Strategic Audit Materiality, Information Asymmetry, and Investment Efficiency

TLDR: In this article, the authors argue that the optimal materiality thresholds are asymmetrical and contingent on firms' reports and identify the conditions under which the investor may benefit from auditors' attestation services.

Abstract: Regulators have proposed materiality standards in order to mitigate audit costs resulted from the Sarbanes-Oxley Act of 2002. We argue that materiality thresholds are a two-edged sword. Restrictive materiality thresholds increase the cost of misstatements, thereby reducing the cost of information asymmetry and increasing investment efficiency. However, investors may be negatively affected by litigation friction resulted from noisy audit evidence and inefficient legal systems. This economic trade-off creates the demand for materiality thresholds. We find that the optimal materiality thresholds are asymmetrical and contingent on firms’ reports. Investors impose restrictive materiality if firms’ reports are optimistic; otherwise, the discrepancy between audit evidence and firms’ reports may be ignored. We further identify the conditions under which the investor may benefit from auditors’ attestation services. Our analysis implies that a mandatory materiality threshold imposed by the Act may lead to investment inefficiency.