Changes to audit reports are valuable to independent investors and this benefit accrues to Non-Big 4 firms.
On 1 August 2019 the Senate referred an inquiry into the Regulation of Auditing inviting submissions from a range of key stakeholders, including leading academics, asking them to provide an understanding as to which regulations were working well; which regulations needed to be changed and; which regulations should go.
Submissions to the inquiry stressed the importance of introducing regulations just for the sake of it.
While the Senate Inquiry released its preliminary findings in March, the final results were released in November.
Monash Business School’s Professor Robyn Moroney’s research over the past ten years has focussed on the consequences of audit regulation. More recently she has become interested in Key Audit Matters (KAMs), an element of Enhanced Audit Report (EAR).
“A lot of my research has been about the consequences and unintended consequences of those regulations.” Professor Moroney says
“A big area of research is around professional scepticism and how firms have responded to inspections.”
Recently she explained her views on the topic of KAMs at a recent Monash Business School Masterclass.
Key Audit Matters
After years of consultation and deliberation, international standard setters introduced an Enhanced Auditor’s Report (EAR) in response to concerns that the traditional audit report provided little information that was useful to users.
For listed entities, the EAR includes a new section identifying matters of most significance in the audit: Key Audit Matters (KAMs) or Critical Audit Matters (CAMs).
Key Audit Matters are those matters that in the auditor’s professional judgment are of most significance in the audit of the financial statements of the current period.
While audit reports can include KAMs, it is up to the auditor to determine whether they need to be included.
Prior research has considered how EARs affect auditor, management and investors’ judgments. The current study provides evidence on when KAMs impact judgements.
In this paper, they considered when the provision of KAMs is likely to affect non-professional investor perceptions regarding the value of the audit and the credibility of the auditors reporting on KAMs.
“Our finding has implications for regulators and standard setters because it shows that investors react to KAMs rather than the new audit report format per se and the number of KAMs has no effect on the perceived value of the audit,” Professor Moroney says.
“Our study informs international standard setters in their post-implementation review of the adoption of EAR.”
Big 4 and key findings
Based on the research, Professor Moroney is able to conclude three key findings:
- Investor perception of the value of the audit is enhanced when KAMs are included in the audit report
- Investor perception of the credibility of the auditor is enhanced when KAMs are included in the audit report; and
- The benefits of including KAMs accrue only to Non-Big 4 firms as value and credibility are already high for the Big 4.
“An important objective of the EAR is to help financial statement users better understand the audit through the use of KAMs,” she says.
According to the research, firm size plays a key role as investors tend to place greater reliance on audits conducted by Big 4 firms and consider these firms to be more credible than Non-Big 4 firms; this means that the Big 4 firms likely have less to gain from reporting KAMs than Non-Big 4 firms.
Professor Moroney says that it appears investors perceive Big 4 firms provide a valuable audit and are credible, indicating a possible ceiling effect.
The study uncovered a potential unintended consequence of including KAMs in audit reports. When examining participants’ responses to open-ended questions, the researchers found that KAMs have an effect on whether core messages, common to all audit reports, resonated with participants.
While participants, who read an audit report that included KAMs, are more likely to list the information that is new/extended in the new EAR they are less likely to list core messages, including the auditor’s opinion than those who read an audit report without KAMs.
This suggests that the inclusion of KAMs may distract readers from core information included in an audit report.
Assisting auditors and investors
“Our study is subject to limitations. Our results may not generalise to companies that operate in different industries or when different types of KAMs are included in the EAR,” Professor Moroney says.
They also opted not to include a manipulation check question regarding whether or not the audit report included one or more KAM/s.
“As we did not measure this directly via a manipulation check question we cannot report definitively whether the manipulation was successful,” she says.
This study has been published in a leading journal. The findings help standard setters, auditors, and investors gauge the value of KAMs by demonstrating the conditions under which KAMs make a difference to investor perceptions of the value of the audit and the credibility of the auditor.