Financial report readability and audit fees: a simultaneous equation approach

Abstract

Purpose This paper aims to investigate whether audit fees and financial report readability are bi-directionally related. Design/methodology/approach The authors test their hypotheses with empirical data. Specifically, they adopt a two-stage simultaneous equation regression model to assess the bi-directional relationship between audit fees and financial report readability. Findings While poor readability increases the fees charged by the auditor, higher audit fees improve the readability of the financial reports. Research limitations/implications This study is based on US data. Future research may extend this study to other countries. Practical implications Poor financial report readability encumbers stakeholders of the firms. Understanding the interaction between financial report readability and audit fees will help both auditors and firm managers. Social implications Audit committees aggressively negotiating for lower audit fees should be aware of the link of low audit fees, potentially indicative of poor quality, to less readable reports. Investors and regulators too should be concerned about this relationship, especially in instances when auditors low-ball audit fees or when firms aggressively negotiate for lower audit fees. Originality/value To the best of authors’ knowledge, this study is the first to document the bi-directional relationship between financial report readability and audit fees and assess the positive impact of audit fees on financial report readability.

MD&A readability, auditor characteristics, and audit fees

“…Building upon Abernathy et al (2019) and Xu et al (2019), this study contributes further evidence on auditor reactions when financial report readability signals that they are exposed to a high level of risk. Different to the previous studies, we take into consideration the fact that auditors are different in terms of size, experience and expertise, which is unlikely to lead to a uniform response to a high level of risk.…”

“…They show that auditors spend more effort, charge higher fees and are more likely to issue a modified going concern opinion in response to a higher level of audit engagement risk. Xu et al (2019) show that while auditors charge higher fees for less readable financial reports, the readability of financial reports improves when higher fees are paid to auditors. These findings suggest that auditors spend more effort to improve audit quality and to reduce risk when faced with a high-risk client.…”

“…However, auditors are able to see through the strategically complex language used in financial reports and action accordingly (Abernathy et al, 2019;Xu et al, 2019). Abernathy et al (2019) argue that auditors are able to infer audit engagement risk from the readability of financial statement footnotes.…”

“…By establishing the connection between audit fees, audit efforts and MD&A readability, we confirm that audit effort is a channel through which MD&A readability affects audit fees. Both Abernathy et al (2019) and Xu et al (2019) show that auditors charge higher fees when financial reports are less readable. Furthermore, Abernathy et al (2019) use audit report lag as a proxy for audit efforts and show that auditors increase audit efforts when financial reports are less readable.…”

The influence of narrative disclosure readability, information ordering and graphical representations on non-professional investors' judgment: evidence from an emerging market

“…Through literature, the importance of corporate narratives readability can be reasoned to making an effective communication of value-relevant information (Fisher et al, 2019;Loughran and McDonald, 2014), where it can enhance the quality of information provided by firms and thus, helping users in their decision making and affecting their reactions in the market (Cui, 2016;Hsieh et al, 2016;Lawrence, 2013;Miller, 2010;Rennekamp, 2012;Tan et al, 2014Tan et al, , 2015Twedt and Rees, 2012;You and Zhang, 2009). In addition, readability of different disclosures can increase informational efficiency Influence of narrative disclosure readability (Hesarzadeh and Rajabalizadeh, 2019), affect analysts' followings (Aymen et al, 2018;Lehavy et al, 2011), affect firms' cost of capital (Ertugrul et al, 2017), provide incremental information about audit engagement risk (Abernathy et al, 2019) and affect the audit fees as well (Abernathy et al, 2019;Xu et al, 2019). Many prior studies examine corporate narratives' readability from the users' side.…”