The Importance of Quantifying Uncertainty : Examining the Effects of Sensitivity Analysis and Audit Materiality Disclosures on Investors’ Judgments and Decisions

The amount of estimation uncertainty contained in financial statement items may be obscured from investors, given that all estimates, regardless of their imprecision, are reported as precise figures on the face of the financial statements. Our study examines two disclosures expected to help investors evaluate the reliability of subjective fair value estimates: a quantitative sensitivity analysis and the auditor's quantitative materiality threshold. Using an experiment, we predict and find that when both a quantitative sensitivity analysis and a materiality threshold are disclosed, investors judge the reliability of a reported estimate to be significantly higher when it is relatively precise (i.e., low sensitivity) compared to imprecise (i.e., high sensitivity). However, 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 the amount of imprecision in the high sensitivity condition exceeds audit materiality multiple times over. Furthermore, when both disclosures are absent and only a qualitative description of sensitivity is provided, investors appear to assume the worst and judge the estimate's reliability to be lower than when the sensitivity analysis is quantitative in nature