Newly Extended Audit Report and Cost of Debt: Empirical Evidence from Thailand

Abstract

This study examined the association between key audit matters (KAM) and the cost of debt. Financial records and auditors' reports were used to collect data for the fiscal years 2016 and 2017, which were the first two years after KAM was implemented in Thailand. Samples are listed companies in Thailand, where the financial system is primarily debt-based and external auditors play an important role in maintaining financial reporting quality. The final samples for the two-year period consist of 770 observations. The KAM is measured in three aspects: the number of issues, the number of words, and the readability, while the cost of debt is measured by the ratio of interest expense to total debt. The research finds that the KAM readability is significantly and negatively related to the cost of debt. Meanwhile, the number of issues and words have no significant effect on the cost of debt. The finding suggests that auditors' writing skills play a crucial role in the lending decisions of creditors.

1. Introduction

To uphold the quality of financial reporting, external auditors are hired to audit the financial statements of business entities (Jensen & Meckling, 1976; Watts & Zimmerman, 1986). Besides, an auditor’s report is a source of information regarding the auditor’s opinions on the audited financial statement. However, stakeholders have been increasingly vocal and critical of the informativeness of audit reports, especially after the financial crisis or fraud cases (Minutti- Meza, 2020). As a result, the International Auditing and Assurance Standards Board (IAASB) have made significant changes to the audit report format from a pass/fail report to an extended audit report that contains entity-specific information (IAASB, 2015b). Key audit matter (KAM) paragraphs are one of the new additions in the new audit report format whereby auditors are required to disclose areas of significant risks or areas that require significant auditors’ judgments during the current year audit; and provide details as to how these risks are dealt with (IAASB, 2016)[1]. Specifically, KAM provides financial statement users with relevant information to assess entities’ significant risks (e.g. FRC, 2015; Minutti- Meza, 2020; Wuttichindanon & Issarawornrawanich, 2019). Since investors and creditors are primary users of financial statements (IASB, 2018), it is thus of particular interest to investigate their reactions to the new format of the auditor’s report.

Following the introduction of the new audit report format, research attention has been centered around the implementation of the new format, the content, and KAM disclosure. Cordoş and Fülöp (2015) reviewed the comments received by IAASB for its 2013 exposure draft of the new report format; and concluded that most of the comments failed to realize the benefits of the new format to financial users. Besides, auditors expressed concerns about how to carry out the task since the KAM disclosure is no longer standardized or generic following the implementation of the new format. Specifically, since December 14, 2016, following the most recent revisions, auditors are required to disclose KAM, and the disclosure is no longer standardized but idiosyncratic (i.e., varied among firms). As a result, an increasing number of empirical research studies have re-examined the benefits of KAM disclosure. Nevertheless, the informative value of KAM is still inconclusive (Velte & Issa, 2019).

Existing studies reported a positive impact of KAM on various financial statement users, including investors (Christensen et al., 2014; Sirois et al., 2018), creditors (Trpeska et al., 2017), and firms’ managers with regard to earnings quality (Li et al., 2019). However, other studies found no such beneficial effect of KAM (Bédard et al., 2019; Boolaky & Quick, 2016).

Velte and Issa (2019) reviewed existing research on KAM and found that 45% focused on reactions of shareholders, 25% on board of directors, 16% on external auditors, 6% on debtholders, and 8% on other stakeholders. There exist many studies on the impact of KAM on investors but the majority of the studies focus on the U.S. Meanwhile, there exist only three studies on debtholders, and the research results are inconclusive. Specifically, Trpeska et al. (2017) conducted a survey of loan officers in Macedonia and confirmed the informative value of KAM, while Boolaky and Quick (2016) found no beneficial effect of KAM in a survey of German bank directors.

Porumb et al. (2019) used archival data of the UK private debt market to examine lenders’ reactions to KAM and reported that the number of risks disclosed is positively correlated with loan spread but uncorrelated with loan maturity and the number of lenders. Porumb et al. (2019) also examined the relationship between the number of words disclosed and loan features but found no significant relationship between both variables. Šušak (2020) examined the relationship between KAM and cost of debt in Croatian samples; and found no significant relationship. According to Velte and Issa (2019), the impacts of KAM disclosure on investors’ reactions have been extensively researched, while those on creditors’ reactions are severely limited, especially those that rely on archival data. The authors of this research believe that the results based on archival data could empirically validate the informative value of the new audit report format.

