title: Evidence from the U.K. on Auditor's Judgment in the Risks of Material Misstatement: Determinants and Consequences
Creators: name: Alduraywish, Yaqoub
Publisher: name: Griffith University
Year: 2019
Subjects: subject: Auditor’s judgment
subject: Risks of material misstatement
subject: Materiality level
subject: Corporate governance
subject: Audit fees
subject: Non-audit fees
subject: Information asymmetry
subject: Stock liquidity

description: An auditor report is prepared by an independent external auditor in a bid to provide reasonable assurance on a client company’s financial statements. Frequently in the past and following the global financial crisis, users of auditor’s report including investors are apprehensive in their appreciation of auditor’s report. They argue that auditors have failed to report the crisis. The ongoing contention of investors is that auditors use a standardized language that provides a uniform description of the audit process weaning away some key matters that could be of greater importance, hence leaving an information gap. In response to this serious ongoing criticism, standard setters made significant changes in auditor’s reporting model by issuing a new auditing standard. For example, the U.K., Financial Reporting Council (FRC) in 2013 issued International Standard on Auditing (UK and Ireland) 700, the Independent Auditor’s Report on Financial Statements. Aiming to narrow down information gap between auditors and investors as well as to enhance transparency in the auditor’s report, this new auditing standard requires the auditor to communicate with investors via his/his report about (1) the risks of material misstatement (RMM) with the greatest impact on engagement team effort, (2) the application of materiality in the audit, and (3) the scoping decisions made in the execution of the audit (FRC, 2013a). Similar auditing standard has been also adopted in other countries including the U.S. However, the U.K. is one of the earliest adopters of this new auditing standard. Consistent with the aim of this new auditing standard and motivated by the lack of research in this area, this thesis has three objectives. First, it empirically investigates the determinants of auditor’s disclosures in relation to the risks of material misstatement with the greatest impact on engagement team effort and the application of materiality in the audit. Second, it explores the consequences of this new auditing standard on audit and auditee firms in terms of audit fees and non-audit service fees. Third, it examines the influence of this new auditing standard on information asymmetry in the market for the firm's stock. The above objectives should provide a comprehensive view on the determinants and the effects of the new auditing report, hence increase our understanding on the determinants and the effects of such disclosures. Based on the research objectives, three studies are developed using relevant underpinning theories. The first study aims to investigate the influence of firm governance and characteristics on auditor’s disclosures in relation to the risks of material misstatement and the audit materiality level. In doing so, this study uses (1) key corporate governance elements including board structure, audit and nomination committees’ structure, internal ownership, and institutional ownership, and (2) auditee characteristics and performance including firm size, profitability, tangible assets, firm growth, the structure of asset, firm leverage, and firm complexity. Based on corporate governance models, Study One develops two models to achieve the objective of this study. The regression models rely on hand-collected data on the risks of material misstatement and material level from 322 London Stock Exchange listed firms with a premium listing of equity shares. Consistent with the expectation of this thesis, this study reveals a significant positive relation between corporate governance elements and auditor’s risks of material misstatement judgment. Specifically, board size, number of meetings in audit committee, size of nomination committee, and institutional ownership have a positive relationship with the risks of material misstatement disclosures. In addition, board size and institutional ownership are found to significantly and positively affect materiality. Results also indicate that the rate of sales growth and firm complexity increase RMM disclosures, while highly performing firms measured by ROA, firms with larger tangible assets accounts, and firms with a high rate of leverage have a negative relationship with such RMM disclosures. With audit materiality level, firm size has a positive influence on the materiality and this materiality increases in firms with better financial performance, contrary to firms with a higher rate of sales growth. Study Two addresses the impact of the adoption and implementation of ISA 700 on audit and auditee behavior in the context of the risks of material misstatement and audit and non-audit service fees. The sample of this study is based on a merged hand-collected data on the risks of material misstatement from 1008 annual reports in the U.K. with audit and non-audit service fees and their control variables from Bloomberg, Datastream, and Audit Analytics. A balanced panel data is then used. Study Two applies random-effects (RE) regression in examining the relation of risks of material misstatement with audit and non-audit service fees and with their control variables including ratios of receivable and inventory to total assets, sale growth, foreign operations, firm size, tangible assets, total accruals, return on assets, leverage, current ratio, return volatility, audit opinion, audit firm type, Z-Score, business subsidiaries, merger, loss, and year and industry dummies. As predicted, the second study finds that high audit fees are associated with high the risks of material misstatement. Specifically, it shows that both the number of risks of RMM and its contents in number of words have a positive and significant relationship with audit fees including non-audit service fees An important question is whether the implementation of auditing standard “ISA 700” would improve the information environment of firms whose shares are publicly traded. Study Three, therefore, investigates the link between information asymmetry component in the market measured by trading cost, price impact of trade, and immediate of shares, and increased accounting disclosures following the adoption of new auditing standard in the U.K. This study uses 1047 company’s annual reports to manually collect data on the disclosures of risks of material misstatement and uses Datastream and Bloomberg to collect daily market and financial data. It adopts Hail's (2002) disclosure model with its control variables, including firm size, net income, sales growth, asset tangible, return volatility, stock price, firm leverage, current ratio, Z-Score, and year and industry dummies to examine the relationship between the disclosures of risks of material misstatement and information asymmetry in the market for the firm’s stock. The results of this study, using the pooled ordinary least squares, support the argument that increased accounting disclosures increase firm information environment which have significant influence on the information asymmetry in turn enhancing stock liquidity. Specifically, this study shows that the disclosures of risks of material misstatement significantly and negatively affect bid-ask spread, significantly and positively affect stocks liquidity ratio, and significantly and positively affect number of trades and trading volume. This thesis contributes to the existing literature on current corporate governance, audit process and fees, and accounting disclosures literature and to regulators. First, it adds to the existing literature by investigating how corporate governance elements influence auditor’s disclosures of the risks of material misstatement and audit materiality in the extended auditor’s report. This area has not been considered in previous research. In addition, this study is the first attempt to use both audit fees and non-audit service fees and link them the risks of material misstatement in the extended auditor’s report. Furthermore, for the first time, this research uses a number of proxies related to information asymmetry component in the market in attempts to study the influence of such discourses on these proxies. The findings of this research could have significant implications for standard setters and regulators as this thesis shows that the information asymmetry is reduced with the new auditor's report, hence regulators may consider requiring auditors of smaller U.K. entities and secondary listing(s) entities to disclose the risks of material misstatement in the new auditor’s report. Overall, the results of this thesis show (1) how audit strategies are responsive to a client corporate governance, and characteristics, (2) show that audit fees are a function of client size, risk, internal controls weakness, and financial restatements, and (3) the auditor’s report provides more value-relevant information to investors which decreases the level of information asymmetry. To the best of my knowledge, this study is the most comprehensive study related to the new auditing standard; that is, ISA 700.