This literature review is of interest to auditors, standard setters, investors, regulators, and other stakeholders affected by auditor’s reporting, as the disclosure of KAMs significantly changes auditors’ communication. Readers will gain insights into initial research findings on KAM disclosure that will help evaluate the consequences of the new reporting requirements.

The auditor’s report is the primary mean of communication between auditors and financial statement users (PCAOB 2017). However, the traditional reporting model is highly standardized and therefore frequently perceived as insufficiently useful, informative, and transparent (Asare and Wright 2012; Church et al. 2008; IAASB 2011). In particular, in the aftermath of the financial crisis of 2008, regulators, standard setters and the investment community started seriously questioning the informative value of the auditor’s report. Similarly, academic research in the last decade has also repeatedly emphasized that there may be a need for change, motivating audit report reforms. For example, Carcello (2012) and Turner et al. (2010) find that users generally valued the auditor’s opinion but showed little interest in reading the actual report given its highly standardized format. Users assessed the traditional auditor’s report as uninformative in particular because nearly all public companies receive the same unqualified opinion (Church et al. 2008; Gray et al. 2011). In their research synthesis, Mock et al. (2013) conclude that stakeholders desire more information about the audit, the auditor and financial statements. Moreover, Vanstraelen et al. (2012) find that users were interested in additional disclosures on audit findings such as key areas of risks. Overall, research results indicate that there is a gap between information that users desire about financial statements and the audit and what is available through a company’s audited financial statements and the auditor’s report. Standard setters and researchers refer to this phenomenon as the “information gap” (IAASB 2012; Mock et al. 2013). In 2012, the chairman of the IAASB stressed that “more than ever before, [...] users of the audited financial statements are calling for more pertinent information for their decision-making in today’s global business environment with increasingly complex financial reporting requirements” (IAASB 2012). The information gap is closely related to the long-standing expectation gap which describes the difference between users’ expectations of an audit and what an audit actually is (IAASB 2011). As academic research provides ample of evidence on the persistence of this gap (e.g., Chong and Pflugrath 2008; Gold et al. 2012), Gray et al. (2011) argue that there is a need to make significant changes to the auditor’s report in order to reduce misperceptions.

These debates and research findings have resulted in multiple initiatives across the globe to enhance the communicative value of the auditor’s report. The International Auditing and Assurance Standards Board (IAASB), the European Commission (EC), the Public Company Accounting Oversight Board (PCAOB), and the U.K. Financial Reporting Council (FRC) finalized their projects to enhance the auditor’s report. One of the most significant amendments is the disclosure of Key Audit Matters (KAMs) or Critical Audit Matters (CAMs, which are the equivalent concept in the U.S. jurisdiction) in the auditor’s report. According to ISA 701.8, key audit matters are “those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period”. Unlike the traditional auditor’s report, the revised form allows for more customized information disclosed about the client- and engagement-specific observations made by the auditor. As such, the primary objective of standard setters and regulators is the transformation of the traditional pass/fail-model into a more individual and valuable report in order to meet the informational needs of financial statement users.

In this paper, we review the emerging body of academic research which examines the effects of KAM disclosures in the auditor’s report. We do so by examining four distinct streams of research. First, we review research papers that investigate whether KAM disclosures indeed have the potential of meeting the expectations of standard setters and regulators with respect to providing a more valuable reporting model. Second, some scholars argue that the introduction of the KAM section in the auditor’s report may not only influence financial statement users’ perception and decisions but could also have an influence on the audit itself. For example, Reid et al. (2018) suggest that auditors may exert more effort during the audit because of an increased sense of accountability due to anticipation of KAM disclosure. Similarly, the IAASB (2015b) refers to such potential increases of auditor professional skepticism in areas where KAMs are identified and, as a result, increased audit quality, not only in the perception of the users. As a result of the potential of audit quality implications, a second stream of research examines auditor responses to KAM disclosures. Third, in the course of the development of the new reporting requirements, auditor legal liability was a frequently debated controversy, particularly in the United States (e.g., Tysiac 2013). The concern is that disclosing KAMs might increase jurors’ perceptions of auditor liability, especially when auditors have failed to detect misstatements. Hence, a third stream of literature examines the effects of KAM disclosure on auditor’s liability. Fourth, there is a burgeoning literature on client management reporting behavior in response to KAM disclosure. A potential benefit of KAM disclosures in this area is that client management may adopt less aggressive accounting in anticipation of auditor disclosure (Reid et al. 2018). The IAASB (2015) also referred to increased attention by management to KAM disclosures, which could have an indirect, beneficial effect on reporting behavior.

