Narrative disclosures, firm life cycle, and audit fees

• Date: 01 November 2019
• Published date: 01 November 2019
• DOI: http://doi.org/10.1111/ijau.12169
• Author: Santanu Mitra,Feras Salama,Mahmud Hossain

ORIGINAL ARTICLE

Narrative disclosures, firm life cycle, and audit fees

Mahmud Hossain

1

| Mahmud Hossain

2

| Santanu Mitra

3

| Feras Salama

4

1

Department of Accounting, LaPenta School of

Business, Iona College, New Rochelle, New

York, USA

2

Department of Accounting and MIS, College

of Industrial Management, King Fahd

University of Petroleum & Minerals, Dhahran,

Saudi Arabia

3

Mike Ilitch School of Business, Wayne State

University, Detroit, Michigan, USA

4

Department of Accounting, School of

Business Administration, American University

of Sharjah, Sharjah, UAE

Correspondence

Mahmud Hossain, Department of Accounting,

LaPenta School of Business, Iona College, New

Rochelle, New York, USA

Email: mhossain@iona.edu

This study examines the relationship between narrative disclosure properties in terms

of readability, optimism, and ambiguity of annual reports and audit fees, and how the

relationship changes across firms' various life-cycle stages. Using 54,883 observa-

tions for the years from 2000 to 2016, we find that these textual disclosure proper-

ties have positive audit pricing consequences. We suggest that narrative disclosure

properties play an important role in estimating audit risk, and thus in audit fees. We

further posit that the audit fee consequences of these disclosure characteristics vary

across different phases of a client firm's corporate life cycle. Though we observe that

with a decrease in readability and an increase in optimism and ambiguity of disclosure

language that audit fees increase in the introduction phase, a firm's entry to the

growth phase moderates the influence of these narrative disclosure features on audit

fees. However, the impact of these lexical features on audit fees increases as client

firms switch (1) from the growth phase to the maturity phase and (2) from the matu-

rity phase to the decline phase. Based on these findings, we argue that, when exam-

ining the audit fee implication for management's disclosure strategies, researchers

should treat client firms as dynamic evolving entities.

KEYWORDS

audit fees, firm life cycle, qualitative disclosure

1|INTRODUCTION

In recent years, narrative disclosures in financial reports have

attracted significant attention of accounting and finance researchers.

Although prior studies (e.g., Ertugrul, Lei, Qiu, & Wan, 2017; Huang,

Teoh, & Zhang, 2014; Loughran & McDonald, 2011, 2014) show that

users of financial reports, such as investors, credit rating agencies, and

financial analysts, benefit from narrative disclosures, very few studies

have tested the impact of such disclosures on audit fees.

1

This is sur-

prising, given that narrative disclosures are likely to play a vital role in

an auditor's estimation of audit risk, and therefore audit fees. For

example, numeric disclosures provide information on a client firm's

past and current financial positions; however, textual disclosures can

provide more forward-looking information on a client's business risk

(Stanley, 2011). Furthermore, various narrative disclosures may help

auditors estimate risk by assessing managerial incentive to obfuscate

information reported in financial statements. Based on this notion, we

fill the void in the literature by examining the audit pricing

Received: 9 October 2018 Revised: 28 June 2019 Accepted: 2 July 2019

DOI: 10.1111/ijau.12169

Int J Audit. 2019;23:403–423.

wileyonlinelibrary.com/journal/ijau

© 2019 John Wiley & Sons Ltd

403

consequence of narrative disclosure properties such as readability,

optimism, and ambiguity. We further argue that, for a better under-

standing of the audit pricing implication of these disclosure properties,

a client firm should be viewed as a dynamic evolving entity whose

corporate life cycle is likely to play an important role in an auditor's

pricing decision. We consider this issue in our primary analyses.

Client-specific audit risk induces auditors to include a risk pre-

mium in quoted fees and/or increase their engagement efforts to min-

imize the risk at an acceptable level that results in higher audit fees

(e.g., Bell, Landsman, & Shakelford, 2001; DeFond, Lim, & Zhang,

2015; Hay, Knechel, & Wong, 2006).

2

To assess audit risk, auditors

need to understand managers' policies and actions, including client

firms' philosophies, operating styles, integrity, and ethical values (Bell

et al., 2001; Picconi & Reynolds, 2013). Managers' public financial dis-

closures help auditors evaluate client-specific financial reporting and

audit risk. Extant literature finds that financial reporting attributes,

such as high discretionary accruals, are positively associated with

audit fees, implying that managerial opportunism in presenting

financial information increases the risk of material misstatements and

audit risk (Gul, Chen, & Tsui, 2003).

3

Drawing upon the evidence

reported in prior studies, we argue that various qualitative disclosure

traits could also help auditors better assess the risk of financial mis-

reporting and audit risk. For instance, readability of the financial

report is important, because less readable textual disclosures may

reflect managerial opportunism in financial reporting, as managers

tend to use less readable disclosures to obfuscate poor firm perfor-

mance (Bloomfield, 2008; Ertugrul et al., 2017; Loughran &

McDonald, 2011). Furthermore, management's use of ambiguous text

is associated with a greater likelihood of reporting fraud and material

internal control weaknesses (Li, 2010a; Loughran & McDonald, 2011).

