Real effects of reporting key audit matters on auditors' judgment and choice of action

• DOI: http://doi.org/10.1111/ijau.12154
• Author: Karsten Asbahr,Klaus Ruhnke
• Date: 01 July 2019
• Published date: 01 July 2019

ORIGINAL ARTICLE

Real effects of reporting key audit matters on auditors'

judgment and choice of action

Karsten Asbahr |Klaus Ruhnke

School of Business and Economics,

Department of Finance, Accounting and

Taxation, Freie Universitaet Berlin, Berlin,

Germany

Correspondence

Klaus Ruhnke, Freie Universitaet Berlin, School

of Business and Economics, Department of

Finance, Accounting and Taxation, Thielallee

73, D‐14195 Berlin, Germany.

Email: klaus.ruhnke@fu‐berlin.de

This experimental study analyzes whether reporting an accounting estimate as a key

audit matter (KAM) can influence auditor judgment about the accounting estimate

and the corresponding action. We find that skeptical action in the form of proposed

adjustment amounts is significantly lower when the accounting estimate is reported

as a KAM. Thus, the disclosure of a KAM can serve as a moral license to waive an

adjustment. Taking into account that the KAM disclosure does not affect auditors'

skeptical judgments in the form of a reasonableness assessment of the accounting

estimate, our results indicate the existence of a judgment–action gap. Furthermore,

implicit client pressure does not enlarge the moral licensing effect of the KAM disclo-

sure. We also find evidence that audit effort is not affected by reporting a KAM.

Overall, our study contributes to the current debate about the audit reporting model

by showing that reporting a KAM might have unintended “real effects”on auditors'

actions.

KEYWORDS

accountability, accounting estimates, audit reporting, auditor judgment, client pressure, key audit

matters, moral licensing, real effects

JEL CLASSIFICATION

M40; M41; M42

1|INTRODUCTION

Reports from several enforcement institutions repeatedly show that

the audit of accounting estimates is especially error prone (Financial

Reporting Council, 2015; International Forum of Independent Audit

Regulators, 2015; Public Company Accounting Oversight Board

[PCAOB], 2013, 2016). While current exploratory interview and sur-

vey studies have tried to identify the underlying problems on an insti-

tutional and task level (Cannon & Bédard, 2017; Christensen, Glover,

& Wood, 2012; Glover, Taylor, & Wu, 2017a, b; Griffith, 2016;

Griffith, Hammersley, & Kadous, 2015), the uncertain nature of

accounting estimates can also lead to biases on the psychological level

of the individual auditor (e.g., Bratten, Gaynor, McDaniel, Montague, &

Sierra, 2013; Martin, Rich, & Wilks, 2006). To mitigate these cognitive

or motivational biases and enhance the professional skepticism when

auditing accounting estimates, recent studies have examined the use

of various debiasing strategies. In addition to the efforts targeted at

changing auditors' ways of thinking (e.g., Backof, Bamber, &

Carpenter, 2016; Griffith, Hammersley, Kadous, & Young, 2015;

Plumlee, Rixom, & Rosman, 2015; Rasso, 2015), another strategy aims

to change auditors' motivations. In this latter line of research, a central

area of interest is the creation of accountability (e.g., Kennedy, 1993,

1995), such as through different forms of disclosure or justification

requirements. In a similar vein, we examine whether the reporting on

key audit matters (KAMs) can influence auditors' judgments and

decision‐making (JDM) when auditing accounting estimates.

Primarily, the reporting of KAMs aims to provide more information

relevant to users based on the audit that was performed. Additionally,

“real effects”may occur. We define real effects as situations in which

the disclosing person or reporting entity changes the allocation of

Received: 13 November 2017 Revised: 6 February 2019 Accepted: 7 February 2019

DOI: 10.1111/ijau.12154

Int J Audit. 2019;23:165–180. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 165

resources and judgment as a result of the disclosure requirement (Leuz

& Wysocki, 2016). When reporting KAMs, real effects could arise if

auditors anticipate that certain accounting matters will be disclosed

as a KAM while making judgments about financial statement asser-

tions. Thus, this additional disclosure can influence auditors' JDM of

the respective financial matters to be reported as a KAM. The Interna-

tional Auditing and Assurance Standards Board (IAASB, 2015b, p. 2)

itself states that the new auditor reporting model should lead to a

“renewed focus of the auditor on matters to be communicated in

the auditor's report, which could indirectly result in an increase in pro-

fessional skepticism.”

Whereas some archival and survey studies have investigated the

impact of KAMs on the information content of expanded audit reports

(Boolaky & Quick, 2016; Guttierez, Minutti‐Meza, Tatum, & Vulcheva,

2018; Lennox, Schmidt, & Thompson, 2018; Reid, Carcello, Li, & Neal,

2018) and on auditor liability (for a review, see Gimbar, Hansen, &

Ozlanski, 2016), only a few studies have analyzed the impact of the

new auditor reporting requirement on the process of the audit itself

—for exceptions, see Fuller (2015) and Cade and Hodge (2014); and

for a comprehensive review of the current research, see Bédard,

Coram, Espahbodi, and Mock (2016).

