September 20, 2023 • By The UCI Paul Merage School of Business
In 2013 the UK initiated a massive worldwide shift in audit reports with the introduction of a new regulation requiring auditors to provide client-specific disclosures about the risks and other significant matters considered in the audit of the company's financial statements.
The new UK rule provided more information for investors, but it also raised compelling questions. What impact would this new reporting have on investors? Could these expanded audit report disclosures be helpful in assessing a company’s financial risk?
Professor Patricia Wellmeyer of the UCI Paul Merage School of Business, together with her colleagues María-del-Mar Camacho Miñano of the University of Madrid, Nora Muñoz-Izquierdo of CUNEF University, Madrid, and Morton Pincus of the UCI Paul Merage School of Business, set out to examine the usefulness of these new audit disclosures in assessing a company’s financial distress risk. The results of their research, recently published in The British Accounting Review under the title “Are Key Audit Matter Disclosures Useful in Assessing the Financial Distress Risk of a Client Firm?” provide insights into how investors can use audit reports to capture the financial distress risk associated with a firm.
“This ruling—the first of its kind in over 70 years—forever changed audit opinions,” says Wellmeyer. “Prior to this, an auditor would write a single paragraph that merely affirmed the financial statements fairly represented the company’s transactions. Now, with this new ruling, auditors are required to provide more information to investors regarding the risks of material misstatements present in a company’s financial statements.”
These new disclosures, denoted as Key Audit Matters (KAM), give new insights into where independent auditors believe the financial risks for a company lie, providing information auditors previously held proprietary. “There’s a lot more disclosure in the UK regulation that makes it very, very useful to investors and researchers with new data we’ve never had before.”
After the UK ruling in 2013, Wellmeyer and her team decided to make use of the new audit reporting data to determine how these KAM disclosures could help investors, regulators, and practitioners assess more information about a company's financial standing.
“We took a list of 800 premium-listed firms in the UK, followed them for the next six years, and hand-collected the KAM disclosures over that time frame,” she says. “It took a small army to create our own database. After the first three years, we submitted the initial draft of our paper in 2016, then gathered additional data over another three years to produce the report we recently published.”
Once the data were gathered, Wellmeyer and her coauthors began analyzing the disclosures they’d collected. “We were curious what these risk areas could potentially signify about the financial health of a company,” she says. “That’s when we started to focus on the idea of financial distress.”
Auditors are required to evaluate whether or not a company is in danger of becoming a growing financial concern, so “financial distress” was a positive indicator for their research. “Auditors are tasked with projecting whether a company is likely to remain a viable entity over the next year,” says Wellmeyer. “If we think it’s not, our explanatory paragraph needs to reveal why. Even if the company’s financial statements are clean, we have to give our reasons.”
Even though this type of reporting is a requirement for auditors, Wellmeyer notes many firm bankruptcies are not preceded by auditor going-concern opinions. “If you look at the history of going-concern opinions and examine the academic research surrounding them,” she says, “what you’ll find is less than 40 percent of companies that went bankrupt typically had going-concern opinions from their auditors.”
Numerous reasons may lie behind auditors so often failing to issue going-concern opinions when a company is distressed. Wellmeyer believes there may be a few strong possibilities. “Most auditors do the best they can, but these are complex assessments, and they don’t always get it right. Another possibility is auditors are afraid a going-concern opinion could become a self-fulfilling prophecy and create negative investor response that essentially weakens the company financially, leaving them leery of issuing these types of opinions.”
With the new auditing disclosure requirements in place, Wellmeyer and her colleagues wanted to know if they might provide a better mechanism for using auditor reporting to gather information about the financial distress levels of companies—the idea being auditors now don’t have to qualify their opinions about the viability of a company to signal financial distress risk. KAM disclosures could provide information that investors could use to make their own assessments about the health of companies.
“This is where our study comes in,” says Wellmeyer. “We didn’t know whether KAMs would be associated with the financial distress level of firms, but we imagined if they were, then these disclosures could provide another avenue for investors to use audit information to measure the financial distress of a company.”
Wellmeyer and her coauthors’ research focused on examining the relationship between a company’s financial distress level and the type and number of Key Audit Matters that auditors disclose on their expanded reports.
The results of their research showed companies with more KAM disclosures were also more likely to be in financial distress. “While these results are useful to investors,” she says, “they are also useful in the classroom, as it gives auditing professors much more context in which to illustrate the benefits of applying a risk-based approach to audits. Not every company is the same, so it is important for auditors to understand and correctly identify where the risk areas lie for each company they audit. Illustrating the relationship between risk areas and financial distress gives our students a practical example of the link between risk assessments and company fundamentals.”
“What really excites us about the results of our study is that it gives financial statement users another avenue—not available in the past—for using auditor report data to assess financial distress levels at firms,” Wellmeyer says. “As investors, we no longer have to rely on an auditor to write a going-concern opinion to alert us to the risk of impending bankruptcy. These opinions haven’t been good signals in the past. We now show KAM disclosures can provide a more accurate and timely signal of financial distress that investors can use to make decisions.”
“If you look at KAM disclosures for UK companies versus Critical Audit Matter (CAM) disclosures for US companies, you’ll see US companies have far less of these disclosures than comparable UK companies. This is creating concerns about the company-specific nature of US CAM disclosures and whether they may be boilerplate and vague,” says Wellmeyer. “For example, where UK audit reports have an average of three to four KAM disclosures per company, nearly two-thirds of US company audit reports report only a single CAM, and the average number of CAM disclosures across all US public companies is approximately 1.4. These include large organizations like Google and Microsoft, where you’d expect to see at least two CAMs or more reported.”
Now that the research has been published, Wellmeyer is hopeful US regulators will dive deeper into CAM disclosures in the US. “I think it is something of a red flag to our US regulators that US CAM disclosures are so few compared to those for UK companies,” she says. “If we want these disclosures to be meaningful for investors, they need to provide transparent company-specific information about where auditors assess the risk areas for a particular client.”