Bank Directors’ Perceptions of Expanded Auditor's Reports

• Published date: 01 July 2016
• Author: Pran Krishansing Boolaky,Reiner Quick
• Date: 01 July 2016
• DOI: http://doi.org/10.1111/ijau.12063

Bank Directors’Perceptions of Expanded Auditor’sReports

Pran Krishansing Boolaky

1

and Reiner Quick

2

1

Griffith University

2

Darmstadt University of Technology and University of Southern Denmark

Subsequent to thefinancial crisis, standardsetters developed suggestionsfor enhancing the audit function,in order to

increase financial stability. One related idea is to expand theaudit report disclosed to the public,to ensure that it is fit

for purpose.This study investigates the impactof expanded audit reports,namely information on the assurance level,

materialitylevels and key audit matters (KAM),on bank director perceptionsof the quality of the financialstatements,

the audit and the audit report, as well as on their credit approval decisions. We conduct an experiment involving a

sample of 105 bank directors and use ANCOVA to determine the predictors of bank director perceptions and

decisions. Our findings suggest that disclosing the assurance level has a significantly positive impact. In contrast,

we cannot demonstrate a material effect of expanding the audit report to include the materiality level or KAM. As a

consequence, standard setters should carefully analyse the effect of additional information before making decisions

on expanding thecontent of the audit report. Such expansions are not necessarilyperceived as useful by stakeholders.

Key words: audit report, assurance level, key audit matters, materiality level

1. INTRODUCTION

External auditing and assurance are key contributors to

financial stability, trust and market confidence, because

auditors provide an independent professional opinion on

whether the financial statements give a true and fair view.

In order to enhance the reliability of financial statements

which are used by investorsto make decisions, the auditor

issues an audit report, which investors use as one basis for

making sound judgments,which in turn promotes efficient

capital markets. Hence, the basic function of statutory

audits is to reduce agency costs. However, there are also

information asymmetries (Jensen & Meckling, 1976)

between auditors and the users of the audit report, i.e. the

auditor has more, better and earlier information on the

performance of the audit and its results than the users

(Antle, 1982,1984; Baiman, Evans & Noel, 1987;Ballwieser,

1987; Ewert, 1990; Baiman, E vans & Nagarajan, 1991). The

auditor (i.e., the agent) can reduce such information

asymmetries by providing additional information to the

principal(i.e., the addressees of the audit)(Ng, 1978; Ewert,

1993; Göbel,2002) and the audit report is a potentialmeans

by which such information could be made available.

The audit findings and conclusions are presented in the

auditor’s report which is the auditor’s primary means of

communicating with an entity’s stakeholders. Currently,

the auditor’s report is short and standardized.It describes

the financial statements being audited, the respective

responsibilities of management and the auditor, the audit

process, and ends with the auditor’s opinion (ISA 700).

Some commentators on recent corporate scandals and

failures, and on the global financial crisis, suggest that

had audit reportsbeen more informative, many riskscould

have been known and thus avoided. This indicates that

there is an information gap in the audit report. The gap

can be defined as the divide between what users believe

is necessary to make informed investment and fiduciary

decisions, and what is available through a company’s

audited financial statements, the audit report or other

publicly available information (IAASB, 2012). According

to Porter (1993),the expectation gap refers to thedifference

between user expectations from the auditor and the

financial statement audit, and auditor performance as

perceived by soci ety. There are two main response

strategies to the expectation gap, namely a defensive

approach focusi ng on education and reas suring of the

public, and a constructive approach, seeking to change

audit activities to meet public concern (Humphrey,

Moizer & Turley, 1992).

The present tension in the audit profession and the

debate on its reshaping provoke mixed reactions. Some

suggest thatthe information in audited reportsis sufficient.

Others arguethere is a need to providemore information in

order to increase user confidence in the audited financial

statements. Another group argues for reformatting the

report by including the audit opinion in the conventional

second paragraph. The advocates of the information gap

argue that the auditor’s report should provide greater

transparency about significant matters in the financial

statements, as well as more detail on the conduct of the

individual audit (IAASB, 2012). Otherwise, stakeholders

will be unaware of the limitations of an audit, such as

materiality, sampling techniques, role and responsibility

of the auditor in the detection of fraud, and the responsibility

of managers, which can then all widen the expectation gap

(European Commission, 2011). The IAASB (2015a, 2015b)

argues that the main objective of expanded audit reports is

to enhance their informational value and relevance. By

providing greater transparency about the audit that was

performed, expanded audit reports shall result in an

increase of confidence in the audit and the financial

statements, which is in the public interest. Thereby they

contribute to robust and resilient capital markets. We

participate in t his debate by conduct ing, for the first

time, an experimental study on expanded audit reports

relating to bank directors. These subjects were chosen

due to the outstanding role of banks as providers of

capital, as well as an element of the German corporate

governance system. We aim to demonstrate directors’

perceptions of the effect of expanded audit reports on

reporting and audit quality, as well as on their credit

granting decisions.

Thefactthatcompanies’financial statements are

audited does not mean that there is an obligation on

Correspondence to: Reiner Quick, Darmstadt University of Technology,

Department of Accounting and Auditing, Hochschulstrasse 1, 64289

Darmstadt,Germany. Email:quick@bwl.tu-darmstadt.de

International Journal of Auditing doi: 10.1111/ijau.12063

Int. J. Audit. 20:158–174 (2016)

©2016 John Wiley& Sons Ltd ISSN 1090-6738

the auditor to ensure that audited accounts are entirely

free from misstatements (European Commission, 2010).

