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Rikke Holmslykke Kristensen

Assistant Professor
Department of Entrepreneurship
and Relationship Management
University of Southern Denmark
Universitetsparken 1
DK-6000 Kolding
e-mail: rhkr@sam.sdu.dk
Judgment in an auditors
materiality assessments
Rikke Holmslykke Kristensen

Abstract
Materiality is considered a key audit concept both theoretically and in practice, but
regulation enforcers are concerned about the different views on materiality held by
preparers, auditors, users and enforcers, respectively, because different levels of ma-
teriality could result in users having a heterogeneous decision basis. This may seem
surprising considering that the rule-of-thumb is simply to calculate materiality as 5%
of net income before taxes. By analysing the prior audit materiality literature through
a comprehensive literature review, this paper identifies the important quantitative and
qualitative components of materiality judgments, which include both task, person and
interpersonal interactions in line with general audit judgment and decision-making
theory. This analysis offers an enhanced understanding of what the black box of pro-
fessional materiality judgment contains. The analysis will enable auditors to make more
homogeneous judgments; and it will allow external stakeholders, such as financial state-
ments users, legislators and standard setters, and regulation enforcers to achieve a bet-
ter understanding of the materiality concept and any divergent materiality decisions.

1. Introduction
Materiality is considered a key audit concept both in theory and in practice (Messier
et al. 2005; Corte 2010; EC 2011; Keune and Johnstone 2012; ESMA 2013). The con-
cept of materiality states that: Information is material if omitting it or misstating
it could influence decisions that users make on the basis of financial information
about a specific reporting entity. (IASB 2010: 84). In other words, materiality de-
pends on users (stakeholders) and what they find will influence the decisions they
make on the basis of financial information. Furthermore, the concept specifies that
materiality depends on quantitative concerns, e.g., the magnitude of the item, but also
on qualitative concerns, e.g., the nature of the item and the specific entity.

Standard setters, regulation enforcers and legislators like the European Commission
(EC) find the concept of materiality interesting as they are concerned about different

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views on the materiality concept held by preparers, auditors, users and enforcers (EC
2011; ESMA 2011; IAASB 2013; PCAOB 2013). The European Securities and Markets Au-
thority (ESMA) has expressed concern about apparently heterogeneous materiality as-
sessments made by auditors, resulting in different information in financial statements
and thus different decision bases for users (ESMA 2011; ESMA 2013). Both the Interna-
tional and the American standard setters, the IAASB and the PCAOB, are conducting
projects that aim to improve audit reporting on financial statements, recommending
more information in the auditors report about materiality (IAASB 2013; PCAOB 2013).

Considering the significant concern raised about the materiality issue by important
stakeholders such as the EC, ESMA, the IAASB and the PCAOB, it is surprising that
audit practitioners do not seem to consider that materiality is problematic. The Big-4
audit firms1 audit manuals prescribe a practical rule-of-thumb stating that auditors
should simply calculate materiality thresholds as 5% of net income before taxes (see,
e.g., audit manuals and Eilifsen et al. 2014: 84; Eilifsen and Messier 2015). This paper
claims that one reason for this discrepancy is that materiality is a matter of profes-
sional judgment, which besides quantitative calculations includes qualitative judg-
ments (Martinov and Roebuck 1998; Messier et al. 2005). The principle-based interna-
tional standards on auditing (ISA), primarily ISA 320 and 450 (IFAC 2009), consider
materiality a matter of the auditors professional judgment, which for users and other
stakeholders of financial statements is a misunderstood and opaque concept (Hol-
strum and Messier 1982; Patterson and Smith 2003; Edgley 2014).

Materiality assessment is considered a black box (Bernstein 1967: 90; Edgley 2014:
267) as it remains unknown specifically how the auditors judgment is made. Audit
theory, specifically audit judgment and decision-making theory, states that an audit
judgment consists of three important features; the audit task, the auditor himself and
the interaction between auditors and between the auditor and other stakeholders (Nel-
son and Hun-Tong 2005). Surprisingly, prior audit judgment research on the assess-
ment of materiality has mainly focused on materiality as a task (Nelson and Hun-Tong
2005: 45-46) rather than perceived materiality as a judgment that includes both a task,
a person and interpersonal interactions.