As a result, this current research examines the relationship between KAM disclosure and the cost of debt using secondary data of listed companies in Thailand. Thailand has a concentrated ownership system (Claessens et al., 1999; Shleifer & Vishny, 1997) which contributes to a relatively weak corporate governance mechanism (Alba et al., 2003; Salacuse, 2006). Besides, the capital structure of local firms, including listed companies, is primarily based on debt rather than equity (Rahman et al., 2010; Rajan & Zingales, 1998). In addition, external auditors play an important role in the East Asian region, including Thailand (e.g. Alba et al., 2003;Fan & Wong, 2005).

Based on the aforementioned, the Thai setting is appropriate for investigating the reactions of lenders to KAM disclosure in the auditor’s report. Existing research on KAM using Thai samples primarily focuses on equity investors, while there exists no research that focuses on lenders’ reactions to KAM using Thai samples. Meanwhile, there exist studies on KAM disclosure one year (Pratoomsuwan & Yolrabil, 2018; Tangruenrat, 2017) and two years (Wuttichindanon & Issarawornrawanich, 2019) after the KAM implementation. Big Four audit firms and independent directors are positively correlated with the number of KAM (Wuttichindanon & Issarawornrawanich, 2020). Besides, there are studies on investors’ reactions (Boonyanet & Promsen, 2019; Srijunpetch, 2017) and auditors’ and management’s reactions (Boonlert-U-Thai et al., 2019; Suttipun & Swatdikun, 2021) to KAM disclosure. However, research on lenders’ reactions to KAM disclosure is lacking. As a result, this current research aims to fulfill this gap in the context of Thailand and to provide insights on the informative value of KAM to lenders.

Regarding the measurement of variables, this study differs from prior studies in that. First, the independent variable (i.e., KAM) is tested in three aspects: the number of KAM issues, the number of words in KAM paragraphs, and the readability of KAM. The KAM readability is an extension of the existing studies which focus on the number of KAM issues and words (Porumb et al., 2019; Šušak, 2020); and second, unlike Porumb et al. (2019), who studied the reaction of debtholders using information contained in the loan contracts, this study relies on an average interest rate. Interestingly, Šušak (2020) studied the response of debtholders using the average interest rate measure but found no significant relationship.

In addition, this current research also finds that the readability of KAM disclosure is significantly negatively associated with the cost of debt. In other words, the more reader-friendly the KAM, the lower the cost of debt. However, neither the number of KAM nor the number of words significantly affects the cost of debt, consistent with prior studies (e.g. Porumb et al., 2019; Šušak, 2020). Specifically, the research result suggests that auditors’ writing skills play a crucial role in the readability of KAM.

The contributions of this research are as follows: First, the research results provide evidence on lenders’ reactions to KAM disclosure, given the fact that there exist limited studies on this subject, and the conclusion is inconclusive (Velte & Issa, 2019). Specifically, the research findings confirm the informative value of KAM disclosure to lenders, thereby fulfilling the IAASB’s aim of introducing the new audit report format. Second, prior studies of Thailand samples found that the number of KAM issues weakly influences the investors’ reactions (Boonyanet & Promsen, 2019; Srijunpetch, 2017). However, this current study discovers the significant lenders’ reactions to KAM. Since Thailand’s financial system is primarily debt-based, the reactions of lenders to KAM are more pronounced than those of investors. External auditors also play an important role in the pricing of debts (i.e., cost of debt) in the Thai setting as they are responsible for the issuance of KAM, consistent with prior studies (Alba et al., 2003; Fan & Wong, 2005). Third, the findings on the three aspects of KAM shed light on the possible reasons why existing studies found no significant results with respect to KAM (e.g.Porumb et al., 2019; Šušak, 2020). It could be inferred from the research results that the KAM readability exerts the most influence over the lenders’ reactions, rather than the number of words and KAM issues. The finding agrees with existing studies on the impact of the readability of notes to financial statements and annual reports on the cost of debt (e.g. Chen & Tseng, 2021; Luo et al., 2018).

