Reference Elizabeth Gutierrez, Universidad de Chile; Miguel Minutti-Meza, University of Miami; Kay W. Tatum, University of Miami; Maria I. Vulcheva, Florida International University. “Consequences of Changing the Auditor’s Report: Evidence from the UK” Working Paper 2016 (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2741174) |
Overview & Background
A recent study by Elizabeth Gutierrez, Miguel Minutti-Meza, Kay W. Tatum, and Maria I. Vulcheva entitled “Consequences of Changing the Auditor’s Report: Evidence from the UK” examines the consequences of the new auditor’s report in the UK, in terms of the costs of audits, audit quality, and investors’ reaction to the report’s filing.
The paper won the Best Paper Award at the 2016 American Accounting Association (AAA) International Accounting Section Midyear Meeting.
The Regulatory Drive for a Change in the Auditor’s Report
The auditor’s report has long been criticized for its standard nature and boilerplate wording. Arguably, the previous auditor’s report did not provide investors with much, if any, insight into the audit process. The UK’s Financial Reporting Council (FRC) decided to address these concerns by issuing International Standard on Auditing 700 (UK and Ireland, revised June 2013), The Independent Auditor’s Report on Financial Statements. The revised standard applies to the audit reports of companies with a premium listing of equity shares on the London Stock Exchange (LSE) main market with fiscal years beginning on or after October 1, 2012. The FRC standard requires auditors to describe the most significant risks of material misstatement; disclose the levels of overall and performance materiality; and explain the scope of the audit.
The International Auditing and Assurance Standards Board® (IAASB®), the European Union (EU), and the US Public Company Accounting Oversight Board (PCAOB) have taken, or are taking, steps similar to those of the FRC.
In January 2015, the IAASB released its new and revised Auditor Reporting standards (effective for audits of financial statements for periods ending on or after December 15, 2016), designed to significantly enhance auditor’s reports for investors and other users of financial statements. New standard, ISA 701, Communicating Key Audit Matters in the Independent Auditor’s Report, requires a new section in the auditor’s report for audits of financial statements of listed entities (voluntary application allowed for audits of other entities) to communicate key audit matters (KAM). KAM are those matters that, in the auditor’s judgment, were of most significance in the audit of the current period financial statements. Other changes for all audits include the following: presenting the Opinion section first; enhancing auditor reporting on going concern; including an affirmative statement about the auditor’s independence; and enhancing the description of the auditor’s responsibilities.
The EU has also promulgated new requirements that are effective for fiscal years beginning on or after June 17, 2016. The EU requirements are somewhat more detailed than those of the FRC and IAASB. The auditor must provide the most significant risks of material misstatement (including those due to fraud), a summary of the auditor’s response to those risks, and key observations arising with respect of those risks (where relevant).
The PCAOB issued a proposed standard in August 2013 and has indicated that it expects to issue a re-proposal in the second quarter of 2016. While the proposed standard retains the basic elements from the existing auditor reporting standard, it mandates significant changes, including a discussion of critical audit matters.
What Do the New UK Audit Reports Look Like Two Years after the Changes in Regulation?
The recent study examines the characteristics of the new audit reports in the two years before and after the regulatory changes in the UK. Consistent with prior academic literature, it focuses on non-financial companies (eliminating banking, insurance, trust, and investment companies traded on the LSE).
The authors find that the average size of the report has tripled. The number of words in the new report has increased to 2,400 compared to 757 in the old report, and about 30% of these words are used in the discussion of the significant risks of material misstatement. The auditor discloses on average four risks of material misstatement per report. Revenue recognition is the risk most often disclosed by the auditor, followed by impairment of goodwill and other long-lived assets, tax accounting, and business combinations. The average level of materiality used by the auditor is 0.6% of total assets.
What Are the Consequences of the New Audit Report for Firms, Auditors, and Investors?
The authors investigate whether the changes to the auditor’s report are associated with higher audit costs, improved audit quality, and any changes in investors’ reaction to the information in the report.
They find mixed evidence of a change in audit fees, ranging from an increase of nearly 4% to no change, depending on the specification of their statistical models. In further analyses, results indicate that the number and length of risks of material misstatement are positively associated with audit fees. That is, audit fees are generally higher the greater the number and length of risks of material misstatement. These results suggest that auditor’s effort and/or auditor’s risk premium are associated with the assessment and disclosure of difficult audit matters. Furthermore, comparatively smaller materiality thresholds are associated with higher audit quality.
The authors do not find significant changes in audit quality or investors’ reaction to the new auditor’s report. The study uses absolute discretionary accruals[1] as a proxy for audit quality and three-day cumulative abnormal trading volume and abnormal returns around the public dissemination of the annual report, including the audit opinion (i.e., report filing date), as proxies for investors’ reaction to the auditor’s report. Abnormal returns reflect the average change in investors’ beliefs due to an announcement. Abnormal trading volume, in turn, reflects the change in individual investors’ beliefs.
There are at least two possible general explanations for these findings. First, regulators did not expect a large revision to the auditors’ methodologies. Instead, the new auditor’s report makes public several issues already discussed between the auditor and the audit committee. Second, the information disclosed by the auditor might not be strictly new or could be difficult to process by investors. Stakeholders could have had access to this information prior to the regulatory changes through other sources, such as the management’s discussion and analysis, financial analyst reports, or audit committee disclosures. However, the authors note that the changes in the auditor’s report might have long-term consequences that cannot be captured in an analysis of the first two years of the standard’s application.
Concluding Remarks
Overall, the results of the study suggest that the new disclosures of risks of material misstatement for the company and the materiality level used by the auditor are not completely boilerplate, since they are associated with audit cost and quality. However, the change in the auditor’s report format has not resulted in a significant change in the manner in which the audit is conducted or in an increase in audit costs in the two years after the introduction of the new rules.
The findings of this study may encourage further discussion regarding audit report requirements. Reviews of the first two years of reports conducted by the FRC, involving discussions with investors and auditors, suggest that there is room for improvement, for example, by increasing the granularity of risk reporting and providing additional explanation regarding materiality, scope, and risk disclosures.
See The New Auditor’s Report for more information on the IAASB’s new and revised Auditor Reporting standards.
[1] Absolute discretionary accruals capture the portion of total accruals, which is created at management’s discretion without a sound business reason such as growth of the business or length of its operating cycle.
