Enhancing earnings quality: Effects of internal control weaknesses and key audit matters

ABSTRACT This paper aims to determine whether the expanded audit report, specifically the adoption of International Standard on Auditing (ISA) 701, influenced earnings management (EM) in the Brazilian capital market, particularly in firms with publicized internal control weaknesses (ICW). Previous research has not thoroughly explored the impact of ISA 701 on EM in the context of Brazilian firms with ICW. We address this gap by examining how enhanced audit disclosures affect earnings quality (EQ). Thus, this study is relevant for regulators, researchers, market participants, auditors, and managers. It provides insights into how audit regulations, such as ISA 701, can improve the quality of financial reporting and reduce opportunistic EM behaviors. The analysis shows that ICWs elevate EM, while ISA 701 mitigates this by enhancing transparency through key audit matters (KAM). ISA 701 also moderates EM in firms with past ICWs, emphasizing its regulatory impact. We emphasize the importance of timely and adequate disclosure by auditors and managers. Using an econometric approach, we analyzed data from 240 Brazilian listed companies from 2010 to 2019. The methodology included descriptive statistics, correlation analyses, regression analyses, and differences-in-differences tests. Ordinary least squares (OLS) regressions were used to assess the impact of ISA 701 adoption on EQ proxies. Our study finds that Brazilian companies with ICW engage in EM through discretionary accruals more than others. The adoption of ISA 701 led to a reduction in EM, especially in firms with ICW, indicating improved EQ. These findings highlight the relevance of ICW and KAM disclosures for monitoring EM.