The organization of this research is as follows: Section 1 is the introduction. Section 2 reviews literature on the new audit report format and details the hypothesis development. Section 3 deals with the research samples and the construction of the hypothesis model, and Section 4 discusses the research results. The final section concludes the research results and limitations.

2. Literature Review and Hypothesis Development

2.1. Newly Extended Auditor Report

The International Auditing and Assurance Standards Board officially implemented the newly extended auditor report on December 14, 2016, with the aim to increase transparency and informative value of auditor’s reports (IAASB, 2015c). As a result, the new audit report format also includes entity-specific information, giving rise to a diversity in the content and information among auditors’ reports (Deloitte, 2016). The information diversity is typically reflected in KAM disclosures.

According to IAASB (2016), auditors of listed companies are required to disclose significant matters requiring auditors’ attention in the audit of current-year financial statements in the KAM paragraphs. Examples of the significant matters are higher assessed risks of material misstatement, critical auditor judgment on accounting estimates, and significant events during the period. The requirement contributes to diversity in auditors’ reports among firms. A comparison of KAM between firms in the same industry provides greater insights into the industry (Deloitte, 2016) and also the firms’ and industry’s inherent risks (Wuttichindanon & Issarawornrawanich, 2019).

Prior studies have examined the patterns of KAM disclosures and the determinants. Specifically, auditors in the UK issue an average of 4.2 KAMs in the first year after implementation (FRC, 2015), while those in Southeast Asian countries, including Malaysia, Singapore, and Thailand, issue an average of 2 KAMs (ACCA, 2018; Tangruenrat, 2017; Wuttichindanon & Issarawornrawanich, 2019). In practice, auditors can choose to present KAM in descriptive or table format. According to Tangruenrat (2017) and Wuttichindanon and Issarawornrawanich (2019), Big Four auditors are more likely to opt for the table format, unlike their non-Big Four counterparts. Besides, KAM disclosure (as measured by the number of issues, the number of words, and readability) is influenced by the firm’s characteristics (e.g., size, complexity), auditor characteristics (e.g., litigation risk, genders, audit fees), and corporate governance mechanisms (e.g., audit committee, board of directors) (Pinto & Morais, 2019; Sierra-García et al., 2019; Suttipun, 2020; Velte, 2018, 2020;Wuttichindanon & Issarawornrawanich, 2020).

Evidence shows that KAM is informatively beneficial to shareholders (Cordoş & Fülöp, 2015; Sirois et al., 2018), is economically essential to lending banks (Trpeska et al., 2017), and reduces earnings management (Li et al., 2019). However, other studies refute such findings (e.g. Bédard et al., 2019; Boolaky & Quick, 2016). Specifically, investors are indifferent as to the number of KAM issues or the information content (Bédard et al., 2019; Boonyanet & Promsen, 2019; Srijunpetch, 2017), nor are lenders (Boolaky & Quick, 2016; Šušak, 2020).

2.2. Hypothesis Development

According to Velte and Issa (2019), existing studies on KAM focused chiefly on investors’ reactions, particularly in the U.S. setting. However, there exists limited research on lenders’ reactions to KAM disclosure. Trpeska et al. (2017) surveyed corporate loan officers in Macedonia and documented that the respondents attached great importance to auditors’ reports and KAM disclosures. Meanwhile, Boolaky and Quick (2016) survey 105 bank directors in Germany and found no material effect of KAM on the bankers’ decisions.

Porumb et al. (2019) examined the archival data from the private debt market in the UK and reported that a reduction in the number of KAM by one issue reduces the loan spread by 20 basis points; however, there is no significant between KAM disclosure and loan maturity or the number of lenders. Likewise, the number of words in KAM paragraphs has no statistical significance with the loan terms. In addition, Šušak (2020) studied the archival data of 79 non-financial firms in Croatia to determine the relationship between the number of KAM and an average interest rate; but found no significant relationship between KAM disclosure and the cost of debt.