The objective of this paper is to provide an overview of the existing literature and to summarize the preliminary findings and implications of 22 studies.¹In our review, we include research studies available until 1 August 2018. Since research in this area is in its infancy, we include working papers in our review rather than focusing exclusively on published articles.

The remainder of this paper is organized as follows. In the next section, we provide a brief overview of related regulatory developments. Section 3 summarizes and discusses the results of academic studies on KAM disclosures. The final section presents our conclusions including implications for future research and for the audit profession.

In May 2011, the IAASB published the consultation paper “Enhancing the value of auditor reporting: Exploring options for change”, discussing possible ways to improve the auditor’s report, particularly regarding the increased need for information by users and the persisting expectation and information gap (IAASB 2011). The IAASB’s (2012)Invitation to Comment resulted in a high level of support by various stakeholders for the amendments proposed by the IAASB (Prasad and Chand 2017; Simnett and Huggins 2014). In July 2013, these initiatives were followed by the Exposure Draft “Reporting on audited financial statements: Proposed new and revised International Standards on Auditing (ISAs)” (IAASB 2013). On 15 January 2015, the IAASB concluded its project with the release of the final version of the new and revised ISAs including the requirement to disclose KAMs in the auditor’s report of public entities (IAASB 2015a, ISA 701). KAMs are selected from matters communicated with those charged with governance and that required significant auditor attention in performing the audit including including significant auditor judgments, areas of higher assessed risk of material misstatement, and the effect on the audit of significant events or transactions that occurred during the period. (ISA 701.9). The description of a KAM shall include an explanation of (1) why the matter is considered as strongly significant in the audit, (2) how the matter was addressed in the audit, (3) and a reference to the related disclosures in the financial statements (ISA 701.13). ISA 701 is effective for audits of financial statements of listed entities for periods ending on or after 15 December 2016.

The European Commission aspires to improve auditor reporting in a similar way. According EU-Regulation No 537/2014 the auditor’s report shall provide: (1) a description of the most significant assessed risks of material misstatement, (2) a summary of the auditor’s response to those risks, and (3) where relevant, key observations arising with respect to those risks. The EU-Regulation is directly applicable in all Member States and is effective for audits of public interest entities from 17 June 2016 (European Parliament and European Council of the European Union 2014).

In the UK, the FRC revised their reporting requirements already in June 2013 in order to enhance the transparency of the auditor’s report aiming a better communication between auditors and users. Provisions became effective for audits of financial statements for periods commencing on or after 1 October 2012 and require auditors, among other things, to report the risks of material misstatement that had the greatest effect on: (1) the overall audit strategy, (2) the allocation of resources in the audit, and (3) directing the efforts of the engagement team (FRC 2013).

In a similar vein, the PCAOB is currently undertaking changes to the existing auditor’s report, including the communication of Critical Audit Matters. Similar to KAMs, these are matters that were communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements, and (2) involved especially challenging, subjective, or complex auditor judgment. The new requirements regarding CAM disclosures will take effect for audits for fiscal years ending on or after 30 June 2019 for large accelerated filers. For all other companies to which the provisions apply, the new regulations will be effective for periods ending on or after 15 December 2020 (PCAOB 2017).

Despite the use of different terminologies, the implemented reforms of expanded auditor reporting overlap considerably. Although the requirements differ in the details, standard setters and regulators globally have clearly concluded that there is a need to disclose additional information about risk-related matters in the auditor’s report. Thus, for the first time, investors gain insights into significant audit findings and procedures.

A substantial and growing body of literature investigates the effects of the disclosure of KAMs in the auditor’s report. To find the relevant studies, we used different databases (for example EBSCO, Google Scholar, SSRN, Web of Science) and searched for the key words “key audit matters” and “critical audit matters” in combination with “auditor reporting”, “audit report” and comparable terms. Due to the currency of the topic, a time limitation was not necessary. Although it is common to consider only published research in literature reviews, we extended our literature review to include publicly available working papers because the majority of related studies have not yet been published. Therefore, we included working papers that have been presented at pertinent academic conferences (e.g., conferences of the American Accounting Association (AAA), the European Audit Research Network (EARNet), the International Symposium on Audit Research (ISAR)).²

The existing studies are based on experimental designs and archival data. We note that due to the lack of archival data, the majority of KAM research is experimental. Related reforms were adopted very recently, so that the only archival data for meaningful analyses is currently available from the UK, where auditors were required to report KAM since 2013.

