How does auditor planning materiality affect audit pricing of fair values and external valuation?

Abstract

In response to regulatory calls for research on materiality judgements and regulators discovering shortcomings in the audit of fair values, we provide the first empirical evidence on the impact of auditor planning materiality for fair value assets on the audit. Auditing standards require auditors to plan the audit considering the materiality of accounts based on both qualitative (i.e., nature of the account) and quantitative thresholds. The inherently risky, complex, and subjective nature of fair value assets render them a prime candidate to examine how auditor materiality judgments affect the audit. We also consider how external valuation of fair value assets affects the audit. We situate our study in the Australian real estate industry because fair value assets comprise the majority of assets in this industry. Using extensive hand-collected data spanning 2010 to 2020, our findings show that fair values below the quantitative materiality threshold of 10% are not related to audit fees. However, when fair value asset accounts are at least at the 10% threshold, they are positively associated with audit fees. In addition, we find that external valuation of fair value assets reduces the impact of material fair values on audit fees. Taken together, a primary implication of our results for regulators and policy makers, the audit profession, and literature is that auditors appear to be emphasizing quantitative materiality over qualitative materiality considerations even for accounts where qualitative considerations are warranted. Moreover, auditors also are relying on external valuations in their audit of material fair value assets, which raises implications for relying on the work of non-auditor specialists.