SPILLOVER EFFECT OF DISCLOSURE REGULATION: EVIDENCE FROM AUDIT REPORT CHANGES IN THE U.K

Abstract

I examine the spillover effects of the 2013 revision to the U.K. audit report standard, the International Standard on Auditing (ISA) 700 (UK and Ireland), from firms subject to the regulation (i.e., Premium companies listed on the London Stock Exchange (LSE)), to firms not subject to it (i.e., those listed on the Alternative Investment Market (AIM) of the LSE). The new regulation requires increased disclosures in three areas: audit risks, materiality and the scope of the audit. I hypothesize that application of the new rules to regulated clients will result in changes in audit styles and auditor mindsets that would be transferred to other (non-regulated) clients. If so, such effect of the new regulation on audit outcomes – specifically improvement in audit quality - for regulated clients will spill over to non-regulated clients. Because I expect the auditor to be the conduit for the spillover, I examine the difference in changes in audit quality for two groups: (1) AIM clients in audit offices that audit both Premium and AIM clients and (2) AIM clients in audit offices that audit only AIM clients. The results show that AIM firms in the first group (i.e., AIM clients of audit offices that also have Premium clients) experience lower absolute discretionary accruals, reduced propensity to have small positive earnings, and are more likely to receive a modified opinion under the new regulation. However, there is no change in audit quality for the AIM client firms of audit offices with only non-regulated (AIM) clients. These results are consistent with audit quality benefits spilling over from regulated clients to AIM clients, brought about by auditor-level changes. Further analyses indicate that the audit quality spillovers are more prominent for AIM clients with greater audit complexity, AIM clients of large audit offices, and London audit offices.