Evidence from the U.K. on Auditor’s Judgment in the Risks of Material Misstatement: Determinants and Consequences

Abstract

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 ii 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 ma