Auditors play a critical role in capital markets by providing assurance that public company financial statements are reliable. Historically, however, audit reports provided little insight into how auditors assessed risk. That changed with expanded audit reporting requirements, which mandate disclosure of especially challenging areas of the audit—known in Europe as Key Audit Matters (KAMs).
In the United States, auditors report something similar called Critical Audit Matters (CAMs). Both KAMs and CAMs are designed to provide greater transparency into the audit process and the areas auditors view as involving heightened risk.
The topic of KAMs is at the heart of Jess Filosa’s research paper, “Does Tax Enforcement Inform Auditors Risk Assessment? Evidence from KAMs,” published in Contemporary Accounting Research. The study examines whether auditors incorporate external regulatory oversight, specifically tax enforcement, into their risk assessments, as revealed through KAM disclosures.
“KAMs are a relatively recent regulatory development where, for the first time, auditors have to publicly explain areas of the audit that involve heightened risk or complexity,” Filosa said. “Prior to this, audit reports were largely pass-fail opinions. Now, we can see more clearly how auditors are identifying and communicating risk.”
While auditors assess financial reporting risk, tax authorities also examine corporate reporting as part of their enforcement efforts. This overlap raises an important question: Do auditors adjust their risk assessments when tax enforcement is stronger?
“Tax authorities and auditors are both scrutinizing corporate reporting, though from different perspectives,” Filosa said. “We wanted to know whether auditors view strong tax enforcement as a complementary form of oversight.”
Using cross-country variation in tax enforcement across European countries, Filosa and her co-authors find that auditors report fewer KAMs in countries with stronger tax enforcement, consistent with auditors perceiving lower residual risk. The effect is strongest in high book-tax conformity countries, where financial and tax reporting rules are closely aligned, and among auditors exposed to more complex tax environments.
“Essentially, we examined when tax enforcement should matter more,” she said. “And that’s exactly what we found. Auditors incorporate tax enforcement into their risk assessments when the oversight is more directly relevant to the financial statements.”
Because expanded audit reporting requirements are still relatively new, both internationally and in the U.S., the research provides timely evidence to regulators and stakeholders about how these disclosures function in practice.