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In this recently published paper, Melina Heilman (Technische Universität Dortmund) and I review the emerging body of academic research which examines the effects of KAM disclosures in the auditor’s report. We do so by examining four distinct streams of research. First, we review research papers that investigate whether KAM disclosures indeed have the potential of meeting the expectations of standard setters and regulators with respect to providing a more valuable reporting model. Second, some scholars argue that the introduction of the KAM section in the auditor’s report may not only influence financial statement users’ perception and decisions but could also have an influence on the audit itself. For example, Reid et al. (2018) suggest that auditors may exert more effort during the audit because of an increased sense of accountability due to anticipation of KAM disclosure. Similarly, the IAASB (2015) refers to such potential increases of auditor professional skepticism in areas where KAMs are identified and, as a result, increased audit quality, not only in the perception of the users. As a result of the potential of audit quality implications, a second stream of research examines auditor responses to KAM disclosures. Third, in the course of the development of the new reporting requirements, auditor legal liability was a frequently debated controversy, particularly in the United States (e.g., Tysiac 2013). The concern is that disclosing KAMs might increase jurors’ perceptions of auditor liability, especially when auditors have failed to detect misstatements. Hence, a third stream of literature examines the effects of KAM disclosure on auditor’s liability. Fourth, there is a burgeoning literature on client management reporting behavior in response to KAM disclosure. A potential benefit of KAM disclosures in this area is that client management may adopt less aggressive accounting in anticipation of auditor disclosure (Reid et al. 2018). The IAASB (2015) also referred to increased attention by management to KAM disclosures, which could have an indirect, beneficial effect on reporting behavior.
We identified 22 research studies examining the consequences of KAM disclosures for investor behavior, auditor responses, jurors’ assessments of auditor liability, and client management responses.Several research findings support the intended benefits of KAM disclosures. For example, experimental evidence suggests that KAMs have the potential of influencing the decisions of financial statement users, particularly with regard to non-professional investors. KAMs also have the potential of effectively directing financial statement users’ attention to pertinent areas and decrease managers’ earnings management attempts. While these findings are promising, preliminary archival research fails to support a wider capital market reaction to KAM disclosures, raising questions about the economic significance of the changed reporting model. KAM disclosures also appear to have some unanticipated, and sometimes even adverse consequences. Archival research finds efficiency losses in terms of increased audit report lags and audit fees, and experimental evidence suggests that auditors may be less professionally skeptical in the presence of KAMs. Finally, managers’ willingness to share information with their auditor as well as their risk-taking behavior is affected by anticipated KAM disclosures, not always in a beneficial direction.
Read the full article in the open access journal Maandblad voor Accountancy & Bedrijfseconomie: https://doi.org/10.5117/mab.93.29496
IAASB (International Auditing and Assurance Standards Board) (2015a) International Standard on Auditing (ISA) 701 Communicating Key Audit Matters in the Independent Auditor’s Report. https://www.ifac.org/publications-resources/international-standard-audit...
Reid LC, Carcello JV, Li C, Neal TL (2018) Impact of auditor report changes on financial reporting quality and audit costs: Evidence from the United Kingdom. Working paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2647507
Tysiac K (2013) PCAOB’s reporting model proposal poses risks, rewards for audit firms. Journal of Accountancy, August 23. https://www.journalofaccountancy.com/news/2013/aug/20138576.html