The importance of quantifying uncertainty: Examining the effects of quantitative sensitivity analysis and audit materiality disclosures on investors’ judgments and decisions

In recent years, standard setters worldwide have considered how to enhance financial statement users’ understanding of the estimation uncertainty contained in many financial statement items. Our study examines two disclosures expected to help investors evaluate the reliability of subjective fair value estimates: a quantitative sensitivity analysis (QSA) and the auditor’s quantitative materiality threshold. Using an experiment, we predict and find that investors judge the reliability of a reported estimate to be higher and are more willing to invest when a QSA disclosure is indicative of low sensitivity (i.e., greater precision) compared to high sensitivity (i.e., greater imprecision), but only if the auditor’s materiality threshold is also disclosed. When materiality is not disclosed, investors fail to recognize differences in reliability between the two levels of sensitivity, even though the amount of imprecision in the low sensitivity condition represents a fraction of materiality, while in the high sensitivity condition, this amount exceeds materiality multiple times over. Furthermore, when both disclosures are absent and only a qualitative description of sensitivity is provided—as required by current standards—investors perceive the disclosure to be relatively uninformative and respond to the ambiguous disclosure by decreasing their willingness to invest. The results of our study should be informative to accounting and auditing standard setters as they continue to consider the types of disclosures that may help investors understand the most complex and subjective aspects of financial reporting.