The Effect of Key Audit Matter Disclosures and Non-GAAP Earnings on Investor Judgments

Two recent changes in corporate reporting involve the inclusion of both GAAP and non-GAAP earnings in the annual report and the inclusion of Key Audit Matters (KAMs) in the auditor's report. Managers have discretion in determining the excluded items in non-GAAP reporting. The frequently excluded items in non-GAAP earnings, such as goodwill impairment loss, are also frequent items discussed in KAMs. The research on non-GAAP earnings excluding a KAM item helps us understand how the auditor's report can impact investors' use of non-GAAP measures. This dissertation provides evidence on how investors react to managers' non-GAAP reporting and auditors' KAM disclosures through two studies. In Study One, I conduct a 2×2 between-subjects experiment to investigate the joint effect of excluding a KAM item relating to goodwill impairment loss from non-GAAP earnings and investor position on investor judgments. Drawing on motivated reasoning theory, I predict and find that for investors holding a long (short) position, investors perceive management to be more (less) credible when non-GAAP earnings exclude a KAM item than when non-GAAP earnings do not exclude a KAM item. In addition, lower management credibility assessments result in higher impairment loss estimates (i.e., less favourable earnings-related judgments). These findings inform regulators and managers on the impact of KAM disclosures on investors' reactions to non-GAAP reporting. Study Two holds constant the investor position as long investors, and the non-GAAP earnings with a KAM item excluded. I conduct a 1×4 between-subjects experiment. The four conditions are the high awareness of management discretion in non-GAAP earnings condition, the high auditor scepticism implied in the KAM disclosures condition, the audit outcome presence in the KAM disclosures condition, and a control condition without any treatment. I find that when investors have a higher awareness of management discretion in non-GAAP reporting, their earnings-related judgments are more favourable than those who have lower awareness of management discretion in non-GAAP earnings (i.e., the control condition). The level of scepticism implied in the description of how the KAM was addressed in audits and including the outcome of the auditor's procedures in the KAM disclosures do not significantly affect long investors' earnings-related judgments