The impact of audit committee expertise on external auditors' disclosures of key audit matters

• Published date: 01 April 2022
• Author: Penny F. Zhang,Greg Shailer
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/ijau.12256

ORIGINAL ARTICLE

The impact of audit committee expertise on external auditors'

disclosures of key audit matters

Penny F. Zhang | Greg Shailer

Research School of Accounting, The Australian

National University, Canberra, Australian

Capital Territory, Australia

Correspondence

Greg Shailer, Research School of Accounting,

The Australian National University, Canberra,

Australian Capital Territory, Australia.

Email: greg.shailer@anu.edu.au

This paper investigates relations between audit committee expertise, auditors' disclo-

sures of key audit matters (KAMs) and audit committees' disclosures of significant

issues (SIs) in the United Kingdom. We find that audit committee accounting and

industry expertise reduces both total KAMs and KAMs that are unmatched with SI

disclosures. Further, changes in audit committee accounting and industry expertise

significantly affect auditors' subsequent adoptions of previous SIs as new KAMs. This

subsequent adoption of unmatched SIs is negatively related to prior abnormal audit

fees but is not significantly related to prior abnormal accruals, suggesting that an

auditor's initial omission of a subsequently adopted SI may be a consequence of

lower audit effort but is not necessarily a signal of lower audit quality. The overall

results are consistent with non-alignment of KAMs or SIs being consequences of

ineffective communications and that communication or AC persuasiveness improves

when AC accounting expertise increases.

KEYWORDS

audit committee expertise, extended audit report, key audit matters, audit committee report

1|INTRODUCTION

The internationally promulgated audit reporting standards requiring

the disclosure of key or critical auditing matters (KAMs) are intended

to enhance audit transparency (Financial Reporting Council

[FRC], 2016a). The standards differ across jurisdictions in their details

for determining the matters auditors should disclose, but, in all juris-

dictions, disclosed risks are expected to be selected from matters that

are communicated with audit committees.

1

Audit committees have a

crucial role in monitoring and communicating with their external

auditors and are a key influence in the financial reporting and audit

process (Beattie et al., 2014). Thus, communications between auditors

and audit committees are critical in the extended audit reporting

regime (Deloitte, 2016a; International Auditing and Assurance Stan-

dards Board [IAASB], 2015; Public Company Accounting Oversight

Board [PCAOB], 2017). Understanding how this engagement between

auditors and audit committees affects external auditors' reporting

decisions will assist in understanding and evaluating the role of the

extended reports in promoting audit transparency. Although interac-

tions between audit committees and auditors are not publicly

observable, the UK reporting regime provides us with a rare opportu-

nity to gain important insights in this regard.

The UK Corporate Governance Code specifies that a company's

annual report should contain a separate section that describes the

work of the audit committee in discharging its responsibilities; most

companies identify this section as the audit committee report. In the

United Kingdom, expanded audit committee reporting requirements

were implemented at the same time as the enhanced auditor reports.

KAMs disclosed in an audit report are those matters that the auditor

perceives were of most significance in the audit of the financial state-

ments for the current period. The FRC's changes to the UK Corporate

Governance Code require the audit committee to describe significant

issues that it considered in relation to the financial statements (SIs).

The United Kingdom is currently the only jurisdiction that requires

both auditors and audit committees to publicly disclose material mat-

ters they regard as key financial reporting issues.

2

The auditor and

audit committee are expected to engage on significant matters and,

although an exact alignment between auditors' disclosures of KAMs

and audit committees' disclosures of SIs is not mandated, the FRC,

investors and auditors expect a significant overlap between KAMs

Received: 8 December 2020 Revised: 20 October 2021 Accepted: 6 December 2021

DOI: 10.1111/ijau.12256

Int J Audit. 2022;26:151–170. wileyonlinelibrary.com/journal/ijau ©2021 John Wiley & Sons Ltd 151

and SIs (Deloitte, 2016b; FRC, 2015; KPMG, 2014).

3

The extent to

which audit committees and auditors might identify the same or dif-

ferent issues may be influenced by the extent to which they have

common perspectives and the effectiveness of their communications.

We argue that audit committees and their auditors are more likely to

have effective communications and reach similar judgements

regarding critical accounting issues and risk assessments when audit

committees have more accounting and industry-relevant expertise.

4

It is widely accepted that audit committee expertise has impor-

tant consequences for corporate reporting and auditing. There is per-

suasive evidence that audit committee financial expertise increases

voluntary disclosures (Mangena & Pike, 2005), reduces accounting

irregularities (e.g., Abbott et al., 2004; Badolato et al., 2014) and

reduces earnings management (Bédard et al., 2004).

