In light of the closing of the comment period for the PCAOB reproposal of an expanded audit report standard (see this PubCo post and this PubCo post), including a requirement to disclose critical audit matters, it may be useful to examine the experience of another country that has already implemented a similar concept in its audit reporting standard. This academic study, Tell Me More: A Content Analysis of Expanded Auditor Reporting in the United Kingdom, examined whether the expanded audit report requirement in the UK was even helpful in improving communication value.
The study evaluated the evolution of the audit report in the UK from a standard two-paragraph boilerplate report to the more expansive individualized audit report requirement adopted in 2013, International Standard on Auditing (UK and Ireland) 700, The Independent Auditor’s Report on Financial Statements (“ISA 700”), the first attempt by a standard-setter to include expanded auditor disclosure in the audit report. As shown by prior studies cited by the author, financial statement users have had some difficulty understanding the information in audit reports. The standard audit report typically provides an unqualified pass — and a rare fail — opinion regardless of the underlying risks of the audit client; notably, it largely did not convey financial risks during the financial crisis.
ISA 700 requires in the audit report “a discussion of: 1) the risks of material misstatements with the greatest impact on engagement team effort; 2) the application of materiality in the audit; and 3) the scoping decisions made in the execution of the audit.” This additional information was intended to provide “insights into the auditor’s decision process during the audit.” To improve the probability that the new standard would achieve its objective of enhancing communication between the auditor and the financial statement user, the standard indicates that the additional disclosures should be client-specific and not general or standardized.
The study author considered “communication value” to be “when the message that is intended to be conveyed by the report is received by the intended user.” To make that determination, the author used “readability” and “tone” as proxies for communication value: “Readability is a communication measure that captures whether the receiver can understand the message delivered by the sender. If the receiver understands the message, then the message is useful to the receiver thereby improving the communication value of the message. Tone is a measure that captures the ‘affect or feeling of a communication’…. If the audit report reflects the tone of the audit engagement, as expressed in the choice of words used in describing the audit, the receiver’s understanding is improved thereby enhancing communication value.” The author also looked at changes in one type of sell-side analyst behavior, analyst forecast dispersion; prior studies have shown that improved readability of publicly filed reports is associated with lower forecast dispersion.
The author concluded that readability did improve in the post-ISA 700 period, which the author argues, supports the concept “that ISA 700 meets the objective of improving the value of the audit report to the financial statement user.” The author also found that the expanded audit report reflected increases in “negative and uncertain tone.” According to the author, this finding indicates “that auditors capture the underlying risks of their clients by utilizing negative and uncertain words in the expanded audit report. The audit report tone results also provide indirect evidence that the auditor disclosures were not boilerplate but varied in language choice. This finding rebuts criticisms that the new audit report includes boilerplate language that is not useful to the reader….” Finally, the author found that in the post-ISA 700 period, analyst forecast dispersion decreased, which the author believes lends support to the basic contention that the expanded audit report did affect the behavior of financial statement users. Whether these types of benefits would also accrue to enhanced audit reporting in the US, assuming some form of the PCAOB reproposal is adopted, remains to be seen.