The impact of key audit matter reporting on analyst forecast accuracy and forecast dispersion: evidence from Chinese listed firms

Abstract

Purpose The purpose of this study is to investigate the decision usefulness of key audit matters (KAMs) disclosures from the perspective of financial analysts. Design/methodology/approach Using data from two groups of Chinese-listed firms subject to different audit standards, the authors use a quasi-natural experiment and the difference-in-differences approach to examine the impact of KAMs on analyst forecasts. The authors also conduct a textual analysis on management disclosures as well as on the content of KAM disclosures. Findings The results of this study show that both forecast errors and dispersion have significantly declined for the firms disclosing KAMs compared to the firms without such disclosures. Further analysis presents evidence that KAM disclosures have resulted in simultaneous increase in management disclosures and audit quality. In addition, auditor characteristics, such as auditor’s dependence on client fees and its industry specialization, and firm’s characteristics, such as its ownership structure and its social connection with the auditor, appear to affect the informativeness of KAM disclosures. The authors also perform content analysis of KAMs to provide additional insight. Research limitations/implications As AH firms are required to adopt the expanded audit report one year before A shares firms, by design, there is only one year in which these two types of companies differ. Therefore, the results without overgeneralizing the impact of KAM disclosures should be interpreted. In addition, this study involves the Chinese market alone and, therefore, may be affected by factors peculiar to the functioning of the Chinese economy and financial markets. Originality/value The main contribution of this study lies in highlighting the salience of KAM context in shaping the relationship between auditors, managers and analysts and its collective impact on information environment. The findings of this study are significant in that they help establish the importance of KAM disclosures in helping to assure that higher quality financial information is available to capital markets, as well as information that is otherwise unavailable given disclosure mandates in China. This study adds to the literature on the importance of providing additional means of safeguarding auditor independence and on the value of auditor expertise in providing useful content in audit disclosures. Moreover, the findings suggest that the expanded audit report can help reduce the level of asymmetric information, especially for state-owned entities. They provide insight on how the new audit rule influences managers and auditors communicating complex accounting matters as well as the moderating effect of the social connections between auditors and firm executives.

The effect of key audit matters on the association of credit risk and earnings quality

“…Therefore, they conclude that the effect of KAM disclosures on debt contracting is positive. In addition, Hu et al (2022) find that KAM disclosure was associated with a decline in financial analyst forecast errors and forecast dispersion with respect to firm earnings in China and Hong Kong compared to the results for firms not making such disclosures. This is a clear indication of the information impact of KAM disclosures on those whose intellectual product influences capital allocation.…”

Auditors' interpretation of risk and the quality of analysts' earnings forecasts: Evidence from textual analysis of key audit matters

“…Impact of KAMs in the emerging Chinese capital market Since 2016, many scholars have focused on the information value of KAMs in the Chinese capital market. They found that communicating KAMs can improve cumulative abnormal returns (Wang et al, 2018), the quality of analysts' earnings forecasts (Hu et al, 2022;Kong et al, 2022) and firms' investment efficiency (Wang & Zou, 2022).…”

“…Second, we contribute to research on how KAMs affect analysts' earnings forecasts. Unlike Kong et al (2022) and Hu et al (2022), we believe that auditors' interpretations of the risk of material misstatements can help analysts discern the quality of financial statements and, thus, improve the quality of analysts' forecasts. Third, we identify the conditions under which auditors' interpretations of the risk of material misstatements improve the quality of analysts' earnings forecasts in emerging markets.…”

“…In their additional analysis, Kong et al (2022) demonstrate that communicating KAMs can improve the accuracy of analysts' earnings forecasts by increasing the public information available to analysts. Based on the path through which communicating KAMs can improve audit quality, the quality of financial reports and management disclosure, Hu et al's (2022) empirical testing indicates that communicating KAMs has a positive impact on the quality of analysts' earnings forecasts. It is worth noting that Kong et al (2022) did not specify the nature of public information.…”

“…It is worth noting that Kong et al (2022) did not specify the nature of public information. Meanwhile, Hu et al (2022) did not directly conduct a text analysis on the interpretations of the risk of material misstatements in KAMs. To address this problem, we propose that, as public information provided by independent auditors, the nature of KAMs is auditors' interpretations of the risk of material misstatements.…”