Earnings management, key audit matters and audit report readability

Abstract

PurposeAccording to the management obfuscation hypothesis, managers have incentives to influence the audit reports’ communicative value. This study aims to examine the relationship between corporate earnings management and the readability of Chinese-text audit reports and the impact of key audit matter (KAM) disclosure requirements on this relationship.Design/methodology/approachThis research adopts Taiwanese firms from 2010 to 2019 to investigate the association between earnings management and readability of Chinese-text audit reports within the framework of the KAM disclosure requirements implemented in 2016.FindingsThe findings show that auditors tend to issue less readable audit reports to firms undertaking earnings management, particularly after introducing KAM disclosures. Additional analyses indicate that such adverse impacts of client earnings management on audit report readability have become more pronounced for firms audited by a newly pointed or long-tenure lead audit partner, with high business risk, poor monitoring of governance mechanisms or a large amount of nonaudit services. These results suggest that auditor partners may compromise auditor independence and use flexible narratives in audit reports as a form of moral insurance.Practical implicationsAs auditors may manage audit report readability to reduce audit liability, authorities must formulate policies concerning audit report disclosure to strengthen its communicative value and simplify language usage. Additionally, authorities should strengthen quality control standards concerning auditor independence to reduce auditor pressure from clients’ economic importance.Originality/valueThis study provides valuable insights into auditors' responses to corporate earnings management behavior, particularly regarding the interplay between earnings management, audit report quality and regulatory changes, thus expanding our understanding of the dynamics within the auditing profession.