Auditors' interpretation of risk and the quality of analysts' earnings forecasts: Evidence from textual analysis of key audit matters

• Published date: 01 January 2024
• Author: Yan Sun,Yan Gao,Justin Jin
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/ijau.12323

ORIGINAL ARTICLE

Auditors' interpretation of risk and the quality of analysts'

earnings forecasts: Evidence from textual analysis of key audit

matters

Yan Sun

1

| Yan Gao

2

| Justin Jin

3

1

School of Management, Harbin Institute of

Technology, Harbin, China

2

Business School, Northwest Normal

University, LanZhou, China

3

DeGroote School of Business, McMaster

University, Hamilton, Ontario, Canada

Correspondence

Justin Jin, DeGroote School of Business,

McMaster University, 1280 Main St. W.,

Hamilton, ON L8S 4L8, Canada.

Email: jinjus@mcmaster.ca

Funding information

Chinese National Natural Science Foundation,

Grant/Award Number: 72072078; Humanities

and Social Sciences in the Ministry of

Education Foundation, Grant/Award Number:

18YJC790145

This study examines the impact of key audit matters (KAMs) on the quality of ana-

lysts' earnings forecasts in the emerging Chinese market. The nature of KAMs is audi-

tors' interpretations of the risk of material misstatements. Based on a quasi-natural

experimental environment created by the phased adoption of communicating KAMs

in the emerging Chinese market, we find that communicating KAMs can improve the

quality of analysts' earnings forecasts by increasing forecast accuracy and decreasing

dispersion. We also find that the extent of auditors' interpretations of the risk of

material misstatements is positively related to the quality of analysts' earnings fore-

casts. The positive relationship between the extent of auditors' interpretations of the

risk of material misstatements and the quality of analysts' earnings forecasts is more

pronounced for firms with less information transparency and less skilled analysts.

KEYWORDS

external auditor, interpretations, key audit matters, quality of analysts' earnings forecasts

1|INTRODUCTION

Analysts' high-quality earnings forecasts can guide investors to invest

rationally and facilitate the smooth operation of capital markets. Pub-

licly disclosed information serves as a crucial foundation for analysts'

earnings forecasts (Schipper, 1991). Studies show that the quality of

analysts' earnings forecasts can be significantly affected by various

types of information, such as other comprehensive incomes, intangi-

ble assets, earnings pre-announcements, social responsibility and

management discussion and analysis (MD&A) (Deol, 2013; Dhaliwal

et al., 2012; Hassell et al., 1988; Hope et al., 2016; Kravet &

Muslu, 2013; Matolcsy & Wyatt, 2006; Wang et al., 2017;

Waymire, 1986). Key audit matters (KAMs) communicated by auditors

can also affect the quality of analysts' earnings forecasts. In their addi-

tional analysis, Kong et al. (2022) demonstrate that communicating

KAMs can improve the accuracy of analysts' earnings forecasts by

increasing the public information available to analysts. Based on the

path through which communicating KAMs can improve audit quality,

the quality of financial reports and management disclosure, Hu

et al.'s (2022) empirical testing indicates that communicating KAMs

has a positive impact on the quality of analysts' earnings forecasts. It

is worth noting that Kong et al. (2022) did not specify the nature of

public information. Meanwhile, Hu et al. (2022) did not directly con-

duct a text analysis on the interpretations of the risk of material mis-

statements in KAMs. To address this problem, we propose that, as

public information provided by independent auditors, the nature of

KAMs is auditors' interpretations of the risk of material misstate-

ments. Auditors interpret significant risks, material management judg-

ments and significant events or transactions using KAMs. These

interpretations can provide evidence for analysts to accurately discern

the quality of financial statements, enabling them to make high-quality

earnings forecasts. Therefore, we explore the impact of KAMs on the

quality of analysts' earnings forecasts from the perspective of audi-

tors' interpretations of the risk of material misstatements.

KAMs are those matters that, in the auditor's professional judge-

ment, are the most significant in the audit of financial statements of

the current period (China's Ministry of Finance, 2016; IAASB, 2015).

We conclude from the following perspectives that the nature of

KAMs is auditors' interpretations of the risk of material misstate-

ments. First, audit report reform's motivation is to establish a channel

Received: 12 March 2022 Revised: 24 May 2023 Accepted: 24 May 2023

DOI: 10.1111/ijau.12323

Int J Audit. 2024;28:125–141. wileyonlinelibrary.com/journal/ijau © 2023 John Wiley & Sons Ltd. 125

through which auditors can interpret the risk of material misstate-

ments to the public. Information users have questioned the usefulness

of conventional audit reports; this is because they present only audi-

tors' opinions and not their interpretations of the risk-assessment pro-

cess behind the conclusion (Church et al., 2008; Humphrey

et al., 2009), despite that auditors have done much to assess and

respond to the risk of material misstatements. Therefore, regulators

have considered steps to expand the content of audit reports and

require auditors to communicate KAMs, thereby establishing a chan-

nel for auditors to interpret the risk of material misstatements to the

public. Second, regarding the regulation of communicating KAMs, the

areas that auditors should consider in determining KAMs are as fol-

lows: (1) areas of higher assessed risk of material misstatements or

significant risks, (2) significant auditor judgments relating to areas that

involve significant management judgments and (3) effect on the audit

of significant events or transactions that occurred during the period.

