The Materiality of Accounting Errors: Evidence from SEC Comment Letters and Implications for Research Proxies

To gain unique insights into the materiality judgments of financial statement preparers, we examine firms’ responses to SEC comment letters that inquire about accounting error materiality. We document that preparers typically use multiple quantitative benchmarks in their materiality analyses and frequently acknowledge departures from the traditional “5 percent of earnings” rule of thumb when deeming errors immaterial. These departures are explained by asserting that the benchmark hurdle is abnormally low and/or that the error does not consistently exceed the hurdle across affected periods. We also document substantial variation in the extent to which qualitative factors are mentioned as considerations. Leveraging these comment letter insights, we propose and test a parsimonious model of materiality judgments that uses data commonly available to researchers. Our tests affirm that a materiality benchmark based on the three-year average of earnings predicts actual materiality judgments better than quantitative proxies used in prior research. Further, we find that including both a control for financial statement misclassification errors and the existence of multiple errors dramatically improves model explanatory power. Our findings shed new light on firms’ complex and nuanced materiality evaluations and help to improve the materiality proxies used in empirical archival research.