With regard to auditors' JDM, some studies have showed unin-

tended consequences of the KAM reporting requirement. Gay and

Ng (2015) indicated that auditors are less likely to communicate an

aggressive accounting estimate to the audit committee if the KAM

standard is to be applied. Compared with a situation where the KAM

reporting requirement is absent, an auditor's propensity to accept

the aggressive estimate also increases. A working paper by

Ratzinger‐Sakel and Theis (2018) focused on possible effects of the

new auditor reporting model on auditors' judgment performances.

Our conceptual setting is quite different, because we differentiate

between auditors' skeptical judgments and corresponding skeptical

actions in order to investigate the potential existence of a

judgment–action gap. Whereas Ratzinger‐Sakel and Theis (2018)

solely examined the likelihood to require an adjustment, we also focus

on the adjustment amount to get a more precise measure for auditors'

skeptical actions and consider audit effort as another dimension of

skeptical action.

1

We further examine whether client pressure moderates the effect

of the KAM reporting requirement. The manipulation of implicit client

pressure is intended to dissect two possible different ways of how the

KAM reporting requirement can affect auditors' JDM. We argue that

the KAM reporting requirement will either work as an accountability

mechanism and stimulate a more balanced and exhaustive processing

of information or will unconsciously serve as a justification template to

justify one's own decision. There is plenty of evidence that client pres-

sure can lead auditors to conform more strongly to clients' prefer-

ences, and thus can increase the need to legitimate their judgments

(e.g., Hatfield, Jackson, & Vandervelde, 2011). Thus, in the case of cli-

ent pressure, KAM reporting is expected to function even more

strongly as a means to legitimize auditors' judgments instead of

enhancing auditors' accountabilities.

We employed a 2 × 2 between‐subject design that manipulates the

auditors' reporting regime (reporting KAM vs. no reporting KAM) and

client pressure (implicit client pressure vs. no client pressure). The par-

ticipants in both KAM manipulations were instructed that the respec-

tive accounting estimate qualifies as a KAM due to its inherent

uncertainty. Whereas the treatment group was informed that the

accounting estimate will be disclosed as a KAM, the control group

was informed that the reporting of KAMs is not yet obligatory and

thus not applicable. We manipulated implicit client pressure by stating

that the client prefers no further adjustments and instead relies on his

or her long‐lasting experience in the case of matters with high uncer-

tainty. Other factors, like the client's economic importance, were held

at a constant level in order to minimize confounding effects of multi-

ple manipulations.

The experiment was conducted as a warranty provision case study.

The final sample consists of 122 highly experienced German auditors.

Participants evaluated the reasonableness of a client‐biased estimate,

the probability of insisting on an adjustment, and the amount of a

potential adjustment after having received information regarding two

main assumptions of the estimate. Participants also indicated the total

amount of additional audit hours needed to reach a final conclusion on

the KAM subject and decided on how to allocate these additional

audit hours on three different audit procedures: test of details, analyt-

ical procedures, and documentation.

In this paper, we directly refer to International Standards on

Auditing (ISAs) and not to German audit standards. In Germany, the

Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer

in Deutschland e.V. [IDW]) outlines auditing standards.

2

As of today,

only minor differences exist between both sets of audit standards

(see IDW, 2017; Köhler, Marten, Quick, & Ruhnke, 2007). The national

audit standard IDW PS 401, which mainly corresponds to ISA 701 (see

IDW PS 401.6), has to be applied for periods ending on or after

December 15, 2017.

In line with our expectations, we do not find a main effect of the

KAM manipulation on the assessment of the reasonableness of the

accounting estimate (skeptical judgment). However, we find that skep-

tical action in the form of the (probability‐weighted) adjustment

amount of participants in the KAM manipulation is significantly lower

than for participants without a KAM requirement. This result is consis-

tent with the theory of moral licensing, indicating that auditors can

unconsciously perceive the reporting of KAMs as a substitute for

requiring adjustments in the financial statements. Taking these two

results together, we find support for the existence of a judgment–

action gap. Furthermore, we are unable to show that the implicit client

pressure fosters a stronger moral licensing effect. Finally, the KAM

1

Another distinction is that our setting removes potential uncertainties with regard to the

decision as to whether a matter should be regarded as a KAM or not. By this, we wanted

to exclude possible effects of the KAM selection process. Otherwise, the additional impor-

tance that is signaled by stating that a case will be reported as a KAM (compared with the

same case not being reported as a KAM) could have led to confounding effects.

2

The EU demands the application of ISAs for statutory audits. A prerequisite is a formal

endorsement (adoption) of ISAs at the EU level. This endorsement is still open. However, all

of the requirements mentioned in the ISAs are currently covered by the German national

auditing standards (IDW auditing standards).

166 ASBAHR AND RUHNKE