Czerney, K., A. Thompson, & J. Schmidt. 2014. Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? The Accounting Review 89 (6): 2115-2149.
Auditors play an important role in the capital markets by providing reasonable assurance that financial statements are free from material misstatement. However, while the audit itself is valuable, many capital market participants do not view the auditor’s report as valuable. The auditor’s report is a 3-4 paragraph statement included with the financial statements that states that an audit was performed, what audit standards were followed, and the auditor’s conclusion about whether the financial statements are presented fairly, in all material respects. While that might sound like a lot of information which should be useful to investors, most audit reports are so similar that investors tend to view them as “boilerplate.” “Why?” you might ask. Well, the wording of the standard audit report is largely prescribed by professional standards, its format has not substantially changed since the 1940s, and nearly all companies receive a clean opinion (i.e., meaning that the auditor states the financial statements are fairly presented, in all material respects). Thus, the general belief is that the auditor’s report provides symbolic value but provides little useful company-specific value.
Given the criticism auditor reports have received, I set out with colleagues, Anne Thompson and Keith Czerney, to investigate whether auditor reports truly are uninformative. During the 2000 – 2009 time period, we found that over 60% of audit opinions issued to publicly traded companies include some non-standard language known as explanatory language. While the report formats are standardized (i.e., include the same basic paragraph structure) and the auditors’ opinions are largely equivalent across companies, there are subtle language differences across the reports. For example, in a large number of reports, the auditor adds a reference to a company-disclosed footnote similar to the following, “As discussed in footnote X, the company changed its method of accounting for Y” or “As discussed in footnote Z, the company has engaged in significant related party transactions.” While the auditor still concludes that the financial statements are fairly presented, we found that the auditor often leaves a clue to the investor about which footnotes the financial statement user might want to review.
More importantly, we found that these subtle language changes provide meaningful risk-related information to financial statement users. In particular, financial statements with audit reports that include this extra “explanatory language” are more likely to be subsequently restated than audit reports without the additional auditor language and that, for the most part, the specific accounts referenced in the audit report are the ones more likely to be restated in the future.
Our findings are important because they imply that the critics of auditors should look more closely at the audit report before calling it entirely boilerplate. Given that most investors are probably unaware of auditing standard AU 508, which enables auditors to add such language, it is likely that investors do not even think to look for these references. Hopefully, our study can help investors find more meaning in present-day auditor reports.