This paper aims to investigate the earnings management (EM) reactions of firms to the key audit matters (KAMs) disclosed in expanded audit reports. Although previous literature has extensively investigated the interconnection between EM and different risks, little research to date examines the association between KAMs and EM strategies, considering both real earnings management and accruals earnings management. To test the hypotheses, we use a sample of UK listed companies over the period 2013 to 2018. The results show a different relationship between KAMs disclosed in the extended audit report and EM strategies. In particular, findings reveal that EM strategies differ according to the number of KAMs, the type of KAMs and each specific type of KAMs. The article contributes to a better understanding of the effect of financial information transparency and accounting quality.
Policy Implications
- Accounting language in financial reporting is necessary to ensure market transparency and consistent decision-making by all stakeholders interested in the evolution of companies.
- If firms' managers modify intentionally financial reporting (earnings management, EM), serious problems arise not only for the main users of the financial statements but also for the society as a whole.
- The audit profession serves the public interest by ensuring the reliability of as is to obtain reasonable assurance on financial information. External auditors, as independent professionals, play a crucial role in increasing the credibility of financial statements. They issue audit reports.
- Audit quality reduces EM activities. A favourable audit can increase investor confidence and improve the prospects for future funding.
- The number of key audit matters (KAMs) disclosed in the extended audit report in the previous year's financial statements increases financial reporting quality through lower levels of sales manipulation.
- Firms significantly decrease their level of sales manipulation when auditors disclose KAM, regardless of whether they refer to a single accounting item or to the overall entity. Moreover, the division of KAMs into entity-level and account-level KAM is crucial to capture their effect on financial reporting quality.
- Our results also have practical implications for several stakeholders as if a firm's audit reports contain KAMs or account-level KAMs, investors can infer that the firm's accounting quality is better, as it reduces the level of earnings manipulation.
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