By analysing the prior audit materiality literature, this paper will identify the impor-
tant quantitative and qualitative components of materiality judgments, including task,
person and interpersonal interactions in line with the general audit judgment and
decision-making theory. The analysis is conducted through a comprehensive literature
review of materiality papers published in top 35 peer-reviewed accounting and audit-
ing journals (Hartzing 2014). This analysis will provide an enhanced understanding
of what the black box of professional materiality judgment contains. This under-
standing will give auditors a basis on which to make more homogeneous judgments.

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Judgment in an auditors materiality assessments

Furthermore, it will give external stakeholders, such as financial statements users,


legislators, standard setters, and regulation enforcers a better understanding of the
materiality concept and any divergent materiality decisions.

2. Theory
The concept of materiality is essentially an accounting term that has been defined by
the International Accounting Standards Board (IASB) as:

Information is material if omitting it or misstating it could influence decisions


that users make on the basis of financial information about a specific report-
ing entity. In other words, materiality is an entity-specific aspect of relevance
based on the nature or magnitude, or both, of the items to which the informa-
tion relates in the context of an individual entitys financial report (IASB 2010:
84) (authors emphasis).

Auditing adopted this definition of materiality. In auditing, the materiality concept is


used to design and perform an audit that provides reasonable assurance of detecting
misstatements that are of a sufficient magnitude to affect the judgment of reasonable
financial statement users, as it is not the goal to perform an audit that catches every
misstatement no matter how small (Eilifsen et al. 2014). Auditors assess materiality for
the financial statements as a whole and decide on performance materiality for signifi-
cant accounts or disclosures. This paper is concerned with the assessment of material-
ity for the financial statements taken as a whole.

Theoretically, materiality has been and continues to be a subject of importance and


interest (Messier et al. 2005; Corte 2010; Keune and Johnstone 2012; Eilifsen and
Messier 2015). The assessment of materiality at each of the phases of the audit is
considered a matter of professional judgment, i.e. a subjective matter (Martinov and
Roebuck 1998; IFAC 2009). Since it is a subjective judgment made by the auditor, the
IASB cannot specify a uniform quantitative threshold for materiality or predetermine
what could be material in a particular situation (IASB 2010: 84).

To date, five broad reviews of academic research of materiality (Holstrum and Messier
1982; Iskandar and Iselin 1999; Chewning and Higgs 2000; Messier et al. 2005; Vance
2011) have been published. Two of the reviews (Chewning and Higgs 2000; Vance
2011) are meta-analyses considering only numbers and effect sizes of materiality. These
will not be analysed further here. The remaining three reviews find that the most
important factor in establishing materiality is the percentage effect on net income. Fur-
thermore, all three reviews find that there are differences between users, preparers and
auditors regarding materiality thresholds and significant variance among auditors. Ac-
cording to Holstrum and Messier (1982), the variance among auditors can be explained

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by the absence of guidelines, and since auditors materiality judgments are diverse and
lack consensus, they result in confusion among users. Messier et al. (2005) also find
that authoritative guidance can have an effect on an auditors materiality judgment.
In addition, both Iskandar and Iselin (1999) and Messier et al. (2005) find that the
auditors personal characteristics, especially experience, are important and that audit
structure/firm type has a significant influence on the judgment made.

Besides being a matter of professional judgment, materiality is one among many judg-
ments in auditing where the outcome of the decision is not clear and where different
auditors can make widely different decisions in the same circumstances (Johnson et
al. 1989). The generally accepted goal for audit judgment research is to understand
and improve auditor decision-making (Johnson et al. 1989). Nelson and Hun-Tong
(2005), e.g., define judgment and decision-making research in auditing as; research
that uses a psychological lens to understand, evaluate, and improve judgments,
decisions, or choices in an auditing setting (p. 41). Audit judgment theory states that
a judgment in auditing consists of the audit task, the auditor himself and the interac-
tion between auditors and between the auditor and other stakeholders. These three
features are integrated in most auditing settings. Auditors perform different tasks to
form an overall audit opinion. This performance draws on the auditors various per-
sonal attributes, which have an influence on the outcome. In the process, the auditor
interacts with other auditors, clients and other participants in the financial reporting
process. These three features do not exist in isolation, though; effects of interper-
sonal interactions likely depend on personal attributes of the auditor who interacts
with others, and on what tasks (Nelson and Hun-Tong 2005: 61).

