas affected by materiality.

Misstatement immateriality was the mostcommon reason for not projecting amisstatement.


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TABLE 1 (continued)

Panel B: Studies Based on Information from Audit Working Papers, continuedAllen and Elder

(2005)200 sampling applications for 53

audits in fiscal year 1999 or 2000.The 1999 sample includes 35clients common to the earlierperiod and an additional 18 clientsthat had not been tested in theearlier period.

Compare these results to the errorprojection decisions from 1994to 1999.

Immateriality continued to be a main reasonfor not projecting misstatements.

There were significant changes in the extentto which individual firms used materiality asa justification not to project errors. One firmincreased the use immateriality for notprojecting misstatements while another firmdecreased immateriality as a reason for notprojecting.

Blokdijk et al.(2003)

Planning materiality judgments from108 audit engagements from 13Dutch audit firms (the Big 5 and8 non-Big 5) for the years199899.

Investigate the planning materialityvalues used by auditors in TheNetherlands.

Planning materiality increased with clientsize, but at a decreasing rate.

Planning materiality increased with theauditors assessment of the quality of thecontrol environment and the magnitude ofthe clients rate of return, and decreased withauditors assessment of client complexity.

Other examined variables (current ratio,inherent risk, illegal acts, leverage, listed,audit firms tenure by the client, and riskapproach) were not significantly related toplanning materiality.

Big 5 auditors planning materiality judgmentwere lower than non-Big 5 auditors.

When reported earnings are around zero,auditors use lower planning materiality.



in KPMGs gauge6). Blokdijk et al. (2003) also reported that planning materiality increaseswith the auditors assessment of the quality of the control environment and the magnitudeof the clients rate of return, and decreases with auditors assessment of client complexity.Other variables considered such as current ratio, inherent risk, illegal acts, leverage,exchange listing, audit firms tenure by the client, and risk approach were not significantlyrelated to planning materiality. Blokdijk et al. (2003) found that Big 5 auditors assessplanning materiality at a lower level than non-Big 5 auditors (cf., Messier 1983). Finally,the study found that when reported earnings are around zero, auditors use lower planningmateriality.

Robinson and Fertuck (1985) examined how auditors made evaluation materiality de-cisions by investigating data from audit files of 610 materiality decisions. Their sampleincluded 61 Canadian companies from three public accounting firms. Robinson and Fertuck(1985) report that (1) the effect of the misstatements on net income was significant inmateriality decisions, but it was not the only relevant factor, (2) objectively verifiable (nojudgment required) misstatements were more likely to be material, as were misstatementsin companies where the client opposes the corrections, and (3) misstatements were lesslikely to be declared material in high debt-ratio companies.

Two studies (Icerman and Hillison 1991; Wright and Wright 1997) examined howauditors decisions to book or waive detected misstatements were affected by materiality.Icerman and Hillison (1991) examined a sample 1,424 misstatements from 49 manufactur-ing companies for 19791981. They reported that the decision to book or waive a mis-statement was a function of the misstatement as a percent of net revenue and audit firmstructure (see Kinney 1986). Firms with structured audit approaches (e.g., KPMG) tendedto book a greater proportion of the individual misstatements than less structured firms.Thus, a firms audit methodology is likely to impact auditors materiality judgments.7

Wright and Wright (1997) also examined factors affecting auditors decisions to waivedetected misstatements. They examined 368 misstatements from 186 Peat, Marwick,Mitchell & Co. (now KPMG) clients. Consistent with prior studies, Wright and Wright(1997) reported that the magnitude of the misstatement relative to planning materiality wasthe most important factor in deciding to waive detected misstatements.8 Other factors thataffected the decision to book or waive the misstatements include the directional impact onincome, the nature of the adjustment (objective cause versus a subjective cause), and clientsize.

Elder and Allen (1998) examined whether detected misstatements are projected as re-quired by auditing standards. They examined 235 sampling applications for 64 audits oftwo Big 6 firms and one large regional firm. Elder and Allen (1998) found that the decisionto project a misstatement was related to several factors, including materiality of the mis-statement (the projected misstatement as a percentage of planning materiality), direction ofthe misstatement, type of test detecting the misstatements, and audit firm characteristics.The immateriality of the misstatement was the most common documented reason for notprojecting a misstatement. This result is disturbing since, as noted by the authors, it would

6 Gauge is KPMGs measure of materiality and it is a nonlinear function of assets or revenues. Elliott (1983, 4)reported gauge as 1.6 (the greater of assets or revenues)2 / 3. It is our understanding that his formula variedby industry and country.

7 Since Kinneys study in 1986, all of the major firms have revised their audit methodologies. It is no longer usedby KPMG but it is an open question whether there are differences in the current structure of large firmsmethodologies.

8 Nelson et al. (2002), in a questionnaire survey of auditors, found that auditors often justified waiving adjustmentdue to immateriality.



appear that the materiality of a misstatement cannot be determined until it has been pro-jected (Elder and Allen 1998, 74).

In a follow-up study, Allen and Elder (2005) collected 200 sampling applications for53 audits in fiscal year 1999 or 2000 (hereafter the 1999 sample). The sample included 35clients common to the earlier study, and an additional 18 clients that had not been testedin the earlier period. They found that there was little change in the extent to which mate-riality is used to justify the failure to project errors (46 percent of nonprojected errors wereconsidered immaterial in the 1994 sample versus 44 percent in the 1999 sample). Thefindings are similar for the matched sample of audits. However, there were significantchanges in individual firm behavior in using materiality as a justification to not projecterrors. One firm had a significant decrease in using immateriality as a justification not toproject errors while another firm had a significant increase.