Due to limited evidence on lenders’ reactions to KAM, this current research thus re-examines the relationship between KAM disclosure and the cost of debt. Although existing research found no significant lenders’ reactions to KAM disclosure (Boolaky & Quick, 2016; Šušak, 2020), the researchers nonetheless expect that KAM disclosure is of informative value to lenders and influences the cost of debt, in accordance with the IAASB’s goal (IAASB, 2015a, 2015b). As a result, it is hypothesized that:

H1: KAM disclosure is associated with the cost of debt.

3. Research Design and Model Construction

3.1. Research Samples

To test the hypothesis, this research uses Thai-listed companies as samples. Thailand’s financial system is primarily debt-based (Alba et al., 2003) due to the concentrated ownership system and weak legal protection for minority shareholders (La Porta et al., 1998, 1999), encouraging Thai firms to rely more on debt financing (Alba et al., 2003). In addition, external auditors in Thailand, particularly Big Four auditors, play an important role in upholding the quality of financial reporting (Fan & Wong, 2005) and pointing out risk issues in the KAM report (Wuttichindanon & Issarawornrawanich, 2020). As a result, Thai-listed firms are appropriate to test the hypothesis of whether the KAM disclosure by auditors has an impact on the lenders’ reactions.

This current research further extends the existing studies with additional aspects. First, apart from the number of KAM and words which are commonly researched (e.g Bédard et al., 2019; Boonyanet & Promsen, 2019; Porumb et al., 2019; Srijunpetch, 2017; Šušak, 2020), this study also incorporates the KAM readability in the analysis. Readability has been extensively studied in accounting literature (e.g. Alivia et al., 2019; Courtis, 1986; Hay, 1998; Jones, 1988; Liu & Liu, 2021; Luo et al., 2018). However, it is Velte (2018, 2020) who recently investigated readability in the context of KAM; and found that KAM readability increases with an increase in the proportion of female audit committee members with financial and industrial expertise. Hay (1998) reported that the readability of auditor reports is diverse among audit firms. Furthermore, the passages in KAM should be more specific, not generic, or in the standardized language (IAASB, 2015b). This research thus expects that the KAM readability influences the cost of debt. Second, this study uses companies listed in the Stock Exchange of Thailand, while prior studies were conducted in European countries, including Croatia and the U.K. The results from different geographical settings would provide further insights into the audit reports and the usefulness of financial statements.

The Thai regulatory body adopted ISA 700 (IAASB, 2015b) and ISA 701 (IAASB, 2016) on December 31, 2016, requiring auditors of listed companies to comply with these audit standards. As a result, auditors’ reports for the fiscal year ended December 31, 2016, and afterward are required to include KAM disclosures. Besides, research on KAM disclosure has greatly increased following the implementation of the newly extended audit report in Thailand, particularly studies on the factors influencing the number of KAM and the impact of KAM on shareholders.

The average number of KAM issues of Thai samples is two, and the KAM issues are mainly concerned with revenue recognition (FAP, 2018; Pratoomsuwan & Yolrabil, 2018; Tangruenrat, 2017; Wuttichindanon & Issarawornrawanich, 2019). The factors that influence the number of KAM include Big Four auditors, business complexity, profitability, and industry types (Wuttichindanon & Issarawornrawanich, 2020). KAM disclosure in Thai samples has little impact on investors (Boonyanet & Promsen, 2019; Srijunpetch, 2017) but significantly and negatively impacts the company’s performance (Boonlert-U-Thai et al., 2019; Suttipun & Swatdikun, 2021). Nevertheless, there exists no study that investigates the impact of KAM disclosure on the cost of debt.

This research thus explores the relationship between KAM disclosure and the cost of debt. Data are collected from financial reports and auditors’ reports during the fiscal years 2016 and 2017, which are the first two years following the implementation of KAM in Thailand. The focus on the first two years after the implementation enables us to investigate the initial reactions of lenders to the new audit report extension. The final samples for the two years consist of 770 observations. The samples from financial companies are excluded since the nature of their cost of debt differs from that of non-financial companies. Table 1 presents the distribution of the research samples by industry and year.

In Table 1, the research samples are collected from six industries during the fiscal years 2016–2017. The number of observations by industry ranges from 59–173, and the average interest of the entire sample is 4.683%. The services industry has the highest average interest rate (5.157%), while the agriculture and food industry has the lowest (4.032%). However, there is no statistical difference in the average interest rates among industries (p-value = 0.0538).

