THE IMPACT OF THE FINANCIAL CONDITION OF THE FIRM ON AUDITORS' MATERIALITY/DISCLOSURE JUDGMENTS: AN EXPERIMENTAL STUDY (DISCLOSURE JUDGMENTS)

Prior research examining the relative importance of factors that enter into materiality judgments has indicated that the profit-related factors (i.e., the income statement factors) were relatively more important than the balance sheet factors in the formulation of final materiality judgments. The effect of the judgment item, irrespective of its nature, on the profit-related factors (i.e., net income) captured the largest proportion of judgment variability in all studies. The effect of the judgment item on the balance sheet factors produced mixed results. A major problem with prior research investigating factor importance in materiality judgments, however, was that the investigation has been carried out within a healthy-firm framework. There are indications that when the firm is financially trouble-free, auditors tend to focus on the effect of the judgment item on the profit-related factors in formulating materiality judgments. If the firm is experiencing financial difficulties, however, the balance sheet factors become important components in materiality judgments. There are also indications that disclosure standards are more stringent for financially-troubled firms.; The objectives of this study were to examine the impact of the financial condition of the firm: (1) on materiality judgments, (2) on the relative importance of factors that enter into materiality judgments, (3) on disclosure judgments, (4) on materiality thresholds, and (5) on materiality/disclosure judgment consensus. The financial condition of the firm was operationalized using four of Mutchler (1984) problem company criteria.; The results indicated that the financial condition of the firm affects the relative importance of the factors that enter into materiality judgments. The profit-related factors were more important under strong financial conditions than under weak financial conditions. The balance sheet factors were more important under weak financial conditions than under strong financial conditions. These results explain the mixed results in prior research, particularly those related to the importance of the balance sheet factors in materiality judgments. The results also indicated that disclosure standards were more stringent under weak financial conditions. The financial condition of the firm did not appear to affect materiality thresholds. Finally, the financial condition of the firm appear to affect the level of judgment consensus. The introduction of unfavorable information about the firm (i.e., financial trouble) caused the level of judgment consensus to decline. (Abstract shortened with permission of author.).