Auditor, client and investor consequences of the enhanced auditor's report

• Published date: 01 April 2022
• Author: Mazen Al‐mulla,Michael E. Bradbury
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/ijau.12255

ORIGINAL ARTICLE

Auditor, client and investor consequences of the enhanced

auditor's report

Mazen Al-mulla

1

| Michael E. Bradbury

2

1

PwC, Auckland, New Zealand

2

Independent Researcher, Auckland,

New Zealand

Correspondence

Michael E. Bradbury, Independent Researcher,

Auckland, New Zealand.

Email: bradwork2021@gmail.com

Funding information

Massey University Research Fund

This study examines the impact of the enhanced auditor's report (ISA 701) in

New Zealand on audit effort (audit fees and auditdelay); audit quality (absolute abnor-

mal accruals); investors (value relevance) and client disclosures (inventory). A notable

feature of the enhancedreport is a section termed Key Audit Matters (KAMs).The pur-

pose of a KAM is to disclose financial reporting risks, thereby enhancing the communi-

cation value of the audit report. We find that by examining audit fees and value

relevance, both auditors and investors price the information in KAMs (in both the first

year of KAM reportingand in the prior year). We note that client disclosures related to

inventory are greaterfor firms with inventory KAMs than firmsnot reporting inventory

KAM, in both the firstyear of KAM reporting and in the prior year.

KEYWORDS

audit expectation gap, audit fees, audit report, auditing standards, disclosure, earnings

management

1|INTRODUCTION

The audit expectation gap is the difference in perception of the audi-

tor's responsibilities between the public (including financial statement

users) and the auditor.The traditional audit report is consideredto be a

major contributor to the audit expectation gap (Asare & Wright, 2012;

Gray et al., 2011; Porter et al., 2012). Financial statement users view

the audit report as a pass/fail document of little relevance (Mock

et al., 2012) or as symbolic with little communication value (Church

et al., 2008). It is also claimed that the standardised form and language

of the traditional audit report detracts from its usefulness (Humphrey

et al., 2009). In responseto these issues the International Auditingand

Assurance StandardsBoard (IAASB) issued a suite of auditingstandards

designed to enhance communication between the auditors, investors

and those charged with governance and promote international consis-

tency in auditor reporting(IAASB, 2015).

New Zealand closely followed the IAASB with new audit report

requirements coming into effect for financial statements ending on or

after 15 December 2016. The most significant change in the

‘enhanced auditor's report’is a new section termed Key Audit

Matters (KAMs). It is envisioned that KAMs will entail greater

transparency about the audit, promote the relevance of the audit and

assist stakeholders in understanding the financial reporting risks of

the entity (XRB-FMA, 2017). The implementation of KAMs has been

described as ‘the biggest change to auditing standards and the audit

report since the introduction of the clarity standards in 2004’

(KPMG, 2017).

The requirement to report KAMs, however, has not received

unanimous support from all stakeholders. Deloitte (2013) and

EY (2016), for example, express reservations that KAMs will increase

auditor liability and associated legal costs. Others argue that share-

holders are already aware of the major risks facing the firm

(CAANZ, 2016). Hence, the new audit report requirements may well

be redundant. Therefore, whether the enhanced auditor's report has

achieved its stated objectives is an open empirical question.

Requirements to enhance the audit report are a global trend.

1

Recent archivalresearch examines the consequencesof expanded audi-

tor's reportin several jurisdictions.

2

With regard to key auditmatter dis-

closures, Bédard et al. (2019) examine Justification of Assessments in

France.Gutierrez et al. (2018), Reid et al. (2019) andLennox et al. (2021)

examine the UK's adoption of Risk of Material Misstatements.

3

The

adoption of KAMs is examined in Australia (Wei et al., 2017), Hong

Kong (Liao et al.,2019) and New Zealand (Li et al., 2019). Li et al. (2019)

and Reid et al. (2019) find that KAMs are associated with better

Received: 21 August 2018 Revised: 5 July 2021 Accepted: 15 November 2021

DOI: 10.1111/ijau.12255

134 © 2021 John Wiley & Sons Ltd Int J Audit. 2022;26:134–150.wileyonlinelibrary.com/journal/ijau

abnormal accruals (accounting quality). The relation between KAMs

and abnormal accruals is not significant in Gutierrez et al. (2018),

Bédard et al. (2019)and Liao et al. (2019).

Utilising a sample of 132 New Zealand listed issuers, we examine

the consequences of the enhanced auditor's report on audit fees,

audit delay, audit quality (abnormal accruals), financial statement users

(value relevance) and client disclosures. Using a pre-post research

design, the initial disclosure of KAMs does not incrementally affect

audit fees, audit delay or absolute abnormal accruals. We also develop

a framework to classify the information in the KAMs. This enables us

to undertake cross-sectional tests. We find the information in the

KAMs is positively related to audit fees in the year KAMs are intro-

duced and in the prior year. That is, the underlying financial reporting

risks described in the KAMs are priced by the auditor.

