Abstract
This study provides new evidence on the influential role of external auditors in enhancing the informativeness of form 10-K annual reports to shareholders. Specifically, we find that the client's choice of a Big 4 auditor (PwC, EY, KPMG, and Deloitte) versus a non-Big 4 auditor contributes to cross-sectional variations in 10-K disclosure volume. We also document that the benefit of enhanced disclosures provided by Big 4 auditors is more pronounced for audit clients with poorer accrual quality and those with higher information asymmetry. Furthermore, we introduce the portion of 10-K length unexplained by operating complexity and observable client characteristics as a new proxy for audit firm effort. Specifically, we find that abnormally long disclosures are associated with higher audit fees and longer audit report lag, which implies that an incremental level of audit effort can be inferred from the discretionary component of 10-K disclosures. As audit effort is costly, a greater volume of 10-K disclosures can be expected to be associated with an improvement in the quality of financial reporting. Overall, our findings show that auditors play more than a simple attestation role in the financial reporting process, and that the quality of financial reporting in a company's 10-K annual report is a joint product of the effort and decisions of both a company's managers and its auditors.
Highlights
While the standard audit report clearly states that an auditor’s responsibility is to express an opinion on financial statements, there is controversy over whether the role of the external auditor is limited to verifying compliance with generally accepted accounting principles (GAAP) or whether that responsibility extends to assuring ‘‘fair presentation’’ to the capital markets (e.g., DeFond et al, 2016)
While the propensity score matching (PSM) model appears effective in forming a balanced sample of Big 4 and non-Big 4 auditors, we consistently find that the average 10-K disclosure volume is still relatively larger for clients of Big 4 auditors (10.61) than those of non-Big 4 auditors (10.57)
While all explanatory variable coefficients are significant and have directional effects consistent with those documented in previous studies, we consistently find that the estimated coefficient of BIG4 is positive and significant, indicating that the variation in 10-K reports between Big 4 and non-Big 4 auditors persists with the PSM
Summary
While the standard audit report clearly states that an auditor’s responsibility is to express an opinion on financial statements, there is controversy over whether the role of the external auditor is limited to verifying compliance with generally accepted accounting principles (GAAP) or whether that responsibility extends to assuring ‘‘fair presentation’’ to the capital markets (e.g., DeFond et al, 2016). We focus on determining whether a client’s choice of a Big 4 auditor contributes to cross-sectional variations in 10-K informativeness as measured by disclosure volume This approach is consistent with Dunn and Mayhew (2004), who argue that a client’s choice of an industry specialist auditor is associated with the client’s intention to provide enhanced disclosure. The findings help to answer the broader question of how auditor choice is associated with the quality of a firm’s disclosure by providing evidence that the choice of a Big 4 auditor is associated with enhanced disclosure practices in 10-K reports This suggests that the auditor’s role in financial reporting is not limited to providing assurance concerning management’s compliance with GAAP.
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