Summary. Research that has relied on firm manuals and working papers has identifieda number of significant findings. First, there appears to be differences in the way firmsestablish planning materiality (Martinov and Roebuck 1998) with judgment playing a sig-nificant role. Second, some version of income continues to be the major factor in deter-mining the materiality of a misstatement. Last, the immateriality of a misstatement is themajor factor in waiving potential misstatements.Public Sources

Studies relying on publicly available data have investigated a wide range of financialreporting items and disclosure issues. Such studies generally examined corporate annualreports to determine if the disclosure of an accounting change and/or auditors consistencyqualifications can provide some boundaries on thresholds for materiality judgments. Thedisclosed amount of the accounting change is used as a surrogate for the auditors and/orpreparers implied materiality decision.9

Among the diversity of financial reporting items and disclosure issues examined areaccounting for capitalization of interest costs (e.g., Morris et al. 1984), inflation accountingdisclosure (Frishkoff and Phillips 1985), foreign currency translation (e.g., Chewning et al.1989), contingency disclosure (e.g., Fesler and Hagler 1989), LIFO disclosure (e.g.,Wheeler et al. 1993), accounting for income taxes (Costigan and Simon 1995), equity-for-debt swaps (Chewning et al. 1998), and cost of postretirement benefits other than pensions(Liu and Mittelstaedt 2002). A number of these studies also investigated the effect of thechange in accounting principle on the auditors consistency exception opinion (Morris etal. 1984; Morris and Nichols 1988; Chewning et al. 1989; Wheeler et al. 1993; Costiganand Simon 1995).10 In addition, Kinney et al. (2002) addressed the materiality of earningssurprise as measured by stock prices. Table 2 provides a summary of these studies.

Frishkoff and Phillips (1985) investigated auditors materiality judgments using inflationreporting by U.S. banks under SFAS No. 33, Financial Reporting and Changing Prices.SFAS No. 33 required current cost information to be disclosed only if the current valuefigures were materially disparate from historical-based data (i.e., material differences be-tween the amount of income from continuing operations on a historical/constant dollarbasis and the amount of income from continuing operations on a current cost basis).Frishkoff and Phillips (1985) reviewed annual reports of the 201 largest U.S. commercial

9 As observed by Holstrum and Messier (1982), such studies cannot distinguish the auditors materiality judgmentfrom the preparers materiality judgment. It is likely that the auditor and preparer negotiate the final materialitythreshold (Gibbins et al. 2001).

10 In 1988, auditing standards (SAS No. 58) removed the consistency qualification and replaced it with an un-qualified opinion that included an explanatory paragraph describing the change in accounting.

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TABLE 2Summary of Archival Studies on Materiality Based on Publicly Available Information

Studies Scope Research Issue(s) Major FindingsMorris et al.

(1984)Audit reports and financial statement

data for 221 U.S. firms thatinitially adopted SFAS No. 34,Capitalization of Interest Costs, in19791981.

Differences in absolute and relativesize and degree of overlap ofdistribution of subsamples whereauditors judged the effect ofinterest capitalized material ornot.

For the absolute dollar amounts of interestcapitalized, the mean was smaller andcoefficient of variation was greater for theimmaterial changes.

Companies receiving a qualified report hadmean ratios (interest capitalized as a percentof net plant) over two and one-half timeslarger than the companies receiving anunqualified report.

The frequency distribution of the ratios forthe two groups had considerable amounts ofoverlap.

Morris andNichols (1988)

Audit reports and financial statementdata for 334 publicly tradedcompanies that initially appliedSFAS No. 34, Capitalization ofInterest Costs, in 19791981.

The relationship between publiclyavailable financial informationand auditors materialityjudgments as signaled byconsistency exception opinions.

Degree of consensus of materiallyjudgments across Big 8 firms.

Correlation between materialityjudgment and audit firmstructure.

The publicly available financial informationmeasures explained a significant portion ofthe variability in auditor materialityjudgments.

Significant differences in judgment consensuswere found between the Big 8 firms.

There was a significant positive correlationbetween judgment consensus and audit firmstructure.

Frishkoff andPhillips (1985)

Annual reports for 201 large U.S.commercial banks and bankholding companies supplementedby questionnaire data coveringadoption of SFAS No. 33,Inflation Accounting Disclosure.

The importance of materiality inthe banks decision to reportinflation accounting data.

Banks that did not report current costinformation did so on the basis of theinformation being immaterial.

Materiality was not the deciding factor forbanks that reported current cost information.


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TABLE 2 (continued)

Chewning et al.(1989)

Audit opinions and financialstatement data from 198083 for284 U.S. companies that adoptedLIFO, and initially applied SFASNo. 52, Foreign CurrencyTranslation, and SFAS No. 43,Compensated Absences.

The propensities to modify auditopinions for a change inaccounting principles as afunction of the effect on income.

The effect of type of accountingchange (discretionary versusnondiscretionary) on thefrequency of audit reportmodifications.

The effect of other hypothesizedvariables on the frequency ofaudit report modification.

Consistency modifications were issued at amuch smaller effect on income thansuggested by previous research.

The discretionary change (LIFO adoption)resulted in a significantly higher percentageof modified opinions than thenondiscretionary changes (foreign currencytranslation and compensated absences).

Limited evidence that Big 8 firms havehigher materiality thresholds than non-Big 8firms.

Wheeler et al.(1993)

Audit opinions and financialstatement data from 198087 for563 U.S. companies that adoptedLIFO, and initially applied SFASNo. 52, Foreign CurrencyTranslation, and SFAS No. 43,Compensated Absences.

The propensities of audit firms tomodify audit opinions for a lackof consistent application ofaccounting principles.

Substantial between-audit firm consensus foropinion modifications when accountingchanges produced traditionally materialeffects.

Substantial between-audit firm differences inpropensities to modify audit opinions whenaccounting changes produced effectsnormally considered immaterial.

Relative litigation experiences, but not auditfirm structure, were significant in explainingbetween-Big 8 firms differences to modifyaudit opinions specifically stated to beimmaterial.

Non-Big 8 firms exhibited a significantlyhigher tendency than Big 8 firms to modifytheir opinions.

Fesler and Hagler(1989)

Financial statements disclosure in1982-83 for 126 lawsuits lostunder SFAS No. 5, Contingencies,from 19751982 by U.S. publiclytraded companies.