Table 1: Distribution of Samples by Industry and Year

One-way ANOVA test: F value = 2.08, p-value = 0.0538. INT is the ratio of interest expense to an average interest-bearing debt outstanding during years t and t−1

3.2. Model Construction

Evidence shows accounting standards (De Moura et al., 2020; Moscariello et al., 2014; Ozkaya, 2018) and auditors (Coffie et al., 2018; Gandía & Huguet, 2020; Minnis, 2011) influence the cost of debt. Specifically, the interest rates of firms with audited financial statements are lower than those without audited financial statements (Blackwell et al., 1998; Minnis, 2011). Furthermore, lenders also attach importance to the content of auditors’ reports and the characteristics of auditors (Schneider, 2018). According to Trpeska et al. (2017), lending banks attach greater importance to KAM disclosure. However, archival research on the relationship between KAM disclosure and the cost of debt is lacking (Velte & Issa, 2019).

Since firms are unlikely to disclose the actual interest rates in the financial reports, this study thus estimates the interest rates (i.e., costs of debt) by dividing the reported interest expense in year t by an average of interest-bearing debt outstanding during year t and t−1. This estimation method has been used in many previous studies (e.g. De Moura et al., 2020; Francis et al., 2005; Gandía & Huguet, 2020; Jantadej & Wattanatorn, 2020; Minnis, 2011; Moscariello et al., 2014).

To investigate the effect of KAM on the cost of debt, this current research also defines a set of control variables. Existing studies rely on the identical set of control variables (i.e., cost-of-debt determinants) in their models, including profitability, liquidity, firm size, sales growth. Meanwhile, this current research relies on the empirical model of Minnis (2011), together with two additional variables, i.e., return on assets and book-to-market value ratio (i.e. De Moura et al., 2020; Trpeska et al., 2017). In line with prior studies (e.g. Blackwell & Winters, 1997; Francis et al., 2005), the model of Minnis (2011) contains the determinants of the cost of debt as follows: audit firm, firm size, interest coverage, sales growth, current ratio, tangible assets intensity, and leverage ratio [2]. Apart from KAM disclosure, loan officers also give consideration to firms’ profitability (Trpeska et al., 2017). As a result, the profitability ratio, as measured by the return on assets (ROA) following Gandía and Huguet (2020) and Lee et al. (2015), is incorporated into the model. According to De Moura et al. (2020), the book-to-market value ratio is significantly related to the cost of debt of listed companies. Since the samples of this research are listed companies, the book-to-market value ratio (BTMV) variable is thus included in the model. The empirical model is as follows:

\(\begin{aligned} \mathrm{INT}_{i, t} &=a+b_{1} \mathrm{KAM}_{i, t}+b_{2} \mathrm{BIG}_{i, t}+b_{3} \mathrm{BTMV}_{i, t}+b_{4} \mathrm{LNTA}_{i, t} \\ &+b_{5} \mathrm{INTCOV}_{i, t}+b_{6} \mathrm{ROA}_{i, t}+b_{7} \mathrm{GROWTH}_{i, t} \\ &+b_{8} \mathrm{CR}_{i, t}+b_{9} \mathrm{TAN}_{i, t}+b_{10} \mathrm{LEV}_{i, t}+b_{11} \mathrm{YEAR}_{i, t=2017} \\ &+\sum_{S=1}^{6} \beta_{S} \mathrm{INDUS}_{i \in s, t}+\epsilon_{i, t} \end{aligned}\)

where INT is the ratio of interest expense to an average interest-bearing debt outstanding during years t and t−1. KAM is KAM disclosures in the auditor’s report for year t, measured in three aspects:

Kam_No is the number of KAM issues.

LnWord is a natural logarithm of the number of words in KAM paragraphs.

Flesch is the Flesch reading ease score in Microsoft Word^® application software.

BIG refers to the Big Four audit firms, coded 1 for firms that use a Big Four audit firm for year t and 0 otherwise. BTMV is the ratio of equity to market capitalization (book-to-market value) at the end of year t.

LNTA is a natural logarithm of total assets at the end of year t.