In terms of value relevance, the nature of the information con-

tained in the KAMs is reflected in investor uncertainty with regard to

net income (but not book value of equity) in the year prior to KAMs

being reported. The uncertainty in net income is no longer present in

the year KAMs are first reported. This might be explained by ISA

(NZ) 701 requiring disclosure of how the auditor addressed the KAM

issue.

4

By way of explanation, we find that client financial statement

disclosures relating to inventories are higher for inventory KAM firms

than non-inventory KAM firms in both the first year of reporting of

KAMs and in the prior year. Hence, investors will have been aware of

the financial reporting risks in the year prior to the KAM being

reported.

New Zealand is an appropriate setting to examine this issue for

several reasons. First, listed issuers in New Zealandare required to fol-

low International Financial Reporting Standards (IFRS) that are well

enforced (Bradbury & Scott, 2020), and New Zealand auditors follow

International Standards on Auditing (ISA). Furthermore, 85% of our

sample has Big4 auditors, which are part of global and national net-

works where knowledge,staff and resources are shared (Carson,2009).

The external validityof our sample is relevant for jurisdictionsthat have

adopted IFRSand ISA. Hence, this study providesevidence for standard

setters and regulators on the extent to which ISA 701 (the enhanced

audit report standard)achieves its intended objectives.

Second, most prior studies examine KAM reporting for large

firms, where the information environment is richer, and this may have

contributed to the non-significant results. For example, in the UK the

reporting of KAMs applied to firms with premium listing on the

London Stock Exchange. Liao et al. (2019) also report the conse-

quences of KAM reporting for a wide range of firms from Hong Kong.

However, these firms are much larger than the firms in our sample.

Furthermore, the scalability of auditing standards to ‘less complex’

entities is currently a major issue internationally (IAASB, 2019).

Hence, our study is likely to provide more appropriate evidence on

the consequences of KAMs for jurisdictions that are expanding the

reporting requirements of ISA 701 to smaller and less complex firms.

Third, while studies try to mitigate confounding effects, it may

not be possible to fully isolate the information on financial statement

risk reported in KAMs. For example, the UK adoption of KAM

reporting occurred concurrently with potential confounding events,

such as (1) a revision of the audit committee report, (2) the replace-

ment of the business review in the annual report with a strategic

report and (3) a requirement for directors to state the annual report is

‘fair balanced and understandable’(Reid et al., 2019). Our sample

does not have these confounding events. However, we acknowledge

that our study is also subject to confounding events. For example, as

discussed in the next section, KAMs were only one of the innovations

made to the new audit report in New Zealand. In this situation,

research from multiple jurisdictions and different event periods can

increase the statistical power of the results.

A fourth advantage of our data is that we have a small number of

early adopters in the sample and we are, therefore, able to align the

initial reporting of KAMs over multiple reporting years. This mitigates

the omitted variable problem that can be potentially severe when

event dates are aligned with the calendar year.

5

The major contribution of this paper is to provide evidence on

the reporting of KAMs in a new setting. Prior research mostly sup-

ports the view that the introduction of KAMs had little impact. How-

ever, this null result might be attributable to the rich information

environment of large firms and confounding events rather than the

low information content of KAMs. Our study contributes to prior

research, because evidence from multiple settings is necessary to

increase confidence in prior results, especially where the null hypothe-

sis is not rejected.

A second contribution is that we develop a framework to mea-

sure the information contained in the KAMs. Both the data and

description of KAMs were provided to us from a survey undertaken

by the audit standard setter (New Zealand Auditing and Assurance

Standards Board) and the regulator (Financial Markets Authority). We

use these descriptions to classify KAMs into whether they are unique

to the sample, auditor or industry. We also classify KAMs as to

whether they relate to financial statement line items (account KAMs)

or relate to transactions (e.g., business combinations) or conditions

(e.g., internal controls).

This paper is organised as follows. Section 2 provides background

to the reporting requirements of the enhanced auditor's report in

New Zealand. Section 3 develops the hypotheses. Section 4 describes

the research designs employed. Section 5 describes the sample selec-

tion procedures and provides descriptive statistics. Section 6 presents

the results. Section 7 is a conclusion and discussion.

2|BACKGROUND

The 2008 global financial crisis spurred regulatory bodies such as the

International Audit and Assurance Standards Board (IAASB, 2015), the

Public Company Accounting Oversight Board (PCAOB, 2017) and the

Financial Reporting Council (FRC, 2014) to initiate projects designed

to enhance the communication value of the audit report (Simnett &

Huggins, 2014). While there are differences in jurisdictions, the pro-

posals are broadly similar. The IAASB, starting with its ‘Clarity Pro-

ject’, engaged in a process of revising auditing standards with the aim

of improving audit quality. KAMs were a response to investors'

AL-MULLA AND BRADBURY 135