Litigation disclosure at variousmateriality levels.

Nondisclosure of litigation contingencies iscommon, even at relatively high materialitylevels.

Disclosure of litigation contingenciesimproves significantly with increasingmateriality levels.


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Studies Scope Research Issue(s) Major FindingsPany and Wheeler

(1989)Financial statement data for 330

U.S. companies representing 25industries for 19771986.

Apply various rules of thumbs forquantifying planning materialityto industry data to identifydifferences in sizes and stabilityof the resulting measures withinand among industries.

Applying various rules of thumbs resulted insizable differences depending upon methodand industry.

There were large differences in stability ofcalculated materiality amounts within andamong industries.

Blended methods and audit gauge were themost stable methods across industries.

Costigan andSimon (1995)

Audit opinions and financialstatement data of 351 U.S.companies that were earlyadopters of SFAS No. 96,Income Taxes.

Factors that triggered audit firms tomodify audit opinions for a lackof consistent application ofaccounting principles.

In addition to the magnitude of financialstatement effects, auditors materialityjudgments were sensitive to the method ofimplementing adoption of SFAS No. 96(cumulative versus retroactive treatment).

Client-firm size positively affected auditorsdecision to modify.

No difference in materiality judgmentsbetween Big 8 firms and non-Big 8 firms,but there were significant differencesbetween structured and less-structured Big 8firms.

The litigation experience among Big 8 firmsdid not explain differences in materialityjudgments.

Gleason and Mills(2002)

Financial statements disclosure ofcontingent tax liabilities underSFAS No. 5 from 19871995 andIRS audited data from 19811995for 100 U.S. industrial companies.

Materiality decisions inferred bydisclosure of contingent taxliabilities.

IRS claims exceeding 5 percent of incomewere not always disclosed.

The probability of disclosure increased withthe relative amount of the claim.

Firms determined materiality with respect tofirm size rather than current-year income.

Materiality is based on normal income(the greater of income or 5 percent of assets)when the firm reports low income or a loss.


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Liu andMittelstaedt(2002)

Financial statements information for437 U.S. firms that were reportingin 1989 under SFAS No. 81,Disclosure of PostretirementHealth Care and Life InsuranceBenefits.

Evaluate expense amountsdesignated immaterial underSFAS No. 81.

The material-immaterial decision waspositively related to materiality measuresbased on cost of postretirement benefits.

The material-immaterial decision was notconsistent across firms.

The material-immaterial decision was alsorelated to factors identified in the voluntarydisclosure literature.

Chewning et al.(1998)

Financial statement data for 154individual U.S. firm-swap yearsfor 198184.

Relationship between frequenciesof auditors extraordinary gainclassification to the relativeeffect on income for equity-for-debt swaps.

Relationship between incomestatement classification of gainsand the strength of the capitalmarkets reaction of swapannouncements.

Auditors materiality decisions follow closelythe conventional percentage-of-income rule-of-thumb.

There was a positive association betweenincome statement classification of gains andthe strength of the capital markets reactionof swap announcements.

Kinney et al.(2002)

Earnings forecasts and stock returndata (U.S.) for 199297.

Materiality of earnings surprises asmeasured by stock prices.

Earnings surprises alone are not material toan investor for an individual security.



banks and bank holding companies, supplemented by a questionnaire requesting informationon the banks decision to report inflation accounting data. One hundred seventy-six banksreported only historical/constant dollar amounts in their annual reports. Fifteen banks re-ported current cost (and constant dollar amounts). The remaining ten banks were notrequired to report inflation information under SFAS No. 33, and either did not report orused gross national product deflator values. These findings indicated that materiality wasnot the deciding factor for the 15 banks that reported current cost in their annual reports.However, the banks that did not report current cost did so on the basis of immateriality.

One of the first studies to examine auditors reporting decisions was Morris et al.(1984). They investigated auditors reporting decisions for firms initially applying SFASNo. 34, Capitalization of Interest Costs. Auditing standards in effect at the time (SAS No.2) required that if a change in accounting principle had a material effect on the financialstatements, then the auditor should issue a qualified (except-for) opinion for a lack ofconsistency in application of an accounting principle. Morris et al.s (1984) sample consistedof 221 firms initially applying SFAS No. 34 for 19791981. Sixty-nine firms receivedqualified opinions and the researchers concluded that the change in accounting principlefor those firms was considered material by the auditors. Morris et al. (1984) report thefollowing main results. First, using the absolute dollar amount of interest capitalized,the mean was smaller and the coefficient of variation (the ratio of standard deviation to themean) was greater for the firms that received an unqualified report. Second, the firms thatreceived a qualified audit report had mean financial ratios (interest capitalized relative tonet income and interest capitalized relative to net property, plant, and equipment) greaterthan 2.5 times those of the firms that received an unqualified audit report. Third, super-imposing the frequency distribution of interest capitalized as a percent of net plant revealedconsiderable amounts of overlap for the two groups of companies.

Morris and Nichols (1988) extended Morris et al. (1984) using a sample of 334 clientsof Big 8 firms that initially applied SFAS No. 34 during 19791981. They found that ninepublicly available financial information measures11 explained a significant portion of thevariability of the auditors materiality judgments and that the consistency exception decisionvaried significantly between Big 8 firms. Finally, a significant positive association was foundbetween audit judgment consensus and the degree of audit firm structure (Kinney 1986).

Chewning et al. (1989) focused on changes in accounting principle resulting fromadoption of LIFO (APB No. 20), and the initial application of SFAS No. 43, Compen-sated Absences, and SFAS No. 52, Foreign Currency Translation. They were interested intesting whether materiality decisions for discretionary accounting changes (LIFO adoption)differed from nondiscretionary accounting changes (compensating absences and foreigncurrency translation). They found that the importance of the effect of the change on incomewas the most significant factor to the auditors materiality judgments. Chewning et al.(1989) also found that report modifications were more frequent for discretionary change.Finally, limited evidence suggested that Big 8 firms were less likely to modify their opinionsthan non-Big 8 firms.

