Extended audit report, key audit matters and cost of debt

Ahmed Elamer Mohamed Elmahgoub

Brunel University London Birmingham City University

Tarek Abdelfattah Collins Ntim

University of Portsmouth University of Southampton

May 2021

Brunel Business School

 05/04/23

Agenda

Introduction

Literature Review

Research Hypothesis

Research Sample and Model

Empirical Results

Conclusion

Brunel University London Presentation Title 2

Extended audit report: Overview

• Information asymmetry….
• Audit report …. Standardised & lacks enough details about audit process & professional
judgements.
• The financial crisis stressed the need to disclose more client-specific information (PCAOB,
2016).
• IAASB, FRC and PCAOB; have made substantial changes in auditing standards.
• In the UK, FRC released ISA 701
• Mandating disclosure of additional information RMMs /KAMs.
• Imposing a new requirement raises several questions about its value and behaviour of users of
the financial statements.
ISA (UK) 701
• Auditor’s responsibility to communicate key audit matters (KAMs) in the auditor’s report.
• Auditors disclose client-specific information related to the risks of material
misstatements (RMMs) that had the greatest effect on the audit, the application of
materiality, and the scope of the audit.
Why communicating KAMs?
• To enhance the communicative value of the auditor’s report
• To provide greater transparency about the audit that was performed.
• To assist users in understanding those matters that auditors see as most significance.
• To assist users in understanding the entity and areas of significant management
judgment.
Literature review: Extended audit report
•Mixed results - Experimental studies

• Doxey (2014): Disclosing KAMs helps in enhancing the users’ perception of the quality of
financial reporting.
• Gold et al. (2020): Managers feel more accountable and exercise less opportunistic
behaviour in areas reported by auditors as KAMs, indicating an improvement in the
financial reporting quality.
• Christensen et al. (2014) and Kachelmeier et al. (2019): Investors perceive ‘‘value’’ in the
EAR and react negatively when they receive a KAMs section in the audit report.
• Sirois et al. (2018): The disclosure of KAMs bring investors’ attention to related
management disclosures.
Literature review: Extended audit report

•Mixed results - Experimental studies

• Asbahr and Ruhnke (2019) and Ratzinger-Sakel and Theis (2019): a potential negative
impact of the disclosure of KAMs on auditors’ judgement performance, resulting in lower
financial reporting quality.
• Boolaky and Quick (2016): No effect of KAMs disclosure on bank directors’ perceptions of
financial reporting quality or their credit approval decisions.
• Cade and Hodge (2014): EAR adoption could motivate managers to hide detailed
information about the accounting choices and estimates they make to avoid the potential
negative effect on users’ perceptions of the firm.
Literature review: Extended audit report

•Limited & mixed results - Archival studies

• Li et al. (2019) and Reid et al. (2019): A significant negative impact on managers opportunistic
behaviours.
• Smith (2017): EAR are easier to read and better reflect the risk related nature of audit. Better
communication value.
• Bédard et al. (2019) and Gutierrez et al. (2018): No impact of EAR on auditor’s quality.
• Bédard et al. (2019) and Gutierrez et al. (2018): No significant market reaction to EAR disclosures,
suggesting that they do not provide new information to investors.
• Lennox et al. (2019): most of the information auditors report would have been previously communicated
to investors through other media, such as, conference calls and previous interim reports. However, KAMs
are negatively associated with the firm’s market value, supporting the value relevance of such
disclosures.
 Negative association between high quality, transparent financial
reports, and the cost of debt capital (Bonsall and Miller 2017;
Cuny and Dube 2018; DeBoskey et al., 2017).

Literature Audit quality has a significant impact on the cost of debt

financing. High-quality audits help in facilitating debt

review: contracting and help companies to get lower cost of debt

financing (Kim et al. 2011 and Minnis 2011).

