Do auditors’ incentives affect materiality assessments of prior-period misstatements?

Abstract

We examine whether auditors' incentives affect materiality assessments of prior-period misstatements. Interviews with global network firm partners reveal consistency across firms in the process used to assess prior-period misstatements and highlight points in the process where judgments are most susceptible to auditors’ conscious or subconscious biases. In related empirical tests, we find that auditors assess misstatements as less material (i.e., misstatements are disclosed less prominently) when auditors face greater engagement risk (comprised of the risk of litigation and reputation loss) or have greater incentives to please important clients. These effects only occur when auditor incentives to avoid further litigation or client losses within an audit office are most salient and when the quantitative magnitude of the misstatement is in a range subject to greater professional judgment. Thus, we identify boundary conditions on the extent to which auditor incentives affect materiality judgments. Finally, additional tests suggest that neither local engagement partners nor professional practice partners are immune from these incentives. Our study should be informative to audit firms when designing and updating quality control structures.