Nelson and Hun-Tong (2005) see assessment of materiality as a task. According to the
definition (IASB 2010: 84), auditing standards (IFAC 2009) and prior reviews of mate-
riality (Holstrum and Messier 1982; Iskandar and Iselin 1999; Messier et al. 2005), as-
sessment of materiality is a judgment. The prior reviews of materiality contain contra-
dictions, though. On one hand, they find the most important factor to be percentage
effect on net income, i.e., a quantitative measure and the practical rule-of-thumb; but
on the other hand, they find that significant differences between and among groups
exist, which should not be possible if a single measure determines the materiality
threshold. These differences between and among groups support the assumption that
assessment of materiality is not just a task, but also includes the person and interper-
sonal interactions.

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3. Method
This paper focuses on identifying qualitative and quantitative components in auditors
assessments of materiality. The components will be identified through a comprehen-
sive literature review of 179 papers published in top 35 peer-reviewed accounting and
auditing journals (Hartzing 2014). Each journal has been searched for the terms ma-
teriality and audit* or account* in the abstract. The 179 papers were manually
reduced to 73 based on relevance, and limiting the potential bias in the manual delimi-
tation by exposure to peer review. The delimitation was based on 4 criteria: 1) mate-
riality is mentioned in the abstract, but the paper is about another topic and does not
discuss materiality assessments (78 papers), 2) the paper replies to or discusses other
materiality papers not discussing the topic, but the methods used or discussing papers
not included in the review (20 papers), 3) book reviews or summaries of other papers
(4 papers) and 4) prior review papers (4 papers).

The relevant papers were analysed using a structured method listing the specific
components in auditors assessments of materiality (Hart 2010: ch. 6). Subsequently,
the components were categorised according to audit judgment and decision-making
theory; prior literature regarding each category was synthesised; and the components
that increase understanding of what the black box of professional materiality judg-
ment contains are enhanced. In this way, the components are deduced from earlier
research findings and thus theoretically justified.

As with all methods involving interpretation, the selection of components developed


from the literature could contain bias. In order to improve the validity and depend-
ability, i.e. the extent to which interpretations are compatible with other researchers
interpretations (Lincoln and Guba 1985), the paper has been exposed to peers from an
early stage and throughout the whole process. With respect to confirmability, i.e. the
extent to which an interpretation is supportable by data and represents a logical set of
conclusions given the specific reasoning, which is to be non-prejudiced and non-judg-
mental, results have been exposed to peers, and the methods used have been clarified
and made transparent.

4. Analysis
The results from the analysis of original research papers on materiality is presented
below in Table 1, where each component is attached to either the audit task, the audi-
tor or interpersonal interactions in audit judgment and decision-making theory (only
components included in three or more original materiality research papers are men-
tioned in Table 1).

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Table 1: Identified components and connection to the three features in audit judgment and decision-
making theory

Feature level Degree of consensus Component level Degree of consensus


Feature in general audit at feature level More precisely, at component level
judgment and decision- Number of papers materiality assessment is Number of papers
making theory (compared to total influenced by (compared to total
number of papers) number of papers)

quantitative client component 38 papers (52%)


industry the client is placed in 9 papers (12%)
nature of the item (asset type), includ-
ing objective or subjective amount 8 papers (11%)
Task 48 papers (66%)
impression of management/
management integrity 3 papers (4%)
control environment 3 papers (4%)
other identified errors 3 papers (4%)

audit firm type and culture 8 papers (11%)


auditors experience (number of years
in the audit industry, prior experience
Person 30 papers (41%)
with the client, the item or the relevant
rules) 7 papers (10%)
consensus among auditors 6 papers (8%)

materiality guidance 11 papers (15%)


intended use of the financial statements 5 papers (7%)
Interpersonal
26 papers (36%) agreement between auditor and user 4 papers (5%)
interactions
who are the users? 3 papers (4%)
materiality levels public 3 papers (4%)