Recently, Abernathy, Guo, Kubick, and Masli (2019) evaluated the

effect of financial footnote readability in auditor–client contracts and

found that footnote readability is associated with subsequent audit

outcome. Their results show that less readable footnotes are associ-

ated with longer audit report lag and higher audit fees in the following

year. Also, firms with less readable footnotes are more likely to

receive a modified going-concern audit opinion. Therefore, less read-

able and/or ambiguous text in financial reporting is deemed to

increase perceived risk of material misstatements in reported financial

information that is likely to heighten an auditor's assessed audit risk

and increase audit fees.

At different phases of the corporate life cycle, managers are likely

to adopt different strategies and undertake risk in response to various

internal (e.g., organizational capabilities, resource endowment) and

external (e.g., competitive pressure) factors (Drake, 2015; Helfat &

Peteraf, 2003; Higgins, Omer, & Phillips, 2015; Miller & Friesen,

1984). Therefore, to better assess audit risk, an auditor is likely to

evaluate textual disclosures differently at various stages of a client

firm's life cycle. This translates into differential audit pricing implica-

tions of disclosure properties in respective life cycle phases.

Drawing upon extant literature, we use three proxies for narrative

disclosure properties: readability, optimism, and ambiguity of annual

reports (e.g., Bonsall, Leone, Miller, & Rennekamp, 2017; Ertugrul

et al., 2017). We rely on Dickinson's (2011) cash-flow-based approach

to define the life-cycle stages.

4

We use a sample of 54,883 firm years

for the period from 2000 to 2016 to examine the relationship

between narrative disclosure properties and audit fees, and how audit

pricing of narrative disclosure properties varies across the introduc-

tion, growth, maturity, and decline phases of a firm's life cycle, using

the shakeout phase as the benchmark. We find that audit fees are sig-

nificantly higher when firms make less readable, more positive, and

more ambiguous disclosures. The primary results hold for both large

and small-sized client firms, and also for the prefinancial crisis period,

financial crisis period, and postfinancial crisis period. Our analyses fur-

ther show that all three narrative disclosure properties are positively

associated with audit fees in the introduction stage. However, the

associations are moderated in the growth phase. The associations

between audit fees and narrative disclosure properties strengthen

when client firms switch from the growth phase to the maturity phase,

and these associations strengthen even further when client firms

enter the decline phase.

Our study contributes to the audit fee literature in a meaningful

way. Although numerous studies in the past show that quantitative

financial information plays an important role in audit pricing, there is

only limited evidence on the extent to which the lexical features of

disclosure impact audit fees. The study's findings are important in light

of the recent concerns expressed by auditors on client firms' disclo-

sure quality. KPMG (2011) and Deloitte (2015) argue that unneces-

sary repetition of information, using too much technical jargon and

complex words, and adding irrelevant and insignificant information

reduce the usefulness of annual reports to users. In a similar vein,

Ernst & Young (2014) opined that investors are not well served if

annual reports contain immaterial details, and recommended that

companies regularly review their disclosure to remove such immaterial

information. By documenting systematic positive association between

narrative disclosure quality and audit fees, this study validates such

claims of auditors. By showing that narrative disclosure properties are

significantly associated with audit fees, this study enhances our

understanding of the factors that auditors are likely to consider in set-

ting audit fees. The results have useful implications for regulators in

their efforts to develop proper standards to enhance the quality of

narrative disclosure in annual reports.

Our study also adds to the recent stream of research on the lin-

guistic analysis of disclosures. Extant studies show that various

groups, such as investors, financial analysts, and credit rating agencies,

benefit when business enterprises improve the quality of their narra-

tive disclosures. As an extension, we demonstrate that narrative dis-

closure properties also have important audit price implications, as the

higher quality disclosure narratives help auditors better assess the risk

underlying audit engagements.

Finally, though scholars acknowledge the relevance of a firm's life

cycle in accounting research, our study exhibits its relevance in audit

fee research. Our findings suggest that business enterprises should be

viewed as dynamic entities when one examines the association

between a client firm's disclosure strategy and audit fees. Audit risks

differ across a firm's life-cycle stages, each of which is characterized

by different levels of managerial risk-taking and rent-seeking behavior

due to differences in organizational capabilities, resource endowment,

growth opportunities, and external pressure.

5

The remainder of this paper is organized as follows. In

Section 2.2.1, we present the background of this study and our

hypotheses. Section 3 details the research method, and Section 4 dis-

cusses the sample and correlations. Section 5 discusses the results,

and Section 6 concludes the paper.

2|BACKGROUND AND HYPOTHESES

DEVELOPMENT

2.1 |Narrative disclosure properties and audit fees

Simunic's (1980) production-based analytical model posited that audi-

tors incorporate any information relating to audit engagement risk

into their audit pricing decisions. Auditors usually spend a

404 HOSSAIN ET AL.