We group the recent studies on KAM disclosures in four categories. The first category examines the effects of KAM disclosure on investor behavior and market reaction (Christensen et al. 2014; Köhler et al. 2016; Boolaky and Quick 2016; Carver and Trinkle 2017; Sirois et al. 2018; Bédard et al. 2018; Lennox et al. 2018; Gutierrez et al. 2018; Almulla and Bradbury 2018). The second category focuses on auditor responses investigating KAM effects on auditor judgement, audit fee and audit quality (Reid et al. 2018; Gutierrez et al. 2018; Almulla and Bradbury 2018; Li et al. 2018; Bédard et al. 2018; Asbahr and Ruhnke 2017, Ratzinger-Sakel and Theis 2018). The third category of papers examines whether the disclosure of KAMs will affect jurors’ assessments of auditor liability (Brasel et al. 2016; Kachelmeier et al. 2018; Brown et al. 2016; Gimbar et al. 2016; Backof et al. 2018; Vinson et al. 2018). Finally, we review a handful of studies that investigate how management reporting practices are affected by (anticipated) KAM disclosures (Cade and Hodge 2014; Bentley et al. 2018; Klueber et al. 2018). Table 1 provides an overview of the recent studies about KAM disclosure.

Responding to extensive criticism of the traditional pass/fail-model of auditor reporting, standard setters and regulators worldwide have recently released new auditor reporting requirements, including the requirement for auditors to disclose Key Audit Matters (KAMs). The disclosure of KAMs is supposed to enhance the information value and decision usefulness of the auditor’s report, and may also have effects on the performance of auditors and managers, as well as liability judgments of jurors. We identified 22 research studies examining the consequences of KAM disclosures for investor behavior, auditor responses, jurors’ assessments of auditor liability, and client management responses.

Several research findings support the intended benefits of KAM disclosures. For example, experimental evidence suggests that KAMs have the potential of influencing the decisions of financial statement users, particularly with regard to non-professional investors. KAMs also have the potential of effectively directing financial statement users’ attention to pertinent areas and decrease managers’ earnings management attempts. While these findings are promising, preliminary archival research fails to support a wider capital market reaction to KAM disclosures, raising questions about the economic significance of the changed reporting model.

KAM disclosures also appear to have some unanticipated, and sometimes even adverse consequences. Archival research finds efficiency losses in terms of increased audit report lags and audit fees, and experimental evidence suggests that auditors may be less professionally skeptical in the presence of KAMs. Finally, managers’ willingness to share information with their auditor as well as their risk-taking behavior is affected by anticipated KAM disclosures, not always in a beneficial direction.

Based on the findings reviewed in this paper, we offer some important implications and recommendations for audit practice. First, auditors should be aware that the disclosure of KAMs has attention-directing impacts on financial statement users and should therefore carefully decide how many, and in particular what matters, they disclose as KAMs in the auditor’s report. Second, some adverse consequences of KAM disclosures can be mitigated by an explanation of the concept of reasonable assurance (e.g., Backof et al. 2018) and providing information specificity in KAMs (e.g., Klueber et al. 2018). As a result, standard setters may consider prescribing more clarifying language in KAM disclosures. In general, standard setters and regulators should pay close attention to adverse effects that KAM disclosures may have in the coming years.

In a relatively short time span, a substantial number of research papers has appeared with the objective of examining the consequences of KAM disclosures for a variety of stakeholders, suggesting this is a growing body of auditing research. The findings thus far suggest several fruitful avenues for future research. In particular, the mixed nature of results of previous studies indicate that there may be insufficient research to assess all the consequences of KAM disclosure. First, due to the mixed findings on investor and market reactions, more research is needed on how exactly investors process the additional information provided in KAM sections, while differentiating between sophisticated and unsophisticated investors. In this regard, we recommend greater use of qualitative research methods (e.g., interviews or focus groups) to better understand how users process this information. Eye-tracking research, such as the study by Sirois et al. (2018) may also provide additional insights into such processes. Second, as data becomes available in ISA jurisdictions, UK archival studies should be replicated to make comparisons between different jurisdictions. As ISA 701 is mandatory for audits for periods ending on or after 15 December 2016, further archival research can be expected soon; and the emerging CAMs in the United States will also offer plenty of research opportunities. Finally, future studies could focus on the production process of KAMs which has not yet been considered in prior research and which may also have (indirect) effects on various reporting and quality outcomes. For example, future field studies could examine the process used to identify and select KAMs and how this process influences auditor communications with management and audit committees.