5

There is also

some evidence that audit committees with both accounting and

industry expertise perform better in monitoring the financial reporting

process than those with only accounting expertise (Cohen

et al., 2014). Based on this evidence, we predict that auditors will

identify fewer significant matters when audit committees have greater

accounting expertise and industry expertise.

There is also evidence that audit committee financial expertise

increases demand for monitoring or effort by auditors (e.g., Abbott

et al., 2003, 2004; Ghafran & O'Sullivan, 2017)—which some interpret

as improving audit quality—and improving the timeliness of audit

reporting (Abernathy et al., 2014; Sultana et al., 2015). This suggests

that audit committee financial expertise improves communications

between auditors and the audit committee and resolution of auditors'

concerns. Therefore, we predict that audit committee financial

(accounting and supervisory) and industry expertise are positively

associated with the degree of alignment in (or negatively associated

with differences between) auditors' reported KAMs and audit commit-

tees' reported SIs.

These expectations regarding the effects of audit committee

expertise are consistent with the more general view of expertise in

group contexts, where recognition of another party's expertise

increases information sharing (e.g., Stasser et al., 1995; van Ginkel &

van Knippenberg, 2009) and the weight attached to that party's inputs

(e.g., Baumann & Bonner, 2004).

We are not aware of any prior research that considers the impact

of audit committee expertise on relations between the auditor's and

audit committee's disclosures. Velte (2019) reports evidence of a posi-

tive association between the readability of KAMs and audit commit-

tees' financial and industry expertise but does not explain how or why

this occurs. Gutierrez et al. (2018) examine the effects on investors of

the implementation of the expanded audit reporting regime in the

United Kingdom. Their additional analysis includes whether their mea-

sure of ‘unique risks’identified by auditors, which equate to KAMs

that do not match SIs, is associated with investor reactions, audit fees

or discretionary accruals; they do not find any significant associations

in this regard. Different from Gutierrez et al. (2018), we focus on

differences between auditors' disclosures and audit committees' dis-

closures during the first 3 years of the expanded reporting regime and

identify (1) KAMs in audit reports that are not reported as SIs in audit

committee reports; (2) SIs in audit committee reports that are not

reported as KAMs in audit reports; and (3), in further analysis,

subsequent KAMs that appear to adopt previously disclosed SIs. We

examine how these differences in disclosure decisions relate to audit

committee expertise.

To test our predictions that audit committee financial expertise

and industry expertise are negatively associated with the number of

reported KAMs and positively (negatively) associated with the degree

of alignment in (or differences between) KAMs and SIs, we manually

collect KAM and SI disclosures from the annual reports of nonfinancial

listed UK companies for the first three fiscal years of the UK extended

reporting regime. Our final sample is composed of 693 firm-year

observations.

6

We first model total KAMs relative to audit committee

expertise and then model matched versus unmatched KAMs (those

that do or do not correspond to reported SIs) in relation to audit com-

mittee expertise.

Overall, our results are consistent with our predictions. We find

fewer total KAMs when audit committee accounting and industry

expertise are higher, and fewer unmatched KAMs when audit commit-

tee accounting, supervisory and industry expertise are higher. We

then explore the impact of audit committee expertise on auditors'

subsequent reporting behaviour. This reveals that auditors are more

likely to adopt previously unmatched SIs (i.e., an SI in a previous year

that did not match a KAM in that year) when audit committees'

accounting and industry expertise increase from the prior year to the

current year. Our analysis suggests that this adoption of previously

unmatched SIs is associated with less audit effort in the prior year, as

proxied by abnormal audit fees, but it is not necessarily a reflection of

lower audit quality, as proxied by discretionary accruals.

This study contributes to the audit and corporate governance lit-

erature and has implications for policy development. First, to the best

of our knowledge, there has been little or no prior research on the

interactions between audit reports and audit committee reports. By

comparing the matters disclosed in each entity's audit report and audit

committee report, this study contributes to the emergent literature on

the extended reporting models for both auditors and audit commit-

tees. Second, the study also expands the literature concerned with

the roles and effects of audit committees. Studies predating the

expanded reporting regime identify significant impacts of audit com-

mittee's expertise on external auditors' performance, including audit

fees and audit quality. However, despite the policy developments

concerning the importance of audit committees in promoting audit

transparency, there has been little research investigating the audit

committee's role in relation to auditors' reporting behaviour. We

reduce this knowledge gap by revealing how audit committees' finan-

cial and industry expertise appear to impact on auditors' disclosures.

Third, our results should help inform regulators of the consequences

of the revised reporting standards for both auditors and audit commit-

tees and may influence regulators in their monitoring of audit reports

and audit committee reports and in the provision of future guidance.

This analysis of the impact of audit committees on auditors' reporting

behaviour in the United Kingdom may assist standard setters in other

jurisdictions to better understand auditors' rationales for choosing

152 ZHANG AND SHAILER