Key audit matter disclosures point to greater financial distress

The more key audit matters disclosed in an audit report, the higher the financial distress level of a company, according to a new study. 

The study, which appears in the current issue of the British Accounting Review, looks at the KAMs requirement, which is similar to the critical audit matters, or CAMs, requirement from the Public Company Accounting Oversight Board for U.S. auditing firms. The results showed that entity-level KAMs, certain types of individual KAMs and account-level KAMs with a primary impact on a client's profitability and solvency are  more likely to be disclosed when clients face higher levels of financial distress. The usefulness of KAMs in assessing financial distress increased when considering individual  types of KAMs. Going concern, revenue recognition and contingent liabilities KAMs are the most relevant  KAMs for assessing financial distress.

"In all,  evidence from this study suggests expanded auditor reports can help financial statement users  assess and foresee one of the main risks associated with a firm — the risk of failure," said the study, co-authored by Patricia Wellmeyer and Morton Pincus of  the University of California, Irvine, and María-del-Mar Camacho-Miñano and Nora Muñoz-Izquierdo of Complutense University and CUNEF University of Madrid.

The PCAOB's CAMs requirements differ in some respects from the International Auditing and Assurance Standards Board's KAMs standard. The PCAOB began phasing in required CAMs disclosures in 2019, as part of its AS 3101 auditing standard, defining a CAM as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements; and involved especially challenging, subjective or complex auditor judgment. The IAASB introduced KAMs in 2015 as part of its ISA 701 international auditing standard. KAMs are those matters that, in the auditor's professional judgment, were of most significance in the audit of the financial statements of the current period. 

The researchers used six years of KAM disclosures for U.K. premium-listed companies to investigate the relationship between their financial distress and the number, risk level, financial statement impact, and the individual nature of auditor-disclosed KAMs.

"The implementation of the expanded auditor reporting regulation now enhances  transparency into auditor judgments regarding material client risk areas beyond what can be  gleaned from a modification to a standard audit opinion by requiring auditors to specifically report  these assessments via KAM disclosures," said the study. "While regulators leave the determination of the number of KAMs issued largely to auditor judgment, in identifying a KAM both IAASB and PCAOB  regulations require auditors to consider client areas assessed as significant risks in the audit,  including matters requiring complex and/or subjective estimation."

Wellmeyer and some of her colleagues recently completed a separate study on the U.K.'s expanded audit reporting requirements for auditor disclosure of client-specific quantitative materiality thresholds. The PCAOB decided not to require QMTs for U.S. auditing firms out of concern that providing clients with visibility into this important audit input could enhance managers' ability to engage in undetected income-increasing earnings management. The researchers found evidence that's been happening in the U.K.

"Findings from our study should be of interest to regulators, practitioners and financial statement users alike," said the study, co-authored by Wellmeyer and Pincus of the University of California, Irvine, and Lijie Yao of Beijing Jiaotong University in China. "Our study alerts regulators considering mandating auditor QMT disclosures in expanded audit reports of a potential cost of requiring auditors to disclose this important audit process input. Specifically, we find evidence that public QMT disclosures may significantly enhance managers' ability to engage in undetected earnings management strategies."