The effects of financial statement disaggregation on audit pricing

• Published date: 01 April 2022
• Author: Kevin Koh,Yen H. Tong,Zinan Zhu
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/ijau.12253

ORIGINAL ARTICLE

The effects of financial statement disaggregation on audit

pricing

Kevin Koh | Yen H. Tong | Zinan Zhu

Division of Accounting, Nanyang Business

School, Nanyang Technological University,

Singapore

Correspondence

Yen H. Tong, Division of Accounting, Nanyang

Business School, Nanyang Technological

University, Singapore.

Email: ayhtong@ntu.edu.sg

Funding information

Ministry of Education, Grant/Award Number:

(RG64/19)

We examine whether the extent of financial statement disaggregation affects the

pricing of audit engagements in the United States. We hypothesize and find that

auditors assess higher engagement risk and charge higher audit fees for clients with

more disaggregated financial statements. We also find that these higher audit fees

are not the result of either increased auditor effort to mitigate detection risk or

heightened inherent and control risks reflected in lower financial reporting quality.

Instead, we document that greater financial statement disaggregation is positively

associated with litigation risk. This result suggests that higher audit fees arise out of

auditors' assessments of heightened client and auditor business risks associated with

litigation. While financial statement disaggregation may have beneficial effects on

the quality of financial information, we document that financial statement

disaggregation can impose costs on firms in terms of higher audit fees and a higher

likelihood of litigation. Our study informs standard setters, firms and auditors as they

debate the costs, benefits and extent of disaggregation to be presented in financial

statements.

KEYWORDS

audit fees, audit risk, financial statement disaggregation, litigation risk

1|INTRODUCTION

Whereas current Generally Accepted Accounting Principles (GAAP)

provide the framework and standards for financial reporting, consider-

able discretion is permitted in determining what and how financial

information is presented. Managers have particularly wide discretion

under current GAAP in presenting disaggregated items on income

statements, balance sheets and footnotes. This practice has resulted

in substantial variation regarding the extent to which various balance

sheet and income statement items are presented on firms' financial

statements (Securities and Exchange Commission (SEC), 2011).

The Financial Accounting Standards Board (FASB) and Interna-

tional Accounting Standards Board (IASB) are currently engaged in ini-

tiatives on financial statement presentation. One aspect of these

initiatives proposes a uniform format that presents more dis-

aggregated items and subtotals in financial statements. In 2019, the

IASB issued Exposure Draft ED/2019/7 (General Presentation and

Disclosures, International Accounting Standards Board (IASB), 2019)

that intends to set out principles for the aggregation and disaggrega-

tion of information in financial statements. The FASB also undertook

a project in 2018 (Financial Performance Reporting—Disaggregation

of Performance Information, Financial Accounting Standards Board

(FASB), 2018) that seeks to enhance the usefulness of performance

measures by increasing the level of disaggregation in income state-

ments. Under an initial joint project between FASB and IASB, both

standard setters seem to hold the view that greater financial state-

ment disaggregation can lead to more relevant and useful financial

information for users (Financial Accounting Standards Board

(FASB), 2010).

1

Prior academic research (e.g., Chen et al., 2015; Heitzman

et al., 2010; Riedl & Srinivasan, 2010) suggests that greater financial

statement disaggregation provides more relevant information to

equity market participants. For instance, Chen et al. (2015) find that

greater financial statement disaggregation is associated with lower

Received: 18 June 2021 Revised: 3 October 2021 Accepted: 16 October 2021

DOI: 10.1111/ijau.12253

94 © 2021 John Wiley & Sons Ltd Int J Audit. 2022;26:94–112.wileyonlinelibrary.com/journal/ijau

information asymmetry between firms and equity market participants

such as investors and analysts. With respect to auditing, Libby and

Brown (2013) find auditors believe that greater financial statement

disaggregation may lead investors and other users to rely more on the

disaggregated information, thus affecting their judgement of material-

ity thresholds and tolerance for reporting errors. Although these find-

ings suggest that auditors pay attention to financial statement

disaggregation, Libby and Emett (2014) highlight that the effects of

financial statement presentation attributes, such as disaggregation, on

auditors' behaviour is an understudied area. To our knowledge, there

is scant research that examines how financial statement disaggrega-

tion influences other auditors' decision-making outcomes, such as

audit pricing. To shed light on this relation and to provide insights to

the standard-setting initiatives on financial statement presentations,

we examine whether the extent of financial statement disaggregation

affects the pricing of audit engagements in the United States.

