Are Key Audit Matter Disclosures Useful in Assessing Financial Distress?

• In Event: Critical/Key Audit Matters

Abstract

This study examines the usefulness of new expanded audit report key audit matters (KAM) disclosures in assessing firm financial distress. Using KAM disclosures from a manually-collected sample of Premium listed firms in the U.K. for 2013 to 2018, we explore the association between the number, level (entity versus account), financial category (profitability, liquidity, or solvency), and nature (individual type) of auditor disclosed KAMs and firm financial distress. We find evidence that the greater the number of KAMs disclosed on a firm’s audit opinion, the higher the financial distress level of the firm. Results also show an association between the level and nature of KAM(s) disclosed by an auditor and financial distress level. Specifically, we find evidence that certain entity-level (e.g. going concern, restructuring and discontinued operations, and mergers and acquisitions) and individual account-level (e.g. revenue and management estimates) KAMs, as well as account-level KAMs with primary impact on a firm’s profitability and solvency, are more likely to be disclosed than others when firms are in financial distress. Our findings also suggest that KAMs have predictive ability in assessing the subsequent period financial distress of a firm. In all, the results provide evidence of a significant relation between KAM disclosures and firm financial distress levels, and in so doing, show that expanded auditor report regulation can help financial statement users assess one of the main risks associated with a firm - the risk of failure.

Authors

• Patricia Alvaro Wellmeyer, University of California-Irvine

• Morton Pincus, University of California-Irvine

• Maria-del-Mar Camacho-Miñano, Complutense University of Madrid

• Nora Muñoz-Izquierdo, CUNEF