Therefore, matters identified as KAMs are generally those with a high

risk of material misstatements. The standard requires auditors to

describe why they identify a matter as a KAM, essentially requiring

auditors to interpret the risk of material misstatements or significant

risks, material management judgement and significant events or trans-

actions. Third, in practice, auditors interpret the risk of material mis-

statements in KAMs. They interpret inherent risk, significant volatility

and significant judgement involved in this matter when they describe

why they have identified a matter as a KAM.

China was an ideal setting for this study. The information envi-

ronment of the emerging Chinese capital market is not as strong as

that of the developed markets because of China's weak supervision of

information disclosure. Thus, as demonstrated by previous research,

KAMs are more valuable to information users in the Chinese capital

market than in developed markets where the information environ-

ment is already strong (Goh et al., 2019; Gutierrez et al., 2018; Lennox

et al., 2019; Liao et al., 2022; Wang et al., 2018; Wang & Li, 2019).

Therefore, it would be preferable to conduct extensive research on

KAMs in China.

On 23 December 2016, China's Ministry of Finance issued a

new auditing standard for communicating KAMs and proposed that

A+H-share firms adopt it since 2016 and that other A-share firms

adopt it since 2017. First, using a phased strategy, we adopt a

PSM-DID research design to examine the impact of communicating

KAMs on the quality of analysts' earnings forecasts. Second, we

measure the extent to which auditors interpret the risk of material

misstatements by extracting keywords and conducting a cross-

sectional analysis. The aim is to examine the relationship between

the extent of auditors' interpretations of the risk of material mis-

statements and the quality of analysts' earnings forecasts. Third, we

explore how analysts' abilities and information transparency affect

the relationship between the extent of auditors' interpretations of

the risk of material misstatements and the quality of analysts'

earnings forecasts.

Our empirical evidence yields several key findings. First, we find

that communicating KAMs can improve the quality of analysts' earn-

ings forecasts by increasing forecast accuracy and reducing dispersion.

Second, analysts' forecasts are more accurate and less dispersed when

auditors' interpretations of the risk of material misstatements are

greater. This demonstrates that the extent of auditors' interpretations

of the risk of material misstatements is positively related to the quality

of analysts' earnings forecasts. Third, the positive relationship

between the extent of auditors' interpretations of the risk of material

misstatements and the quality of analysts' earnings forecasts is more

pronounced for firms with less information transparency and less

skilled analysts.

This study extends previous research and contributes to the lit-

erature in several ways. First, we contribute to research on KAMs.

Previous studies have focused on their number, length, type and

readability of KAMs (Klevak et al., 2021; Kong et al., 2022; Liao

et al., 2022; Wang et al., 2018; Wang & Li, 2019). We believe that

the nature of KAMs is auditors' interpretations of the risk of

material misstatements. Therefore, we extend previous research by

measuring the extent of auditors' interpretations of the risk of

material misstatements and by examining their impact. Second, we

contribute to research on how KAMs affect analysts' earnings fore-

casts. Unlike Kong et al. (2022) and Hu et al. (2022), we believe that

auditors' interpretations of the risk of material misstatements can

help analysts discern the quality of financial statements and, thus,

improve the quality of analysts' forecasts. Third, we identify the

conditions under which auditors' interpretations of the risk of mate-

rial misstatements improve the quality of analysts' earnings forecasts

in emerging markets.

The remainder of this paper is organized as follows. Sections 2

and 3present the literature review and hypotheses, respectively.

Section 4explains the sample selection process and research design.

Section 5presents the empirical results, and finally, Section 6con-

cludes the paper.

2|BACKGROUND AND LITERATURE

REVIEW

2.1 |Information environment in the emerging

Chinese capital market

Over more than 30 years, the Chinese capital market has made

remarkable progress. However, the supervision of information disclo-

sure in the Chinese capital market remains not as strong as in devel-

oped markets, resulting in low transparency and quality of information

disclosure in the Chinese capital market (Ke & Zhang, 2020; Liu &

Tian, 2012). First, the penalty for the information disclosure infrac-

tions in the Chinese capital markets was not severe. China has had no

perfect investor protection system for a long time. Most listed firms

with information disclosure infractions were penalized with small cash

fines (the total amount was between 100,000 and 600,000 yuan).

These minor penalties are not effective in encouraging listed firms to

improve their information disclosure.

Second, in the Chinese capital market, more than 90% of listed

firms are audited by domestic accounting firms whose audit quality

126 SUN ET AL.