INTCOV is the ratio of operating income to interest expense for year t.

ROA is the ratio of net profit to total assets at the end of year t.

GROWTH is the sales growth, calculated by sales_{year t} –

sales_{year t−1} / sales_{year t−1}.

CR is the ratio of current assets to current liabilities at the end of year t.

TAN is the ratio of property, plant, and equipment to total assets at the end of year t.

LEV is the ratio of total debts to total assets at the end of year t.

YEAR² refers to the second year of KAM implemen- tation, coded 1 for fiscal year-end 2017 and 0 otherwise. INDUS is a categorical variable representing the following industries: agriculture and foods, consumer products, property and construction, resources, services, technology, and industrials.

In the regression analysis, two financial variables (i.e., INT and INTCOV) are winsorized at the 5^th and 95^th percentiles, and the data of two variables (i.e., LNTA and LnWord) are transformed into natural logarithm.

4. Results and Discussion

4.1. Descriptive Statistics

Table 2 tabulates the descriptive statistics for the relationship between various variables (dependent and control variables) and the cost of debt. The average interest rate (INT) is 4.7%. The average number of KAM issues (KAM_No) is 2.018, with a maximum of 6. The average number of words (KAM_word) in any given KAM disclosure is 535.944 words, with a natural log (LnWord) of 6.144. By comparison, the natural log of KAM words in the Thai samples (6.144) is greater than that of the UK samples (5.41) (Porumb et al., 2019). The readability of KAM paragraphs (Flesch) ranges from 0 (very difficult to comprehend) to 97 (very easy to comprehend) [3]. The average Flesch reading ease score of the Thai samples is 9.523 (very difficult to comprehend), while that of the UK samples is 26.5 (Velte, 2020), indicating that the KAM disclosures of Thai samples are less reader-friendly to users of financial statements. The finding is consistent with Lewis et al. (1986) who noted that accounting report is typically difficult to comprehend and the practice has remained unchanged (Jones, 1988).

Table 2: Descriptive Statistics

For the control variables, 64.7% of the samples used the services of Big Four audit firms (BIG). The average book-to-market ratio (BTMV) is 0.702, and the interest coverage (INTCOV) ranges from −19.031 to 278.552, with an average of 28.859. The negative INTCOV is attributable to the negative operating incomes of certain firms in the samples. The average return on assets (ROA) is 3.9%, with the negative ROA attributable to the negative net incomes of certain firms. The average sales growth (GROWTH) is 4.4%, with a minus sign indicating a decrease in sales figures vis-à-vis the previous year. The current ratio (CR) is 2.33 on average, with a maximum CR of 26.26. The ratio of tangible assets to total assets (TAN) and the leverage ratio (LEV) are, respectively, 36.2% and 26.5% on average.

Table 3 shows the correlation coefficients among the variables. The cost of debt (INT) is significantly negatively associated with the Flesch readability score (Flesch), given the 10% significance level. The cost of debt (INT) decreases if firms use Big Four audit firms (BIG). In addition, larger companies (LNTA) and profitable companies (ROA) have lower costs of debt. The result also indicates that the cost of debt is inversely related to the proportion of tangible assets (TAN) owned by companies. In other words, companies have a lower risk of loan default because their assets can be used to collateralize loans and liquidated to repay outstanding debts in the event of insolvency. The positive sign of INTCOV, CR, and LEV relative to the cost of debt contradicts our initial expectations (i.e., negative sign). As a result, the rationale behind the discrepancy between the expected and actual signs is further investigated, and outcomes are explained in the regression analysis results (Table 4).

Table 3: Correlation Matrix

Note: ***, **, and * denote significant at 1%, 5%, and 10% level of significance based on t-statistics.

Table 4: Impact of KAM on the Cost of Debt

Note: ***, **, and * denote significant at 1%, 5%, and 10% level of significance based on t-statistics.

The correlation coefficients among the independent variables are below 0.80 (Hair et al., 2010), indicating no multicollinearity in the regression analysis.

4.2. Impact of KAM Disclosure on the Cost of Debt

Table 4 presents the hypothesis testing results.