The primary role of auditors is to assure investors and other users

that their clients' financial statements are free of material misstate-

ment. If investors and other users find disaggregated financial state-

ment information has greater relevance and rely on that information

in their decision making, we propose that auditors will also consider

the extent of financial statement disaggregation in the pricing and risk

assessment of their audit engagements. Engagement risk consists of

three main components, which are audit risk, client business risk, and

auditor business risk. Audit risk can be further broken down into

detection risk, inherent risk and control risk (Kinney, 2000). Detection

risk increases with greater financial disaggregation because more

items are subject to potential material errors that are not detected by

audit procedures. More disaggregated financial statements can exac-

erbate both inherent and control risks because more line items and

subtotals increase the likelihood that material errors exist and that

internal control processes will not prevent or detect these material

errors. Both client and auditor business risks increase with greater

financial statement disaggregation because of heightened regulatory

scrutiny and better detection of financial misreporting arising from

disaggregated items (Amir et al., 2014; Libby & Brown, 2013) can

adversely affect auditors' and their clients' reputation and financial

prospects. Thus, we hypothesize that auditors assess higher engage-

ment risk and charge higher fees for clients with more disaggregated

financial statements.

To conduct our empirical analyses, we obtain data from various

databases including Audit Analytics,Compustat and CRSP. To capture

the extent of financial statement disaggregation, we use the measure

constructed by Chen et al. (2015) that reflects the extent of detail in

annual reports and conceptually captures the “fineness”of informa-

tion through the disclosure of accounting items in firms' balance

sheets, income statements and associated footnotes. Our final sample

consists of 28,021 firm-year observations in the United States from

the period 2003 to 2015.

Consistent with our hypothesis, we find that auditors charge

higher audit fees for clients with greater financial statement disaggre-

gation. We further explore the associations between financial state-

ment disaggregation and the various components of engagement risk.

For the audit risk component, we examine whether our findings can

be explained by (i) increased auditor effort to mitigate detection risk,

and (ii) heightened inherent and control risks as reflected in lower

financial reporting quality. Following prior studies (e.g., Jha &

Chen, 2015; Knechel et al., 2012; Knechel & Sharma, 2012; Sharma

et al., 2017), we use days to sign as a proxy for auditor effort and find

no significant relation between financial statement disaggregation and

auditor effort. We then employ accrual-based measures of financial

reporting quality and find that firms with greater financial disaggrega-

tion generally exhibit higher, not lower, financial reporting quality.

Our results suggest that the positive association between audit fees

and financial statement disaggregation is unlikely to be driven by

higher audit risk.

We next explore client and auditor business risks, which are risks

that could adversely affect the reputation and financial outcomes of

auditors, by examining litigation risk.

2

Using an ex post measure based

on incidences of lawsuits filed for alleged financial misstatements, as

well as an ex ante measure based on the probability model in Rogers

and Stocken (2005), we find a positive association between financial

statement disaggregation and litigation risk. This finding suggests that

firms with more disaggregated financial statements are charged higher

audit fees, likely because of higher client and auditor business risks.

In additional analyses, we examine whether the positive associa-

tion between financial statement disaggregation and litigation risk is

concentrated among firms with greater likelihood of financial mis-

reporting. We identify two subsamples of firms: suspect and non-

suspect firms. Suspect (non-suspect) firms are those with (without) at

least one incidence of non-trivial earnings restatements over the sam-

ple period. We find a positive association between financial statement

disaggregation and litigation risk for suspect firms but not for non-

suspect firms. This evidence is consistent with the notion that audi-

tors assess higher business risks (i.e., both client and auditor business

risks) for firms with greater financial statement disaggregation

because it can lead to greater regulatory scrutiny (Libby &

Brown, 2013), greater reliance by users of (misstated) financial state-

ments (Heitzman et al., 2010; Riedl & Srinivasan, 2010) and finer

information that is useful for detecting misreporting (Amir

et al., 2014). These results lend further credence to our inference that

disaggregated financial statements increase auditor assessment of

both client and auditor business risks, which leads to higher

audit fees.

Our study makes several contributions to the extant accounting

literature. Libby and Brown (2013) provide experimental evidence that

auditors take financial statement disaggregation into consideration

when making materiality assessments of errors in reported financial

numbers. Our study complements Libby and Brown (2013) by provid-

ing large-sample evidence that auditors also take financial statement

disaggregation into account when setting audit fees. More impor-

tantly, our results suggest that the positive association between finan-

cial statement disaggregation and audit fees is not likely to be

explained by either (i) increased auditor effort to mitigate detection

risk or (ii) increased inherent and control risks reflected in lower

reporting quality. Instead, our results suggest that financial statement

KOH ET AL.95