11 These measures were interest capitalized divided by net income, net sales, total assets, net property, plant, andequipment, and net worth, respectively, debt-to-equity ratio, net income-to-equity ratio, percentage change inincome from the year immediately prior to disclosure of initial application of SFAS No. 34, and market valueof equity calculated at the end of the fiscal year in which SFAS No. 34 was initially applied.



In a related paper, Wheeler et al. (1993) examined between-audit firm differences inpropensities to modify audit reports using the same three accounting events. After control-ling for client financial condition,12 their results indicated that there was high between-firmconsensus for opinion modification when the accounting change produced income effectstraditionally considered as material (i.e., at least 4 percent effect on operating income).However, they observed that non-Big 8 firms modify their opinions more often than Big 8firms when the accounting change produced immaterial effects (i.e., less than 4 percent onoperating income). Last, relative litigation experience was significant in explaining thedifferences among Big 8 firms in their propensities to modify audit opinions specificallystated to be immaterial.13

Studies by Fesler and Hagler (1989), Gleason and Mills (2002), Costigan and Simon(1995), and Liu and Mittelstaedt (2002) also used accounting changes to examine auditorsmateriality reporting decisions. Not surprisingly, in some cases their results support someof the prior findings. In other cases, their findings are inconsistent with prior studies. Forexample, Costigan and Simon (1995) found that structure explains differences in the ma-teriality judgments of Big 8 firms (see footnote 7), but that there is no difference inmateriality judgments between Big 8 and non-Big 8 firms.

Chewning et al. (1998) extended prior archival research by focusing on the reportedgains and losses for equity-for-debt swaps and the stock market reactions to the announce-ment of swap transactions. SFAS No. 4 required gains and losses from the extinguishmentof debt to be classified as extraordinary items if material. Their sample of swap transactionsincluded 154 individual firm-swap years for the period August 1, 1981 through June 30,1984. Chewning et al. (1998) observed that auditors materiality decisions closely followedthe conventional percentage-of-income rule-of-thumb. This contrasted with prior findings(e.g., Morris et al. 1984; Chewning et al. 1989) that indicated that consistency modificationswere issued at much lower percentages of income than conventional percentage-of-incomerule-of-thumb. Further, they documented a positive association between income statementclassification of gains and the strength of capital market reaction to the swap announce-ments. In combination, these two findings indicate that auditors following conventionalpercentage-of-income rule-of-thumb would, on average, correctly classify transactions hav-ing greater market impacts as material and those transactions having significantly smallermarket impacts as immaterial.

Kinney et al. (2002) examined the materiality or importance-to-investors of earningssurprises as measured by stock prices. Their study was motivated by Commissioner Levittsspeech about the abuse of the materiality concept to manage earnings (Levitt 1998).Using First Call and CRSP stock return data for 199297, Kinney et al. (2002) defined anearnings surprise14 as material if it was associated with a significant market reaction at theindividual firm level. The results show that an investor who trades a security based solelyon foreknowledge of the magnitude of the firms earnings surprise has less than two-thirdschance for a profit. Kinney et al. concluded that knowledge of earnings surprise alone is

12 The companies financial condition was measured using Zmijewskis (1984, 69) financial distress predictionmodel coefficients.

13 This was measured as each audit firms meritorious lawsuit cases for public clients expressed as a percentageof total public-client audits (Palmrose 1988).

14 Earnings surprise is measured as actual EPS reported by First Call minus the consensus as of the last First Callupdate before announcement of earnings for the year.



not important or material to an investor for an individual security, using our stock-price-based materiality definition (Kinney et al. 2002, 1310).15 The lack of materiality is partlydue to the S-shape of the distribution of returns given earnings surprises (steeply slopedfor small absolute surprises and approximately flat for large absolute surprises), and largereturn variation around the mean response for each level of surprise. The S-shape is relatedempirically to the dispersion of analysts forecasts. Thus, factors underlying dispersion ofanalyst forecasts are related to the materiality of the earnings surprise.

Summary. The archival-based research provides a number of conclusions. First, whilethis research examined various reporting items and disclosures, the effect of the item onincome continues to be the most significant factor in auditors materiality and disclosuredecisions. This is consistent with the research that relied on auditor working papers. Second,the choice to modify the auditors report seems consistent with traditional effects of theitem on income. Last, knowledge of an earnings surprise is not important to an investor inan individual security.

Experimental StudiesExperimental studies have examined materiality judgments of users, auditors, and others

(judges/lawyers). Our review of the experimental studies is outlined based on the type ofparticipants included in the studies. Table 3, Panels AC summarizes these studies.

UsersHaka et al. (1986) conducted an experimental study that, among other things, addressed

the effect of materiality on functional fixation in terms of exposure to cost and incomemeasures in a decision-making setting where market value was the appropriate response.Materiality level was manipulated as a percentage difference (at 2, 10, and 20 percent) ofthe dollar difference between the sales price and cost. The responses of the 220 under-graduate participants indicate that materiality had an impact on the functional fixation andstimulus encoding. The results imply that the larger the differences between the higherpurchase and higher sales price, the more likely that the decision maker would choose theasset with the higher sales price. Furthermore, when materiality levels were higher, partic-ipants with more accounting training made more sales-priced-based decisions.

Fisher (1990) used an experimental markets approach to study the effect of the disclo-sure of materiality levels on users in terms of security prices, trading volume, and tradingprofit. Graduate and undergraduate students (proxies for investors) participated in the re-peated single-period, two-asset (cash and shares), double-auction markets in which theinformation availability about the magnitude of materiality was manipulated (i.e., no dis-closure versus private disclosure versus public disclosure). The results indicate that thedisclosure of materiality led to greater market efficiency. Public disclosure of materialityappeared to be more useful than private disclosure.

Tuttle et al. (2002) investigated the appropriateness of common materiality thresholdsemployed by auditors from a user perspective employing an experimental market approach.Twelve market sessions were run, each with six traders and consisting of 12 independentthree-minute trading periods. Seventy-two undergraduate honors business students repre-senting semi-sophisticated investors, were provided either with correctly stated financialinformation, information containing immaterial misstatements or material misstatements.

