Are Key Audit Matter Disclosures Useful in Assessing Financial Distress?

Abstract

This study examines the usefulness of new expanded audit report key audit matters (KAM) disclosures in assessing the level of financial distress present at a firm. Using KAM disclosures from a hand-collected sample of UK Premium-listed firms for 2013 to 2018, we explore the association between firm financial distress and the number, risk level, financial statement impact, and nature of disclosed KAMs. Our study expands on recent literature examining the use of audit report disclosures on financial distress prediction models as well as literature examining the utility of expanded auditor reporting. We find the greater the number of KAMs disclosed, the higher the financial distress level of a firm. Results also show the usefulness of KAMs in assessing financial distress levels increases when considering the level and nature of KAM(s) disclosed. Specifically, certain types of entity-level and individual account-level KAMs, as well as KAMs with a primary impact on a firm’s profitability and solvency, are more likely to be disclosed when firms face higher levels of financial distress. Our findings also suggest KAMs have predictive ability in assessing subsequent period financial distress levels. In all, evidence from this study suggests expanded auditor reports can help financial statement users assess and predict one of the main risks associated with a firm - the risk of failure.