Do Managers Respond to Auditors’ Red Flags? Evidence from Expanded Audit Reports
This paper investigates the impact of expanded audit report disclosure on firms’ financial
disclosure decisions. Specifically, we examine whether firms adjust the levels of disclosure
on goodwill impairment when auditors flag goodwill impairment as a risk of material
misstatements in the expanded audit report. Drawing on a sample of U.K. premium listed
companies with goodwill on their balance sheets over the period 2013-2017, we construct
a unique dataset measuring the levels of goodwill impairment disclosure. We find that
managers increase the levels of disclosure on goodwill impairment when auditors include
this accounting event as a risk of material misstatements in their reports. The increase is
stronger when the associated audit risk is disclosed for the first time and when more risks
are disclosed in the expanded audit report. We further find that firms respond to market
assessment of goodwill impairment in a timelier fashion when auditors include goodwill
impairment as an audit risk. This study contributes to the debate about the usefulness of
the expanded audit report by identifying the mechanism through which expanded audit
report impacts financial reporting and corporate decisions.