Cost of Big 4 audits are associated with lower cost of debt (Karjalainen,
2011)

Debt External auditor report reduces information asymmetry by

increasing the monitoring of management’s actions, limiting
managers’ opportunistic behaviour, and improving the quality
of firms’ information flows (Eskandari et al., 2014).
Research Motivation
 Extensive changes and regulatory initiatives.
FRC report in 2017 shows:
• Investors and creditors welcome more involvement from auditor.
• They will react to this disclosure if they value the information disclosed.
• They may change their behaviour …..effect on share price, market value or cost of
debt….etc.
• Reducing information asymmetry….may affect the pricing of debt capital (cost of
debt).
 Empirical & Theoretical Gap in Prior Studies
• Previous studies investigating the consequences of mandating extended audit report
in the UK context are rare and mixed.
• To the best of our knowledge, this study is one of the first empirical studies that
explore the impact of EAR on creditors’ decisions.
H1: EAR adoption and cost of debt
• Auditors might feel more accountable to financial statement users, and hence, exercise more professional
scepticism and perform additional work after the EAR adoption.
• EAR increases the credibility of financial information and providing more transparent and reliable financial
information that would improve the quality of financial reporting and lower information uncertainty.
• Highly credible financial information reduces banks’ need to rely on alternative information in debt
contracting.
• Ding et al. (2016) outline that higher financial reporting quality would also reduce uncertainties about
future cash flows (information risk), enabling debt holders to evaluate the firm ability to re-pay the loan, so
that they can identify the appropriate interest rate.
• Hence, EAR would improve financial transparency and lessen information risk, resulting in a potential
reduction in debt monitoring costs.

Hypothesis 1: The introduction of the EAR is associated with a lower cost of debt.
H2: KAMs and cost of debt
• Following EAR adoption, FRC reports a number of improvements in audit reports including:
• greater granularity of reported risks,
• clearer explanations about how the scope of the audit was impacted by those risks and
• more comparative information when risks change between periods (FRC, 2015; Lawson et al. 2017).
• Disclosing RMMS/KAMs represent the auditor’s evaluation and reaction to the riskiness of the audited companies.
• Lenders receive additional and more detailed idea of the performance of audited companies and their riskiness.
• The extent of RMMs disclosure may vary. Disclosing more information about RMMs may send signals to the debt
market that the auditor perceived higher risk from those matters compared to other risks provided with less details.
Given that, we test the following hypotheses:
Hypothesis 2a: Cost of debt is positively associated with the number of risks of material misstatements reported as
KAMs.
Hypothesis 2b: Cost of debt is positively associated with the length of risks of material misstatements reported as KAMs.
H3: EAR tone and cost of debt
• Financial reporting studies show that negative reporting tone raises firms' cost of debt/equity capital
(Ataullah et al., 2018; Bonsall and Miller, 2017; Loughran and McDonald, 2011; and Kothari et al., 2009).
• If greater negative EAR tone captures auditors’ uncertainty, we expect this to be positively associated with
rises in the cost of debt.
• Auditors’ use of uncertain and pessimistic tone could derive creditors to increase both price and security
protections, and vice versa.
• Creditors may assign a higher probability of litigation to firms with disclosure negative tone (Loughran &
McDonald, 2011).
• To the extent that creditors perceive negative tone to be associated with high distress risk and financing
costs, they may question the continuity of a firm's business as a result of distress and lack of capital
financing, and thus question its ability and incentive to pay back debts.
Given that, we test the following hypothesis:
Hypothesis 3: EAR tone is significantly associated with cost of debt.
 Research Design
Sample selection and data sources
• The research sample consists of UK non-financial companies that are listed in FTSE
ALL Shares index. The final sample consists of 302 non-financial companies with 2,079
firm-year observations over eight years, from 2010 to 2017.
• KAMs and auditor related variables: Annual reports from companies' websites.
• The rest of variables are collected from Datastream and FAME databases.
Data analysis: OLS based on heteroskedasticity‐robust standard errors, 2SLS
regression and Differences-in-Differences estimation.
Research Design