15 They also observe that SAB No. 99s requirement that registrants and their auditors consider or forecastsignificant market reactions conditional on some types of earnings surprise may be problematic in that it isdifficult to forecast even the sign of markets reactions with modest (0.667) level of confidence (Kinney et al.2002, 1327).

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TABLE 3Summary of Behavioral Research on Materiality

Studies Participants Research Issue(s) Major FindingsPanel A: Studies that Included Users as ParticipantsHaka et al. (1986) Undergraduate

studentsImpact of materiality on wealth

maximization decision making. The materiality of the difference between

the sales price and purchase price wasrelated to the number of sales-price drivendecisions (i.e., stimulus encoding appearedto be contingent upon a materialitythreshold).

Fisher (1990) Business students Whether disclosure of auditor materialitylevels would affect security prices,trading volume, and trading profit.

Disclosure of materiality resulted in moreefficient markets.

Tuttle et al. (2002) Undergraduatestudents

Whether detected misstatements at orbelow commonly applied materialitythresholds result in market prices thatdiffer from prices based on correctlystated information.

Misstatements within conventionallyemployed materiality levels do not affectusers decisions.

DeZoort et al. (2003) Audit committeemembers

Examined audit committee membersresponses to auditors materialityjustification and accounting issueprecision in contentious accountingdisagreements.

Greater support for the auditors positionwhen the auditors materiality includedboth quantitative and qualitative factors andwhen the accounting issue was subject toprecise measurement.

Panel B: Studies that Included Auditors as ParticipantsMayper (1982) Senior auditors Consensus of auditors assessment of

materiality of internal accounting controlweaknesses.

Moderate consensus between individualauditors and among audit firms.

Consensus varied across different internalaccounting control weaknesses.


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TABLE 3 (continued)

Studies Participants Research Issue(s) Major FindingsMayper et al. (1989) Senior auditors The effect of probability and dollar

exposure on auditors internal accountingcontrol weaknesses materialityjudgments.

The auditors models indicated diversity inthe importance of the independent variablesaffecting the auditors materialityjudgments.

Both qualitative and quantitative factorswere considered.

The independent variables were, onaverage, important in explaining auditorsmateriality judgments.

Significant configural processing.Messier (1983) Partners The effect of experience, firm type, and

financial variables on auditorsmateriality and disclosure judgments.

Net income was the most significantvariable with earnings trend next inimportance.

Consensus of auditors materiality anddisclosure judgments were affected byexperience and firm type.

Krogstad et al.(1984)

Partners, seniors,and auditingstudents

The role of financial and nonfinancialinformation on auditors and studentsmateriality judgments.

Auditors focused primarily on the effect onnet income, but they also used variousnonfinancial information to fine-tune theirjudgments.

Professional experience was a significantfactor.

Estes and Reames(1988)

CPAs The effect of differences in auditorspersonal characteristics on materialitydecision making and confidence inmateriality decisions.

Only two of the personal characteristicsstudied (age and employment in publicaccounting) produced significantdifferences.

Personal characteristics exerted greaterinfluence on materiality decisionconfidence.

Wong-On-Winget al. (1989)

Auditors The consequences of auditors perceptionsof management on subsequentmateriality thresholds judgments.

Auditors materiality thresholds weresignificantly associated with their inferencesabout management.


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TABLE 3 (continued)

Carpenter andDirsmith (1992)

Partners, managers,and seniors

The significance of the size of thetransaction, the impact on earningstrend, type of transaction, and auditorexperience on auditor materialityjudgments.

Whether auditor materiality judgments areshaped by other contextual factors.

The auditors materiality judgments wereaffected by the size of the item, its impacton earnings trends, and the type oftransaction.

Experience influenced the use of qualitativeinformation to augment quantitativeassessment of the item.

Carpenter et al.(1994)

Partners, managers,and seniors

The impact of culture and auditorexperience on the formation ofmateriality judgments.

Materiality judgments procedures wereinfluenced by the audit firms culture andexperience.

Whittington andMargheim (1993)

Managers The effect of materiality on externalauditors judgments about the extent ofthe use of the internal auditor function.

Materiality affected the assignment of testof control work to internal auditors.

Bernardi and Arnold(1994)

Managers andseniors

The study examined the influence ofqualitative factors on auditorsmateriality estimates.

The results indicated that materialityestimates were influenced by all of thequalitative factors examined.

Bernardi and Pincus(1996)

Managers Whether auditors quantitative materialityjudgments, based on ten common rulesof thumb, are affected by the prior riskof fraud expectations, the evidenceexamined, and post-audit risk of fraud.

Majority of auditors set their materialityjudgments within the rules of thumb.

Auditors prior fraud expectations were notrelated to their materiality judgments.

Amount of evidence examined or post-auditrisk of fraud did not lead to significantdifferences in materiality judgments.

Arnold et al. (2001) Partners, seniormanagers, andmanagers

The effect of client integrity, uncertaintyavoidance, and litigation on auditorsplanning materiality estimates.

Lower client integrity resulted in lowermateriality estimates.

Higher uncertainty avoidance andincreasingly litigious environment resultedin higher materiality estimates.


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TABLE 3 (continued)

Studies Participants Research Issue(s) Major FindingsLibby and Kinney

(2000)Managers Whether quantitatively immaterial earnings

overstatement misstatements will berecorded when the correction wouldcause reported earnings to fall belowanalysts consensus forecast.

Whether the implementation of SAS No.89 would increase correction ofquantitatively immaterial detectedmisstatements.

Misstatements are less likely to becorrected if they cause earnings to fallbelow analysts forecasts.

SAS No. 89 had no effect on the correctionof such misstatements.

Braun (2001) Partners andmanagers

Whether book-or-waive decisions areaffected by the relative audit feesreceived by the auditor, the clientsfinancial health, the subjectivity of theproposed adjusting journal entry (PAJE),the directional income effect of thePAJEs, and the individual /aggregatemateriality of the PAJEs.

