Measuring Stockholder Materiality

Abstract

SYNOPSIS: The Securities and Exchange Commission (SEC) has recently expressed concern that auditors' use of materiality allows misstatements to go uncorrected. Auditors do not require their clients to correct the financial statements for immaterial misstatements. According to the professional standards, an immaterial misstatement is defined as one that has no effect on a typical or average users decisions. However, little is known about users' materiality perceptions, especially in relation to common materiality measures used by auditors, such as the percentage effect on earnings or the percentage effect on sales. To help clarify what is considered to be material from the stockholders point of view, we investigate empirically various quantitative factors that stockholders consider important in assessing whether earnings are materially misstated. For each factor, we identify a materiality threshold where potential misstatements exceeding the threshold are material. Keywords: materiality; threshold; earnings-response; auditing. INTRODUCTION Auditors' applications of materiality are critical to earnings quality. The Securities and Exchange Commission (SEC) has recently expressed concern that liberal materiality standards might result in financial statements that are not fairly stated. Auditors do not require their clients to correct the financial statements for immaterial misstatements. Former SEC chairman, Arthur Levitt, contends that auditors do not sufficiently prohibit client firms from fabricating earnings in an attempt to attain earnings projections, which in turn may affect the firm's stock price. Levitt (1998) says, markets where missing an earnings projection by a penny can result in a loss of millions of dollars in market capitalization, I have a hard time accepting that some of these so-called non-events simply don't matter. According to the Financial Accounting Standards Board (FASB), Statement of Financial Accounting Concepts (SEAC) No. 2 (AICPA 1984), an immaterial misstatement is defined as one that has no effect on a typical or average user's decisions. For example, an immaterial misstatement, if known to a stockholder, is not expected to result in a security price change. To help clarify what is considered to be material from the stockholder's point of view, we investigate empirically various quantitative aspects of earnings that stockholders consider important in assessing whether earnings are materially misstated. For each quantitative factor, we identify a materiality threshold beyond which potential misstatements are material. Auditors have received little guidance in choosing materiality thresholds. Few court cases have rendered judgments defining materiality and definitions of materiality are not precise. The SEC defines materiality similarly to SFAC No. 2. Rule 1-02 of Regulation S-X describes a material misstatement as information...about which an average prudent user ought reasonably be informed. The professional literature provides no quantitative guidelines and consequently, the choice of materiality involves auditor judgment. The SEC issued Staff Accounting Bulletin (SAB) No. 99 (SEC 1999) to provide more guidance concerning auditors' materiality decisions. However, SAB No. 99 does not suggest that all misstatements should be found and corrected, regardless of their size, because the related benefits do not exceed the costs. As in SFAC No.2 and Rule 1-02, SAB No. 99 does not provide any quantitative criteria for determining materiality. In practice, auditors use materiality to identify the necessary precision of audit tests and to identify the amount of misstatement that requires adjustment in the financial statements. Auditors consider the size of misstatement that would cause a material misstatement of earnings and/or a material misstatement of a particular account. Prior research has identified three quantitative measures that auditors commonly use to determine materiality of an earnings misstatement. …