4.1. The audit task


The audit task regarding materiality assessment is primarily divided between quanti-
tative measures and qualitative client characteristics. 52% of the papers reviewed con-
tain quantitative measures, indicating that it is essential for materiality assessments to
take the actual accounts under audit into consideration. The percentage effect on net
income is found to be the most researched quantitative measure, with earnings trend
or total assets as a distant second. Most of the earlier studies found that a 5% effect
on net income is the most commonly used quantitative benchmark, which is equal to
the practical rule-of-thumb (see e.g. Frishkoff 1970; Steinbart 1987; Chewning et al.
1998; Acito et al. 2009; Libby and Brown 2013).

Qualitative characteristics of the client also affect materiality assessments: an increase


in the clients or the industrys complexity should trigger a decrease in materiality
thresholds (Patterson 1967; Steinbart 1987; Blokdijk et al. 2003; Keune and Johnstone
2009), whereas an increase in the quality of the clients control environment should
trigger an increase in materiality thresholds (Krogstad et al. 1984; Mayper et al. 1989;
Blokdijk et al. 2003). Further findings show that the clients wish to meet earnings
thresholds affects the auditors decision to book or waive audit differences and hence
the materiality level (Ng 2007; Keune and Johnstone 2012). Auditors perception of man-

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agement and the presence of other identified accounting errors also have an effect on
materiality levels (Wong-On-Wing et al. 1989; Reckers and Wong-On-Wing 1991; Dutta
and Graham 1998; Arnold and Bernardib 2001; DeZoort et al. 2003; Acito et al. 2009).

Another part of the audit task is related to items-under-audit. The major finding here
is that auditors use lower materiality levels when the item-under-audit is subjective
(like accounting estimates) or a non-routine transaction. Findings are not completely
clear though, as an older study (Chewning et al. 1989) shows that the materiality level
decreases with the subjectivity of the item, while newer studies (Nelson et al. 2005; Ng
2007) report the opposite. This contradiction can be connected to auditors experience
or audit quality, but it could also be related to the validity of the studies. Chewning et
al. (1989) use evidence from real decisions, while Nelson et al. (2005) and Ng (2007)
use evidence from experiments, which indicates that the validity in the older study is
higher and that more emphasis should be placed on this study. Another angle is that
in the newer studies, the subjective items included estimates which the auditor would
not adjust unless the auditor was certain of the correct amount, whereas older studies
(Boatsman and Robertson 1974; Chewning et al. 1989; Mayper et al. 1989) were either ar-
chival studies or experimental studies not focusing on estimates. This indicates that the
degree of estimation that goes into the item is important in materiality assessments.

The audit task materiality assessment is related to the clients characteristics, either
quantitative or qualitative, including the specific items present at the client. Prior
research has focused extensively on the quantitative part and supports the 5% rule-of-
thumb, which indicates that calculation plays an important role when materiality is as-
sessed. But since a financial report contains many different numbers, it also supports
the assumption that materiality assessments are not just a standard calculation task
because they involve the need for an auditor to choose between the different numbers
in the accounts.

4.2. The auditor


In materiality assessment research, the auditor feature is primarily researched in terms
of auditor experience, consensus among auditors and the effect of the employing audit
firm. Regarding experience, this may be either experience in the audit industry (num-
ber of years as an auditor), prior experience with the client or the item, or experience
with the rules in question. In general, prior research found that the more experience
the auditor has, the higher the materiality threshold is assessed when the item under
audit is a simple item (Messier 1983). This was modified by Carpenter & Dirsmith
(1992), who found that experienced auditors had lower materiality levels than less ex-
perienced auditors when the item under audit was an unstructured item. This indicates
that with experience, an auditor is better able to see through the nature of the item-

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under-audit and to assess the proper materiality of the item. Conversely, higher risk or
greater uncertainty results in a lower materiality level (Newton 1977; Steinbart 1987).

