As investors, we rely heavily on financial reports to make informed decisions about the companies in which we invest.
Hence, it is essential for financial reports to provide a true and fair view of the underlying economic reality.
Auditors play an important role in this regard, through ensuring the accuracy and reliability of financial reports.
They are responsible for examining a company's financial reporting and confirming that it is free of material mis-statements or errors.
This helps to ensure that investors, lenders and other stakeholders have access to reliable and transparent financial information, which enables informed and indeed rational decisions about the company.
But what if auditors not only audit financial reports but are also involved in preparing the same financial reports they are supposed to audit?
A new study sheds light on the highly controversial role auditors often play in formulating their clients' financial reports.
The study, which analysed a sample of more than 3mn observations from private and publicly listed firms in Germany, suggests auditors do exert a significant influence on the narrative parts of their clients' financial reports.
While this involvement could potentially place auditors in a position to directly monitor and ensure the quality of those reports during their preparation, on the other hand it raises questions about objectivity and independence.
Specifically, any auditor involvement in the preparation of financial reports means, ironically and paradoxically, that they are auditing their own work, which is then logically unlikely to be objective.
This is also the reason strict regulations forbid auditors from being involved in book-keeping and other activities related to the preparation of financial statements.
It is therefore potentially problematic if auditors are closely involved in the preparation of the narrative parts of their clients’ financial reports.
And the recent past is replete with both major and minor scandals involving auditors in one form or another.
Auditing the auditors
To shed light on this issue, researchers from the Universities of Bochum and Muenster in Germany have analysed a very substantial sample of private and publicly listed firms from Germany, where information is available on the identity of the auditors responsible for an audit.
Using natural language processing techniques, the authors measured auditor involvement by computing and identifying the similarities between narrative disclosures across firms.
If similarities are abnormally high among auditor-sharing firms, this indicates significant auditor influence.
Confirming this notion, the authors reveal that who exactly is the auditor of the firm makes a substantial difference to the wording, content and structure of management reports and notes.
The investigation demonstrates that the influence of individual auditors is indeed prevalent, as the similarity of their client’s narrative disclosures is clearly evident and goes substantially beyond what one would expect, based on the similarity between firms’ economic activity and business situations.
