The Effect of Auditors’ Incentives on the Assessed Materiality of Misstatements Identified in Previously Audited Financial Statements

Abstract

The correction and disclosure prominence of misstatements identified in previously audited financial statements depends largely on preparers’ and auditors’ materiality judgments. Despite being tasked with independent attestation, we posit that auditors’ incentives to avoid reputational and legal damage associated with more prominent misstatement disclosures align their disclosure preferences with those of management. Thus, we investigate the extent to which auditors’ incentives influence materiality judgments inherent in the misstatement disclosure. In this setting, and holding constant the magnitude of the misstatement, we find that auditors strategically assess misstatements as less material (i.e., misstatements are disclosed less prominently) when auditors face greater reputation risk, greater litigation risk, or have greater incentives to please important clients. Importantly, we find that these incentive effects manifest only when the materiality of the misstatement is less certain but not when the misstatement is clearly material. These findings suggest that the risk of litigation and reputational damage arising from the prominent acknowledgement of failed prior period audits aligns auditors’ materiality assessments with management’s preference for less prominent disclosure. These results provide important insights regarding auditors’ incentives.