The book-or-waive decisions were notaffected by the clients relative fees butwere affected by the clients financialhealth, the PAJEs subjectivity, and thePAJEs aggregate directional effect onincome.

Ng and Tan (2003) Managers The effect of the availability ofauthoritative guidance and theeffectiveness of the clients auditcommittee on auditors perceivedoutcome of auditor-client negotiationsconcerning quantitatively immaterialaudit adjustment that affects the clientsability to meet analysts forecast.

The auditors negotiation outcomeconcerning the audit adjustment is jointlyinfluenced by authoritative guidelines andaudit committee effectiveness.

On average, auditors rated the materialityof the audit adjustment to be moderate notlow, suggesting that the analysts forecastwas a factor in their materiality assessment.

Nelson et al. (2005) Partners andmanagers

Whether auditors decisions to bookdetected misstatements varies by the useof the cumulative (iron curtain) methodor current-period (rollover) method forevaluating detected misstatements.

The results indicate that across a number offactors (e.g., misstatement size, subjectivity,precision, and income effects, and whetherauditors document effects of their clientsquality of earnings) auditors are morelikely to book the misstatement under themethod that makes the misstatement appearmore material.


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TABLE 3 (continued)

Panel C: Studies that Involved Comparative GroupsJennings et al.

(1987)Auditors versus

judges/ lawyersThe degree of consensus on various

disclosure issues both within andbetween auditors and judges/ lawyers.

There were significant differences inmateriality across different cases.

There was no consensus within each of thegroups.

Jennings et al.(1991)

Auditors versusjudges/ lawyers(as proxy forusers)

Investigate the attitudes of auditors andjudges/ lawyers toward materiality anddisclosure.

The judges/ lawyers exhibited higherstandards of disclosure and expressed ahigh level of agreement for explicitquantitative standards on materiality.



Materiality level was manipulated at two levels: conservative materiality (based on the largerof 5 percent of income before taxes or 0.25 percent of net sales) and liberal materiality(based on the larger of 10 percent of income before taxes or 0.5 percent of net sales).Comparisons of prices generated by market participants indicated that undisclosed misstate-ments within materiality thresholds that are consistent with current audit practice (i.e., ator below materiality threshold) do not affect market prices, while large misstatements do.

DeZoort et al. (2003) examined whether the nature of the external auditors materialityjustification and the precision of the accounting issue underlying a proposed adjustmentaffected audit committee members support for an auditors proposed adjustment. Fifty-fivepublic company audit committee members participated in the study and were asked whetherthey supported the auditors position to record the proposed adjustment or managementsposition not to record the adjustment. The accounting issue involved an increase in theallowance for bad debts related to a customer bankruptcy subsequent to year-end wherethe adjustment could be measured precisely or imprecisely. In the quantitative-only mate-riality condition the auditor argued for an adjustment because it represented 4.6 percent ofthe companys pretax income (PTI), which, in their opinion, met their 5 percent of the PTImateriality threshold. In the qualitative, consequences-oriented condition, the auditor sup-plemented this argument by linking it to the interruption of the EPS trend and possiblestock price reaction. The results showed that the audit committee members provided greatersupport for the auditor when the auditors materiality justification included both quantitativeand qualitative consequences-oriented factors and when the accounting issue was subjectto precise measurement.

AuditorsMayper (1982) examined the consensus of auditors assessment of the materiality of

internal accounting control weaknesses (IACWs) during the planning stage of the audit.Thirty-eight senior auditors evaluated the materiality of 12 IACWs. Three independentvariables were manipulated: type of missing control (lack of segregation of duties or formalauthorization), type of asset affected (cash, dental supplies, and dental equipment), andmost likely dollar effect (80 percent or 20 percent of total dollars flowing through thetransaction area). The results indicated a moderate level of consensus for the materiality ofthe IACWs. The mean correlation across participants, within firms, and between firms was.45. There was also only a moderate level of agreement (73 percent) across participants asto which of the 12 IACWs were material. The results also suggest that auditors may needmore structured criteria to make IACW materiality judgments for public disclosure and tomeet other legal requirements.

Mayper et al. (1989) reanalyzed the results of Maypers (1982) experiment using moresophisticated statistical methods. They concluded that the auditors models indicated vari-ability in the importance attached to the three independent variables (type of IACW, typeof asset, and likely dollar effect) and that the auditors considered both qualitative andquantitative factors. For the majority of auditors, there was a significant interaction betweenthe type of IACW and the type of asset. Last, a majority of auditors showed significantconfigural processing.

Messier (1983) analyzed a number of characteristics of auditor materiality/disclosurejudgments. Twenty-nine audit partners were presented with 32 cases and asked to maketwo judgments: (1) the materiality of an inventory write-down and (2) the probability ofseparate disclosure in the income statement. Net income was varied at four levels, whileearnings trend, total assets, total inventories, and current ratio each were manipulated attwo levels. The results indicate that net income was significant for virtually all partners (27



out of 29) and earnings trend was significant for approximately half of the participants.The other three variables were generally not significant. Messier found that audit experienceand firm type were also significant. The less-experienced partners had lower materiality anddisclosure thresholds than more-experienced partners.16 Last, there was evidence of thresh-old differences between Big 8 and non-Big 8 auditors.

Krogstad et al. (1984) investigated the role of experience and the effect of financialand nonfinancial information on auditors materiality judgments. Audit experience was var-ied by using three groups of participants: audit partners, audit seniors, and auditing students.All participants completed 32 hypothetical cases requiring a materiality judgment for aproposed adjustment to the allowance for doubtful accounts. Three financial factors andfive nonfinancial factors were varied at two levels. The results show that the auditorsmateriality judgments were focused primarily on the effect of the item on net income. Theeffect on earnings trend was found to be second in importance, although it explained muchless judgment variance. The results also showed that auditors used nonfinancial informationin their materiality judgments; however, the relative impact of nonfinancial cues was con-siderably less than the effect of net income. There was no agreement as to which specificnonfinancial cues were important. Generally, there was no significant difference in measuressuch as consensus, consistency, and number of cues used between partners and seniors intheir materiality judgments. However, the students measures on these criteria differed sig-nificantly from partners and seniors.

