Heed Explanatory Language in Your Audit Report

Gina Deveney
Posted by in Accounting, Auditing & Tax

Accounting and financial professionals who deal with investing, whether on behalf of consumers or companies, must have strong investment research skills. Research doesn't stop once an initial investment is made; professionals must continue to watch the market, review audit language and provide recommendations for clients.

Investing is risky business, even for those with years of experience and superior knowledge of the market. Financial risks are possibly greater today than ever before due to volatile markets, strained political climates and disruptive developments in the financial field. For example, the use of fantasy accounting principals by technology firms in many reports makes it difficult for investors to ascertain what is really happening on company balance sheets. It doesn't help that start-ups constantly invade well-performing fields such as technology and health care, bringing sudden splashes to stable ponds. The ripple effect can be difficult for accounting professionals to anticipate.

A recent study published by authors from the University of Texas and the University of Illinois might point to a way professionals can use audit reports to bolster the efficacy of their investment research. According to the study, a correlation exists between a certain type of audit language and the future performance of company stock or financial statements. Specifically, when an unqualified audit report is issued with a letter containing explanatory audit language or warnings, the researchers found that it is statistically more likely for the associated financial statements to be restated in the future.

Why should accounting and investment professionals care about the positive correlation between auditor misgivings and the restatement of financials? Restatement of financials can cause stock prices to drop and, in the past, has been associated with reduced earnings and cases of fraud and litigation — all things investors and their service providers like to avoid. The restatement risks were primarily associated with certain types of audit language, according to the study. When researching or managing investments, accounting professionals should pay attention to audit language related to inconsistencies and estimates within a financial report, the use of multiple auditors in an audit, mergers, and transactions between parties that are related.

The authors of the study warn that such audit language is often framed in a vague manner and could be buried far within a longer letter of explanation. One reason for this is that auditors have a financial reason for maintaining a positive relationship with those they audit: the company being audited is often paying for the privilege. Auditors may tiptoe around bad news or misgivings, and they rarely include such information in a prominent position in an unqualified audit report. Auditors are also encouraged to produce unqualified reports because the Securities and Exchange Commission doesn't allow companies that are publicly traded to release qualified financial statements.

Whether you are handling accounting for a firm that is being audited or you provide investment services to an employer or client, understanding audit language is a critical skill. Reading between the lines lets you see the big picture, predict future activity and provide the best advice to clients.

Photo courtesy of Stuart Miles at FreeDigitalPhotos.net



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