Remarkably, prior research regarding consensus among auditors shows that no two au-
ditors are alike. They have different individual decision models (Moriarity and Barron
1976; Moriarity and Barron 1979), and there is a lack of consensus regarding material-
ity within the audit profession (Neumann 1968; Ward 1976; Firth 1979; Mayper 1982;
Jennings et al. 1987; Messier et al. 2005). This indicates both the difficulty of formulat-
ing an exact set of rules for materiality assessments, and the need to ensure that mate-
riality assessments are performed with the same minimum of quality regardless of the
auditor performing it to ensure that users have a homogeneous decision-making basis.

Another part of the auditor feature is the audit firm component (Nelson and Hun-Tong
2005: 48 and 53), which has been researched as the effect from Big-4 versus non-Big-4
audit firms (i.e. large versus small firms). Findings here are contradictory, with older
studies (Messier 1983; Chewning et al. 1989) finding that non-Big-4 audit partners set
lower materiality levels than Big-4 partners, while Blokdijk et al. (2003) and Keune and
Johnstone (2009) found the opposite. The evidence in the older studies are a mix of ev-
idence from experiments and from real decisions (archival studies), whereas the more
recent studies use solely evidence from real decisions. This indicates a higher validity
in the newer studies, but also a need for further research at firm level to see whether
the difference is caused by a change in audit quality in Big-4 and non-Big-4 audit firms
over the past 20 years or if other variables influence the result. One variable that may
come into play here is the enlarged pressure on auditors resulting from the financial
crisis, which could have made Big-4 audit firms more cautious.

Prior materiality research on the auditor feature shows that both experience and the
employing audit firm have an effect on materiality assessments. But since many other
attributes of the auditor, like individual characteristics and cognitive limitations, are
mentioned in audit judgment and decision-making theory, further research concerning
materiality and the auditor is needed. Prior research also shows a lack of consensus
among auditors supporting the assumption that materiality is a complex judgment.
This also supports the concern of standard setters, regulation enforcers and legislators
that auditors prepare materiality assessments heterogeneously, resulting in different
information in financial statements and thus different decision bases for users.

4.3. Interpersonal interactions


The feature entitled interpersonal interactions includes interactions between auditors,
between auditors and their clients, and between auditors and other participants in the
financial reporting process.

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Interactions between auditors and between auditors and their clients are an under-
researched aspect of materiality assessments. Interpersonal interactions between
auditors and other participants in the financial reporting process regarding materiality
assessment can be divided into two; on the one hand interactions between auditors
and users, on the other hand interactions between auditors and standard setters, regu-
lation enforcers and legislators.

According to Hicks (1964), who the users are should always be a consideration for the
auditor as the definition of materiality depends on the user. This assumption is gener-
ally supported by prior research (see e.g. Krogstad et al. 1984; Steinbart 1987; Dutta
and Graham 1998; Corte 2010) finding that reflections regarding the users and how the
auditors assume the users intend to use the financial statements are of importance to
the auditors choices in the materiality assessment procedure. Newer studies regarding
interactions between auditors and users (Jennings et al. 1987; Chewning et al. 1998)
found a lack of consensus among auditors and users contrary to the findings in Boats-
man & Robertsons (1974) older study, which reported that the judgmental processes of
auditors and users apparently do not differ in any important respect. This contradic-
tion can be related to the time periods during which the studies took place, but also to
the validity of the studies. Both Jennings et al. (1987) and Boatsman & Robertson (1974)
are using evidence from experiments, whereas Chewning et al. (1998) use evidence
from real decisions, which indicates that the validity of the newest study is higher.