Where:
• COD is the ratio of total interest expenses to average total debt of firm i in year
t+1.
• EAR is an indicator variable that takes 1 if the extended audit report is adopted.
• KAM is the number of risks of material misstatements disclosed in KAM section in
the audit report.
• LENGTH is the natural log of the average length per KAM.
• TONE is the word count frequency of the positive words minus (negative words
and uncertain words) in an auditor's report texts divided by auditor’s report words
using the word dictionaries developed by Loughran and McDonald (2011).
 Descriptive Statistics
Variables N Mean S.D. Min 0.25 Mdn 0.75 Max
Panel A: Dependent variable: Cost of debt (COD t+1)
COD 2079 0.02 0.02 0.00 0.01 0.02 0.03 0.09
Panel B: Independent variables
KAM 1277 3.78 1.47 1.00 3.00 4.00 5.00 10.00
LENGTH 1277 5.61 0.50 2.46 5.39 5.67 5.93 6.80
TONE 1277 -0.03 0.01 -0.06 -0.04 -0.03 -0.03 -0.01
Panel C: Control variables
RISK 2079 27.69 8.80 13.42 21.44 26.40 32.61 56.71
EM 2079 0.42 0.49 0.00 0.00 0.00 1.00 1.00
INTCOVER 2079 18.07 29.58 -34.72 3.43 7.26 17.08 119.00
GCO 2079 0.01 0.10 0.00 0.00 0.00 0.00 1.00
Big4 2079 0.97 0.16 0.00 1.00 1.00 1.00 1.00
AFEES 2079 6.49 1.25 3.14 5.61 6.38 7.24 10.59
NAFEES 2079 0.31 0.19 0.00 0.17 0.29 0.43 0.71
SIZE 2079 14.02 1.68 9.23 12.84 13.87 15.02 19.51
ROA 2079 0.11 0.08 -0.25 0.06 0.10 0.15 0.27
QUICK 2079 1.11 0.71 0.31 0.69 0.96 1.29 3.99
LOSS 2079 0.13 0.34 0.00 0.00 0.00 0.00 1.00
CATA 2079 0.41 0.21 0.09 0.26 0.38 0.54 0.87
DEBT 2079 0.22 0.16 0.00 0.09 0.21 0.31 0.55
SEGMENT 2079 0.68 0.73 0.00 0.00 0.69 1.39 2.30
 Correlation Matrix
Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19)
(1) COD 1.00  
(2) EAR -0.14* 1.00  
(3) KAM 0.18* . 1.00  
(4) LENGTH 0.04 . -0.16* 1.00  
(5) TONE -0.19* -0.28* -0.22* 0.15* 1.00  
(6) RISK 0.21* -0.15* -0.12* 0.02 -0.14* 1.00  
(7) EM 0.03 -0.01 -0.06* 0.01 0.05 0.07* 1.00  
(8) INTCOVER -0.42* 0.02 -0.24* -0.03 0.11* -0.04 0.07* 1.00  
(9) GCO 0.08* 0.03 0.02 0.01 -0.14* 0.08* 0.00 -0.05* 1.00  
(10) BIG4 0.03 -0.03 -0.01 0.12* -0.03 0.02 -0.03 -0.04 0.02 1.00  
(11) AFEES -0.04 0.05* 0.25* 0.03 -0.07* -0.13* -0.11* -0.06* 0.02 0.06* 1.00  
(12) NAFEES 0.10* -0.23* 0.02 -0.07* -0.00 0.13* 0.05* 0.01 0.02 0.05* -0.24* 1.00  
(13) SIZE 0.18* 0.06* 0.46* 0.06* -0.07* -0.28* -0.13* -0.28* 0.05* 0.10* 0.09* -0.04* 1.00  
(14) ROA -0.18* -0.04 -0.17* -0.11* 0.11* -0.15* 0.13* 0.55* -0.06* -0.02 0.07* 0.02 -0.13* 1.00  
(15) QUICK -0.03 0.01 -0.07* 0.01 -0.11* 0.20* 0.04 0.20* -0.02 -0.09* -0.01 0.08* -0.20* 0.02 1.00  
(16) LOSS 0.16* 0.09* 0.12* 0.11* -0.18* 0.27* 0.03 -0.22* 0.10* 0.04 -0.01 0.05* -0.00 -0.43* 0.10* 1.00  
(17) CATA -0.30* -0.03 -0.17* -0.04 0.07* 0.12* 0.11* 0.29* -0.02 -0.05* 0.08* 0.00 -0.38* 0.18* 0.19* -0.07* 1.00  
(18) DEBT 0.46* 0.04 0.23* 0.02 -0.11* -0.03 0.04 -0.48* 0.05* 0.06* 0.01 0.05* 0.36* -0.11* -0.20* 0.11* -0.43* 1.00  
(19) SEGMENT 0.09* -0.02 0.05 -0.00 -0.06* -0.00 -0.05* -0.12* -0.01 0.02 0.16* -0.02 0.01 -0.07* -0.02 -0.02 -0.03 0.08* 1.00
Notes: * shows significance at the 0.05 level.
 Empirical Results
Dependent variable: CODt+1 H1 H2 H3
EAR -0.005***    
  (-6.38)    
KAM   0.001** 0.001**
    (2.53) (2.30)
LENGTH   0.004*** 0.004***
    (3.49) (3.77)
TONE     -0.124**
      (-2.37)
Controls Included Included Included
Year FE NO YES YES
Industry FE YES YES YES
Observations 2079 1277 1277
Max VIF 2.00 2.22 2.22
F stat 56.41*** 42.55*** 40.72***
Adjusted R2 0.34 0.45 0.45
The above table represents regression coefficients and t statistics in parentheses * p<0.10, ** p<0.05, *** p<0.01.
Sensitivity Analyses (1)

