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...Commission. We examine how materiality uncertainty affects the auditor's evaluation of audit evidence and manager's choice of earnings overstatement in a strategic auditing model where earnings misstatements also include unintentional system error. We find that when the expected cost of accepting financial statements that are materially misstated, which we refer to as an audit failure, is relatively large, an increase in materiality uncertainty results in a more conservative auditor evaluation of the audit evidence and a decrease in the amount of intentional overstatement. Alternatively, if the auditor's expected cost of extending audit procedures is relatively high, then an increase in materiality uncertainty results in a less conservative auditor evaluation of the audit evidence and an increase in the manager's earnings overstatement. The auditor also becomes increasingly conservative as the report increases when the information system is sufficiently noisy. Finally, when the expected cost of audit failure is large, the equilibrium audit risk can increase or decrease in materiality uncertainty despite the corresponding increase in auditor conservatism and decrease in intentional overstatement. Audit risk is the average probability of audit failure across all possible evidence outcomes.
Keywords: strategic audit; materiality; intentional overstatement; system of internal control
I. INTRODUCTION
The issue of materiality has recently garnered renewed attention from the Securities and Exchange Commission (SEC) and the accounting profession. In August 1999 the SEC issued Staff Accounting Bulletin No. 99 (SAB No. 99), Materiality. The purpose of this bulletin is not to adopt precise materiality standards, but to provide "guidance in applying materiality thresholds to the preparation of financial statements filed with the Commission and the performance of audits of those financial statements." Prior to 1999, auditors primarily referred to Statement of Financial Accounting Concepts (SFAC) No. 2, which defines a material misstatement as one such that "the judgment of a reasonable person relying on the information would have been changed or influenced by the ... misstatement" (paragraph 10). (1) The SEC has been concerned about public companies "abusing materiality guidelines in order to manipulate their reported earnings" (Journal of Accountancy 2000, 17-18)--that is, the influence of materiality on intentional earnings misstatement.
We examine, in a stylized, game-theoretic model, how uncertainty regarding the materiality threshold affects the interaction between an auditor and manager when the manager has the opportunity and incentive to intentionally overstate earnings. The manager chooses an amount of intentional overstatement. The auditor evaluates the audit evidence by accepting or rejecting reported earnings as materially correct. (2) In addition to intentional overstatements, reported earnings misstatements contain unintentional system errors. The manager has no private information about earnings and overstates earnings by biasing the information system report on earnings. The auditor observes reported earnings before evaluating the audit evidence. The report allows the auditor to update his expectation of materiality and unintentional system error.
While the SEC has identified materiality as a major concern, it is reluctant to provide precise guidance on the issue. Former SEC Chairman Arthur Levitt states that "materiality is not a bright-line cutoff of 3% or 5%. It requires consideration of all relevant factors that could impact an investor's decision." (See WSJ 1998.) (3) Neither the professional literature, common law, nor statutory law provides a precise materiality standard. However, the impact of a vague definition of materiality is unknown, particularly when intentional misstatements are possible. Previous studies in statistical auditing (see for example, Johnstone 1995), decision theory (see for example, Kinney 1975) and strategic auditing (see for example, Newman and Noel 1989) have assumed that a precise materiality standard exists.
Uncertainty about the materiality threshold (materiality uncertainty) arises from the judgmental nature of materiality and potentially creates additional tensions in the strategic interaction between the auditor and manager. While both the auditor and manager have expectations about the materiality threshold, the actual threshold is affected by qualitative factors such as the quality of accounting estimates. (4)
We find that the effect of materiality uncertainty on the equilibrium strategies depends on the auditor's expected cost of accepting materially misstated financial statements, which we refer to as an audit failure, relative to the expected cost of rejection. The expected cost of rejection includes the cost of extending audit procedures and the resulting loss of client goodwill or lucrative consulting contracts. Materiality uncertainty affects the auditor's evidence evaluation because it affects the updated probability of material misstatement (for a fixed earnings report and audit evidence). When the cost of audit failure is high relative to the cost of rejection, the auditor evaluates the evidence more conservatively because he has a greater incentive to avoid audit failure. (5) Greater uncertainty about the materiality threshold increases the updated probability of material misstatement, exposing the auditor to a greater risk of audit failure. Consequently, the auditor evaluates the evidence more conservatively for higher levels of materiality uncertainty, which, in turn, induces the manager to decrease the amount of intentional overstatement. The opposite effects occur when the cost of audit failure is relatively lower than the cost of rejection. In this case, the manager increases the amount of intentional overstatement and the auditor evaluates the evidence less conservatively.
