Early debt extinguishment transactions and auditor materiality judgments: A bounded rationality perspective

Abstract

Critics have characterized bond refundings and in-substance defeasances as managerial tactics that artificially inflate reported earnings during periods of rising interest rates, and various accounting and auditing pronouncements suggest that such transactions be subjected to more stringent materiality criteria. Extending work that interprets audit judgment formation as a cognitive phenomenon, this study examines hypothesized relationships between materiality judgments and the size and nature of these debt transactions, client earnings trend, and experience of the auditor. Proceeding beyond this cognitive orientation, the study then interprets judgment formation as a social-behavioral phenomenon by examining the applicability of the bounded rationality perspective to auditing. The results obtained from an experiment involving 212 practitioners at the ranks of partner, manager and senior suggest that the size of item, earnings trend and nature of transaction influence materiality judgments, as mitigated by an auditor's experience. Further, quantitative and qualitative, interview-based evidence suggests the usefulness of viewing audit judgment processes as boundedly rational, social-behavioral phenomena.