In fact, auditors just provide reasonable assurance that

the financial statements as a whole are free from material

misstatement.Previous researchhas revealed that auditors’

conclusions on obtaining reasonable assurance are unable

to increase user understanding of the audit. Thus, a

quantification of the obtained assurance level might

improvecommunication with usersof financial statements.

Another limitation of an audit, of which stakeholders

might be unaware,is the concept of materiality. The auditor

only looks for misstatements that may be material to

financial statement users. Thus, laying out the details of

the level of materiality applied to perform statutory audits

could be an appropriate means of enhancing the level of

information accruing to users. Finally, the communicative

value of the auditor’s report could be enhanced by the

provision of more transparency about how exactly the audit

that was performed. Such key audit matters (KAM) assist

usersof financial statements in understandingthose matters

that, in the auditor’s professional judgment, were of most

significance in the audit.

We therefore analyse the effect of disclosing the applied

assurance level, applied materiality level and KAM in the

audit reports.The results from our experiment suggest that

the disclosure of the applied assurance level has a

significant, positive effect on perceived accounting, auditing

and audit reporting quality and increases the probability of

granting credit. With regard to the applied materiality and

KAM, no significant influences can be found. However,

there is a significant interaction between the disclosure of

the applied assurance and materiality levels with regard to

the confidence in financial reporting and to bank loan

decisions. In conditions where the materiality level is

mentioned in the audit report, the positive effect of

publishing the assurance level is diminished.

The contributions of this study are manifold. First,

previous research on the effects of expanded audit reports

was mainly conducted in the US and other Anglo-Saxon

countries. There is a lack of research on Continental

European count ries. Our paper anal yses perceptions o f

German bank dire ctors and thus narrow s this research

gap. Second, it ex plores the perceptio ns of providers of

debt capital, a group of high economic relevance, which

has not been considered in prior research. Third, there is

alackofresearchontheinfluenceofdisclosureofthe

recently implemented concept of KAM. Fourth, it

complements research on the impact of explicit conclusions

from the auditor, as to whether he or she has obtained

reasonable assurance in the audit report, by analysing the

effect of quantifying the assurance level. Fifth, we provide

results on the influence of disclosing the materiality level

for a period after the publication of the related proposal by

the European Commission. Sixth, our findings give reason

to suppose that there is no expectation gap concerning the

applied levels of assurance, i.e. bank directors do not expect

an absolute assur ance, and materiali ty with regard to

high-expertis e subject groups like b ank directors. These

results are highl y relevant for nationa l standard setters,

the European regulator,as well as the IAASB, and contribute

to the ongoing debate on audit report expansions.

The paper proceeds as follows. First, we provide an

overview of current regulatory developments with regard

to the contents of the audit report. The following section

discusses prior research findings concerning the effect

of audit report information on the expectation gap

and on stakeholder perceptions and decisions. The

research questi ons are also presented. We then describe

our experimental case and the subjects participating in

the study.The subsequent section presents and discusses the

multivariate empirical results. The final section summarizes

the main findings, discusses their implications and points

out the study’s limitations.

2. RELATED REGULATORY DEVELOPMENTS

In the aftermathof the global financial and economiccrisis,

the European Commission launched its Green Paper on

audit policy (European Commission, 2010). It raised the

question of how the role of auditors can be enhanced to

mitigate any future financial risk, and challenged the

suitability and adequacy of the current legislative

framework. The fact that numerous banks revealed

huge losses from 2007 to 2009 raised the question of

how auditors could have given clean audit reports to

their clients for those periods (e.g., Sikka, 2009).

Communication by auditors to stakeholders was one

element addressed by the Green Paper. In reaction to

it, the European Commission presented its proposals

regarding the statutory audit of public interest entities,

on 30 November 2011 (European Commission, 2011).

With regard to the audit report, it suggests explaining

on the methodology used, in particular, the proportion

of substantive audit procedures and system and

compliance testing; information on applied materiality

levels, and key areas of risk of material misstatement; a

statement on the entity’s ability to continue as a going

concern; an assessment of the client’s internal control

system; a statement on whether the statutory audit

was designed to detect fraud; and, should the situation

arise, reasons for a qualified or adverse opinion or a

disclaimer of opinion. The European Parliament finalized

the reform of the auditmarket on 3 April 2014, which then

was adopted by the European Council on 14 April 2014

(European Parliament & Council of the European Union,

2014). With regard to the audit report, it shall in particular

include sufficient information on the independence of the

statutory auditor or the auditfirm, on the most significant

assessed risks of material misstatement, and on whether

the statutory audit was considered capable of detecting

irregularities , including fraud (Art icle 10). In contrast

to the Commission’s proposal, information on the

applied materiality levels is not required in the audit

report. However, accordin g to Article 11, the statutor y

auditor or the a udit firm shall su bmit an additional

report to the audit committee of the audited entity which,

amongst others, shall disclose the quantitative level of

materiality applied to perform the statutory audit for

financial statements as a whole and the qualitative factors

considered when setting the level of materiality.

The IAASB also seeks to improve auditor reporting. In

June 2012, it invited stakeholders to comment on its

proposals for the future auditor’s report (IAASB, 2012).

The main identifiedimprovement is additionalinformation

to highlight important matters for user understanding of

the audited financial statements a nd the audit (auditor

commentary), such as areas of significant management

judgment, significant or unusual transactions, and matters

of audit significance. The exposure draft of July 2013

©2016 John Wiley & Sons Ltd Int. J. Audit. 20:158–174 (2016)

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