Estes and Reames (1988) studied the effect of personal characteristics (experience,education, place of employment, frequency of materiality decisions, gender, and age) onauditors materiality judgments and their confidence in those judgments. Five hundredninety-six CPAs responded to a survey that requested materiality decisions on two scenarios:(1) the probability of the uncollectibility of a large account receivable from a single cus-tomer and (2) the amount of obsolete inventory that would cause auditors to qualify theiropinion in a situation where there is disagreement with management concerning the ad-justment. Only age and place of employment significantly affected the participants mate-riality judgments. Employment in public accounting appeared to raise the threshold foracceptance of likelihood of the collectibility of the large receivable (i.e., persons in publicaccounting would accept 8 percent higher probability before qualifying audit opinion). Placeof employment was not significant for the inventory decision. Older CPAs appeared to bemore conservative with respect to qualifying an audit opinion for obsolete inventory.

Wong-On-Wing et al. (1989) examined how auditors perceptions of management af-fected audit decisions and judgments, including materiality threshold judgments. One hun-dred seventeen auditors were asked to indicate the importance of disclosing a gain on saleof long-term assets and the amount of gain they considered material (as a percentage ofincome before taxes) for their disclosure decision. The results indicate that lower materialitythresholds were significantly associated with more dispositional inferences about manage-ment and that participants who inferred a disposition of management (i.e., perception ofmanagement attributes) made more homogenous materiality judgments than those that didnot. Lower materiality thresholds were also associated with a higher perceived importanceof disclosure.

Carpenter and Dirsmith (1992) examined hypothesized relationships between materi-ality judgments and the size and nature of early debt extinguishment transactions, client

16 In a recent working paper, Libby et al. (2005) show that auditors have lower materiality levels for correctingmisstatements that are recognized in the financial statements compared to similar disclosures in the footnotes.



earnings trend, and experience of the auditor. They also examined whether auditor mate-riality judgments were affected by other contextual factors such as management motivation.Two hundred twelve participants (partners, managers, and seniors) were randomly assignedto 12 hypothetical cases. The participants were asked to indicate how material the gainfrom the transaction was for each case. The results showed that the absolute dollar amountof the early debt extinguishment transaction, the size of the transaction relative to netincome and total assets, as well as their interaction effects, influenced the auditors mate-riality judgments. The size of item, particularly relative to net income, was an importantvariable. Participants also considered transactions that reversed downward earnings trendsto be more material than the transactions that did not. The nature of the transaction (i.e.,in-substance defeasance encouraged auditors to exhibit stricter materiality standards thanordinary debt extinguishment and bond refunding) was significant in the formation of theauditors materiality judgment. Experienced auditors or auditors with task-specific knowl-edge scrutinized materiality judgments relating to discretionary, nonroutine transactionsmore closely. Last, the results suggested that the use of qualitative contextual informationaugmented the quantitative assessment of materiality.

In a related study, Carpenter et al. (1994) focused on understanding how auditors formspecific types of materiality judgments as a social process influenced by their firms culture.The study involved 212 partners, managers, and seniors from Big 8 firms making materialityjudgments for hypothetical cases in relation to gains arising from debt extinguishmenttransactions. The results suggest that audit firm culture (organic, intermediate, mechanistic)and experience (partner, manager, senior) influenced the materiality judgment process.

Whittington and Margheim (1993) investigated the effect of inherent risk and materi-ality on external auditors reliance on internal auditors. Forty-two audit managers receiveda case containing information on a hypothetical companys internal auditors and accountsreceivable data. Materiality was manipulated at low and high levels based on the amountof the accounts receivable. The participants were asked to complete an audit time allocationsheet indicating the amount of time assigned to the internal and external audit staff. Theresults suggest that at the low materiality level the audit managers assigned more tests ofcontrol work to the internal auditors.

Bernardi and Arnold (1994) examined the influence of four qualitative factors (per-ceived client level of integrity and competence, level of moral judgment, firm, and expe-rience) on auditors materiality estimates. One hundred fifty-two managers and 342 seniorsfrom five Big 6 firms were presented with a case study and asked to indicate the smallestsize of an error in the inventory account that they considered to be material. Eighty-sevenpercent of the participants estimated materiality at or above the lower end of the anticipatedrange. The low integrity and competence groups estimates were not significantly differentthan the high integrity and competence groups estimates. There were significant differencesacross staff levels within individual firms. The variance of seniors estimates was higherthan the managers estimates, suggesting that increased experience produced more consen-sus. Last, the auditors level of moral judgment was significant for managersthere was areduction in their materiality estimate with an increase in Defining Issues Test scores.

Bernardi and Pincus (1996) examined how auditors quantitative materiality judgmentscompared to ten common rules of thumb used for establishing materiality. In addition, therelationship of prior expectation of risk of fraud, the amount of evidence examined, andpost-audit judgment of the risk of fraud were also investigated. One hundred fifty-two auditmanagers evaluated materiality and risk for an actual case (a restaurant) where materialinventory fraud was undetected. The materiality decision required the participants to specifythe size of a misstatement in the clients inventory from nine categories ranging from a



low of less than $50,000 to a high of more than $400,000 with each interveningcategory covering a $50,000 materiality range. All rules of thumb fell within the four middlecategories. The results indicate that a majority of auditors (75 percent) set their materialityjudgments within the rules of thumb identified by prior audit research. Auditors prior fraudexpectations were not related to their materiality judgments and the amount of evidenceexamined or post-audit risk of fraud did not lead to significant differences in materialityjudgments.