In Table 4, Model 1 tests whether the number of KAM issues (Kam_No) is statistically related to the cost of debt (INT), and the result shows no significant relationship between both variables, consistent with prior research (e.g.Šušak, 2020). In Model 2, the number of words in KAM paragraphs (LnWord) is insignificantly associated with the cost of debt, consistent with Porumb et al. (2019). However, when measured by the Flesch reading ease score (Flesch), KAM disclosure is negatively associated with the cost of debt. Specifically, the easier to comprehend the KAM disclosure, the lower the cost of debt. The finding supports our hypothesis and extends empirical evidence on lenders’ reactions to KAM. The result is also in line with (Chen & Tseng, 2021), who reported that lenders are concerned with the readability of auditor reports, in addition to the readability of notes to financial statements.

For the control variables, certain variables are significantly associated with the cost of debt. Profitable firms (ROA) have a lower cost of debt, consistent with Lee et al. (2015). Companies with a high proportion of tangible assets (TAN) bear a lower cost of debt, in line with Minnis (2011). Big Four audit firms (BIG) have limited influence on the cost of debt (p-value < 0.10). Leverage ratio (LEV) is negatively associated with the cost of debt (INT), consistent with prior studies (Francis et al., 2005; e.g. Gandía & Huguet, 2020; Lee et al., 2015; Minnis, 2011). The finding could be attributed to the economy of scale for monitoring costs (Minnis, 2011) (footnote 24). Specifically, banks charge existing customers lower interest rates because of the lower frequency of monitoring these customers (Blackwell & Winters, 1997). Likewise, firms with concentrated borrowing are charged lower interest rates by their existing lending banks (Blackwell & Winters, 1997). On the contrary, interest coverage (INTCOV) is positively associated with the cost of debt at the 10% significance level [4]^.

Based on the results in Table 4, KAM disclosure has an economic effect on the cost of debt. Specifically, the results show that the conciseness and brevity of KAM disclosures effectively get the message across and ease the creditors’ worries about the business, thereby resulting in a lower cost of debt. The finding is in line with the literature on the readability of notes to financial statements (e.g., Chen & Tseng, 2021), annual reports (e.g. Courtis, 1986; Li, 2008), and the going-concern paragraph in the auditor’s report (Gianfelici et al., 2021).

5. Conclusion

This research determines the impact of KAM disclosure on lenders’ reactions and thereby the cost of debt using Thai-listed companies, given that the financial system in Thailand is primarily debt-based. The KAM is measured in three aspects: the number of KAM issues, the number of words in KAM paragraphs, and the readability. Of particular interest is that auditors’ writing skills play a crucial role in the KAM readability and cost of debt. In other words, the KAM readability and cost of debt are negatively correlated. The significance of the auditor’s report with regard to lenders’ reactions in the Thai setting is consistent with prior studies (e.g. Alba et al., 2003; Claessens et al., 2000; Fan & Wong, 2005), which reported that external auditors considerably influence the users of financial statements in Thailand and East Asian countries. In this study, the results show that creditors attach importance to auditors’ KAM disclosures. This finding thus fulfills the literature gap on the effect of KAM disclosure on lenders’ reactions (Velte & Issa, 2019).

This research also gives attention to the readability of KAM disclosure. Before the introduction of ISA 700 (IAASB, 2015b), audit reports were standardized and generic (Moores, 2009). On the other hand, current audit reports are idiosyncratic and contain entity-specific information. Since users of financial statements attach greater importance to the audit reports, especially the KAM, auditors’ writing skills are increasingly crucial to getting the message across.

This research, however, encounters certain limitations. This research uses only the Flesch reading ease score to gauge the readability. Nevertheless, there are other tools to measure the readability, such as the Gunning Fog Index (FOG) in Pratama et al. (2022) (see more in Lewis et al., 1986). The research result is thus limited to the selected measurement. In addition, this study and prior studies confirm that the readability of auditor’s reports varies between audit firms (Hay, 1998), and the readability affects a firm’s cost of debt. As a result, firms should give more consideration to writing skills and abilities when hiring auditors. Furthermore, subsequent research would include auditors’ writing styles as a determinant of auditor choice, in addition to the conventional determinants, e.g., audit fee auditor’s expertise.