The Determinants and Unintended Consequences of Expanded Audit Reporting: Evidence from Tax-Related Key Audit Matters

Abstract

This study examines the determinants and consequences of tax-related key audit matters (KAMs). We argue that it is important to examine constructs specifically related to KAM topics to draw valid inferences about expanded audit reporting. Tax KAMs provide this opportunity because tax expense is material to most firms, there is substantial risk in the tax function, and tax KAMs are prevalent and discuss a range of issues. Consistent with tax complexity increasing the difficulty of auditing tax expense, we find that firms with greater tax avoidance, greater tax risk, and larger deferred tax asset balances are more likely to receive tax KAMs, and that these tax characteristics map into the content of the tax KAMs. These results illustrate that tax KAM language is specific to firms’ tax activities. In consequences analyses, we find that firms that stop receiving tax KAMs increase their purchases of auditor-provided tax services (APTS), while firms that continue to receive tax KAMs decrease APTS. We further find that firms with unexpectedly low levels of tax KAM disclosure purchase more APTS. Our results are strongest for uncertain tax position and deferred tax KAMs, where the auditor has the most discretion in whether to issue the KAM. These results are consistent with economic bond incentives threatening auditor independence in tax KAM decisions.

Keywords: Tax, Key Audit Matters, Critical Audit Matters, KAM, CAM, Disclosure, Expanded Audit Reporting, Auditor Independence

JEL Classification: H20, H25, M41