Arnold et al. (2001) examined the effect of client integrity ratings, culture (Hofstedes(1980) uncertainty avoidance scores by country), and the level of litigiousness (Windgates[1997] litigation index by country) on materiality estimates from an international perspec-tive. The sample included 181 auditors (25 partners, 67 senior managers, and 89 managers)from Big 6 auditing firms from Denmark, Ireland, Italy, The Netherlands, Spain, Sweden,and the United Kingdom. The audit scenario provided to the participants was the same asthe one used in Bernardi and Arnold (1994) and Bernardi and Pincus (1996). The auditorswere asked to estimate the size of error in the inventory account. The overall mean mate-riality for the seven European countries was significantly higher for the high-integrity groupthan for the low-integrity group ($408,200 versus $323,500). Hofstedes uncertainty avoid-ance factor was also significant. The average materiality estimate increased with an increasein uncertainty avoidance. The litigation variable was also significant, but contrary to ex-pectations, the materiality estimate increased with an increase in the level of litigiousness.

Libby and Kinney (2000) complement archival research on earnings management byexamining auditors judgments of a detected misstatement that is quantitatively immaterialto earnings.17 They conducted two experiments that manipulated the consensus EPS forecastand auditing standards (pre SAS No. 89 or the proposed SAS No. 89). In experiment 1,the auditor believed that managements allowance for inventory obsolescence was under-stated, resulting in overstated pre-audit earnings. Experiment 2 was identical to experiment1 except that the inventory overstatement was objectively determined (i.e., it related toinadvertent duplication of counts of the inventory on hand). The size and magnitude of themisstatement ($0.03 per share) that is immaterial by conventional materiality guidelineswas held constant across all experimental conditions. Audit managers from various officesof a Big 5 firm made judgments about likely magnitudes of reported EPS. Their resultssuggest that auditors expect a majority of clients to make full correction of quantitativelyimmaterial misstatements only if forecast EPS will not be missed. The results also indicatethat SAS No. 89 is likely to increase the number of immaterial corrections of misstatements,but only when the correction does not cause earnings to fall below the forecast.

Braun (2001) examined the impact of reward and risk factors on auditors propensityto waive proposed adjusting journal entries (PAJEs) that exceed materiality in client-auditorconflict situations. The factors manipulated included the clients relative fees as a share ofoffice fees, the clients financial health, the subjectivity of PAJEs, and the PAJEs aggregateeffect on income. One hundred fifty-five audit partners and managers from ten offices of aBig 6 firm participated. The participants completed eight independent cases by recordingtheir decision to waive or insist that the client book the PAJE. Materiality was specified at$1 million. The dollar value of each PAJE varied only slightly across cases with immaterialPAJEs ranging from $625,000 to $650,000 and material PAJEs from $1,235,000 to

17 The Libby and Kinneys (2000) study of SAS No. 89 shows the effect of private regulation of auditors byauditors, whereas SAB No. 99 and SOX applies public regulation to both managers and auditors. Thus, Libbyand Kinney (2000) were working with the limitation of audit regulation as opposed to financial reportingregulation.



$1,265,000. The results indicate that the three risk factors were significant in the auditorsjudgments while the reward factor (relative fees) was not significant. The results also in-dicate that auditors are more willing to waive PAJEs in excess of materiality when PAJEsincrease, rather than decrease, income in aggregate. Last, a higher percentage of participantswere willing to make non-GAAS decisions when the PAJEs were individually immaterialbut material in aggregate, than when the PAJE was a single material amount.

Ng and Tan (2003), using the same instrument as Kinney and Libby, conducted anexperiment in which auditors made a judgment about a proposed audit adjustment (thedifference between the client and proposed auditor revenue recognition method) that wasquantitatively immaterial but if fully booked, would cause the companys adjusted EPS tofall short of the analysts consensus forecast by one cent per share (i.e., a qualitative ma-teriality factor). The availability of precise authoritative guidance (absent versus present)and audit committee effectiveness (low versus high) were manipulated. One hundred thir-teen audit managers from various U.S. offices of Big 4 firms completed the task via theInternet. Results show that auditors perceived negotiation outcome is jointly influenced byauthoritative guidance availability and audit committee effectiveness. On average, auditorsrated the materiality of the auditor adjustment to be moderate; suggesting that they doconsider analysts forecast in their materiality assessments. Auditors materiality and en-gagement risk assessments did not vary systematically across experimental conditions.

Nelson et al. (2005) examined whether two quantitative materiality approaches (cu-mulative or current-period) used in practice affected auditors decisions to book adjustments.Under the cumulative approach, only misstatements detected in the current period are eval-uated while the current-period approach considers not only the misstatements detected inthe current period, but also the rollover effect of misstatements not booked in the priorperiod. Two hundred thirty-four partners and managers responded to eight cases that ma-nipulated qualitative and quantitative misstatement characteristics that prior research indi-cated may affect materiality judgments and adjustment decisions. Nelson et al. (2005) reportthat, across a variety of factors (e.g., misstatement size, subjectivity of the misstatement,precision, and income effect), auditors are more likely to require the client to book themisstatement under the materiality approach that makes the misstatement appear more ma-terial. They recommend that standard setters mandate auditors to adjust any misstatementthat is material under either approach.

Comparative StudiesJennings et al. (1987) conducted an experiment to assess the consistency with which

practicing auditors operationally define materiality as compared to judges/lawyers. Fivefinancial disclosure cases were used (write-off of obsolete inventory, a gain on the sale ofproperty, a lawsuit, a bribe, and discontinued product line) and participants were asked todetermine the dollar threshold at which the misstatement or nondisclosure of an item wouldbecome material. The findings show significantly different views of materiality existedacross cases and there was high variation between the groups in determining materiality.

In a related study, Jennings et al. (1991) investigated auditors and judges/lawyersattitudes toward materiality and disclosure judgments. They found that the attitudes ofjudges/lawyers differed substantially from auditors, with the judges/lawyers exhibitinghigher standards of disclosure. Additionally, the judges/lawyers expressed a high level ofagreement for explicit quantitative standards for materiality.



SummaryThe experimental research studies have produced a number of importan

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