New research indicates that many investors tend to overlook the vague misgivings that auditors might express in letters included with their audit reports, even though those warnings often turn out to be a predictor of future trouble with a company’s financial statements.

Jaime Schmidt, an assistant professor at the McCombs School of Business at the University of Texas at Austin, and her co-authors, Anne Thompson and Keith Czerney from the University of Illinois Urbana-Champaign, analyzed more than 30,000 unqualified (or “clean”) audit reports on public company financial statements between 2000 and 2009. The reports generally provided reasonable assurance that the financial statements were fairly presented in accordance with U.S. GAAP.

However, they pointed out that when auditors give an unqualified endorsement or passing grade to a company’s financial statements, it may not be completely unqualified, as many investors believe. The auditors oftentimes included a letter along with their opinion, and buried in 60 percent of those letters was one paragraph of explanatory language, in which the auditors might allude to the misgivings they had. The misgivings are couched in jargon that the average investor might find hard to understand. 

Professor Schmidt has identified a positive correlation between the presence of this specific language and audit reports being restated in the near future, which can result in reduced earnings, a drop in stock price and even the possibility of litigation or fraud.

The researchers found that financial statements with unqualified audit reports containing explanatory language are significantly more likely to be restated than financial statements with audit reports without such language. The article appears in Volume 89, Issue 6 of The Accounting Review, published by the American Accounting Association. An abstract is available here.

Explanatory language is the additional wording that auditors use to emphasize circumstances or matters encountered during the audit, the professors noted. In theory, such language should not be a signal of increased financial misstatement risk, the researchers noted, but because the Securities and Exchange Commission prevents publicly traded companies from releasing financial statements with any audit opinion except unqualified, adding explanatory language is the auditor’s only practical mechanism to communicate risk.

For investors, this is critical information. “The subsequent correction of a misstatement often reduces earnings and results in a corresponding drop in the stock price,” said Schmidt.

There is a positive correlation between the presence of explanatory language and misstatement risk, but the relationship is driven by specific types of language that should warrant investors’ attention, the researchers noted. Financial statements are most likely to be restated when the corresponding audit report contains explanatory language that refers to mergers, related-party transactions, the use of estimates, financial statement inconsistency such as changes in accounting principles, and the involvement of multiple auditors to conduct the audit. Companies that issued a restatement within the previous year—as noted in an auditor’s explanatory language—are 31 percent more likely to issue another restatement in the future.

According to the study, auditors have incentives to maintain positive relationships with their clients, who are unlikely to view explanatory language favorably. Therefore, to the extent that such language strains the auditor-client relationship, it is not surprising that it would be indicative of misstatement risk.

Even so, investors indicated they disregard auditors’ notes because they assume the report is standardized, containing only boilerplate language, according to preliminary findings from subsequent research by Schmidt and her co-authors.

“We looked to see if the stock market price or trading volume changed for companies that had just released auditor reports with explanatory language because this might indicate whether or not investors are paying attention,” said Schmidt. “From what we can observe, they’re not.”

 

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