Regarding interactions between auditors and standard setters, regulation enforcers


and legislators, prior research on assessment of materiality has focused on the need
for materiality guidance and a request to make materiality levels public. Most studies
are in favour of official materiality guidance as they find that this reduces the variabil-
ity in auditors materiality assessments, making them more equal (see e.g. Patterson
1967; Firth 1979; DeZoort et al. 2006; Pinsker et al. 2009). According to Selley (1984),
requiring auditors to disclose the actual materiality levels used will result in an inevi-
table convergence of materiality decisions in similar situations and industries over
time. Thus, market forces will react and revise materiality where political processes
have failed. This indicates that a requirement to disclose the actual materiality levels
used will solve challenges regarding the assessment of materiality.

The interpersonal interactions feature is important in audit judgment and decision-


making theory as auditors do not work in isolation but collaborate with clients, and
with other participants in the financial reporting process; thus, it is crucial to under-
stand these interactions. Prior materiality research reveals a lack of research into these
interactions. The research mentioned above was not focused on real interactions, but
rather on research involving or related to other stakeholders apart from the auditor.
E.g. in cited articles, it seems that the auditor does not need to interact with actual

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users to learn what will influence the decisions users make based on the financial
information. The lack of research could indicate that interactions are not important
when making materiality judgments, but it is highly probable that it should rather
be interpreted as an indication of the need for further research into materiality and
interpersonal interactions. This is supported by the fact that the definition of material-
ity hinges on the user.

5. Conclusion and implications


According to the practical rule-of-thumb prescribed by the Big-4 audit firms audit
manuals, auditors should calculate materiality thresholds as 5% of net income before
taxes. It is therefore surprising that important stakeholders such as the EC, ESMA, the
IAASB and the PCAOB problematise the materiality issue, and prior theory cannot
answer this question. Using audit judgment and decision-making theory, this paper
performed an analysis of prior materiality research to demonstrate that making a
materiality assessment is a complex judgment. Furthermore, the paper provides an en-
hanced understanding of what the black box of professional materiality judgments
contains. The materiality judgment embraces three features consistent with general
audit judgment and decision-making theory; the audit task, the auditor and interper-
sonal interactions.

The analysis has demonstrated that, besides a significant quantitative element con-
cerning the client in question, making a materiality assessment also includes signifi-
cant qualitative components. The quantitative component is mostly related to the
audit task, whereas the qualitative components are reflected in all three features of the
general audit judgment and decision-making theory. The audit task feature contains
a qualitative client-specific component and a component related to the specific item
under audit. The auditor feature contains experience and the characteristics of the em-
ploying audit firm, which are significant components as no two auditors are alike. The
interpersonal interactions feature is especially interesting in the materiality judgment
as the definition of materiality depends on users. This feature contains a user compo-
nent and an official guidance component. The analysis has revealed that there is a lack
of consensus between users and auditors, which indicates that auditors are unable to
foresee the needs of users or simply do not consider them when making the assess-
ment. This is an essential lack of consensus considering the definition of materiality,
which the auditors should be fully aware of as it can be crucial for users confidence
in the audit profession.

This analysis of prior audit materiality literature has implications for both theory
and practice. Regarding theory, the analysis extends existing literature by increas-
ing the understanding of the contents of the black box of professional materiality
judgments. This understanding is necessary to determine how auditors may achieve

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more homogeneous materiality judgments. Future research could determine if hetero-


geneous materiality judgments are a problem for audit report users and, if they are,
explore how to make auditors conduct more homogeneous materiality judgments.

Regarding practice, materiality assessments are a concern for several standard setters
and regulation enforcers, e.g. the EC, ESMA, the IAASB and the PCAOB. The analysis
confirms their concern as materiality is a complicated judgment involving many dif-
ferent components, but the analysis also gives a better understanding of the material-
ity concept and any divergent materiality decisions. One manner in which improved
information may be provided to the users of financial statements is by giving the
required information either directly in the auditors report as proposed by standard
setters (IAASB 2013; PCAOB 2013) or by providing more general information, which
the users may then elaborate through their own searches.

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Notes
1. The Big-4 audit firms are PwC, Deloitte, Ernst & Young and KPMG.

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