•Sub-samples:
• High versus Low KAM   (1) (2) (3) (4)

groups.   KAM_LOW KAM_HIGH EM_LOW EM_HIGH

• High versus Low KAM     0.001 0.002**

Discretionary Accruals
(Earnings management).       (1.15) (2.31)

LENGTH 0.001 0.008*** 0.002** 0.006***

  (1.42) (3.95) (2.11) (3.37)

TONE -0.048 -0.193** -0.014 -0.180*

  (-0.81) (-2.19) (-0.22) (-1.85)

Sensitivity   H2 H3
Analyses (2) AbnKAM 0.001** 0.001**
•Abnormal KAM,   (2.16) (2.04)
Length and Tone
AbnLENGTH 0.004*** 0.004***
  (2.89) (3.19)
AbnTONE   -0.154**
    (-2.48)
 Sensitivity Analyses (3)
• Endogeneity tests
  H1 H1 H2&H3 H2&H3
  DID Omitted Omitted IV
variables variables (2nd Stage)
ADOPT 0.002*      
  (1.96)      
POST -0.002**      
  (-2.33)      
ADOPT* POST -0.005***      
  (-4.05)      
EAR   -0.001*    
    (-1.70)    
KAM     0.001* 0.001**
      (1.89) (2.15)
LENGTH     0.002** 0.004*
      (2.23) (1.92)
TONE     -0.104** -0.240**
      (-2.36) (-2.07)
Additional   H1 H2 H3
EAR 0.025***    
Analyses (1)   (4.05)    
•Dependent variable: KAM   -0.001 -0.002
Access to debt capital
    (-0.15) (-0.50)
LENGTH   -0.019** -0.015
    (-2.09) (-1.59)
TONE     -1.423**
      (-2.49)
 Additional Analyses (2)
Negative tone - Uncertainty tone - Positive tone

  Negative Uncertain Positive

KAM 0.001** 0.001** 0.001**
  (2.41) (2.13) (2.49)
LENGTH 0.004*** 0.004*** 0.003***
  (3.71) (3.53) (3.30)
TONE 0.205** 0.262** 0.196
  (2.46) (2.42) (1.38)
 •Main Conclusions
• This paper concludes that the EAR can reduce the information
gap between auditors and financial report users in general, but
debt providers in particular.
• Extended auditor disclosure is negatively related to Cost of
debt.
• The number and length of Risk of Material Misstatements
Conclusions/ (RMMs) are positively related to cost of debt.
Implications/ • The auditor tone is significantly related to the firm cost of debt.
•Implications
Limitations • Policy – joint pursuance of auditor disclosure reforms.
• Stakeholders and research – extended audit disclosure
communicate relevant information.
• Audit firms – audit reports tone matters.
•Limitations
• Automated textual analysis.
• Endogeneity – possibly difficult to eliminate completely.
 05/04/23

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Brunel University London Presentation Title 24