Anecdotal evidence suggests that the auditor's expected cost of audit failure is typically large relative to the expected cost of extending procedures. Historically, the audit profession has focused on developing professional standards that promote the avoidance of audit failure. For example, the independence rules in the Code of Professional Ethics prohibit auditors from holding direct investments (even one share of stock) in their client firms (AICPA 2001). This reduces the auditor's incentive to evaluate the evidence less conservatively. In addition, damage awards against auditors for undetected material misstatements have been large. For example, Coopers & Lybrand settled its case with debenture holders of Miniscribe for $140 million and claims against Arthur Andersen for Enron are estimated to be in the billions of dollars. (6) Furthermore, legislative action has addressed the possibility of large expected rejection costs due to lucrative consulting contracts. The Sarbanes-Oxley Act, signed into law on July 30, 2002, prohibits corporations from hiring the same accounting firms for audits and most types of consulting services. (7) To the extent that the expected cost of audit failure is large relative to the expected cost of extending audit procedures, our model suggests that a fixed materiality standard would be detrimental in promoting the avoidance of audit failure.
Though increasing materiality uncertainty induces more conservative evidence evaluation and less intentional overstatement by the manager when the expected cost of audit failure is large, equilibrium audit risk can increase or decrease. Audit risk is the average probability of audit failure across all possible evidence outcomes. Increased auditor conservatism has an indirect negative effect on audit risk. However, this indirect effect may be overwhelmed by the direct positive effect of materiality uncertainty on audit risk for lower levels of materiality uncertainty. For lower levels of materiality uncertainty, the indirect marginal effect of a change in materiality uncertainty on audit risk is relatively small.
We also find that if the information system is sufficiently noisy, the auditor's evidence evaluation strategy becomes increasingly more conservative as reported earnings increases. This result holds despite the fact that higher earnings reports also imply that the expected materiality threshold has increased. If the system is sufficiently noisy, then increases in the report imply that the updated probability of an audit failure also increases, so the auditor evaluates the evidence more conservatively.
Our model most resembles that of Newman and Noel (1989) because we consider two strategic choices very similar to theirs. The auditor chooses an evidence evaluation strategy that is based upon sample information, and the manager chooses an amount of intentional overstatement that affects the distribution of audit evidence. There are two key differences between our model and Newman and Noel (1989). First, the manager in our setting is not limited to a binary choice of "no fraud" and "fraud" that the auditor finds "acceptable" and "unacceptable," respectively. As a result, an uncertain materiality threshold is not possible in their model. Second, we introduce an additional source of reported earnings misstatement--unintentional system error. Neither the auditor nor the manager knows the amount of misstatement due to unintentional system error. Further, the auditor in our model is concerned about total earnings misstatement consisting of intentional and unintentional error.
In Section II, we describe the players' strategies as well as the economic consequences of those strategies. In Section III we discuss our solution technique and determine the equilibrium strategies, while Section IV provides a comparative analysis of equilibrium strategies and audit risk. We present concluding remarks in Section V.
II. MODEL DESCRIPTION
When formulating an audit plan, the auditor considers the motivation and opportunity of the manager to commit fraud and whether potential misstatements materially affect financial statement fairness. After observing an earnings report and obtaining audit evidence, the auditor either accepts the earnings report as materially correct or rejects, extending audit procedures. As in previous strategic audit settings, the manager in our setting obtains benefits from intentional misstatements that are not identified by audit procedures. Consistent with this literature, we also assume that larger intentional misstatements increase both the likelihood that the misstatements are identified and the manager's expected penalty for misstatements if the auditor rejects. The auditor, on the other hand, must balance the expected cost of audit failure against the expected cost of extending audit procedures.
When we...
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