Is there a danger when auditors get too close to their clients?

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.

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 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.

This effect is also not limited to standard legal phrases in the reports, such that auditors seem to actively influence the year-on-year updating of their clients’ management reports and notes. This is an important and potentially alarming finding. 

Furthermore, Martin Nienhaus, one of the senior researchers, comments that the identification strategy and research design are extremely rigorous and reliable, and duly recognised by a publication in a FT50 journal, which has a tough review process.

The research project was also funded by the DFG (German Research Foundation), a highly reputable foundation and also subject to a thorough review process.

To verify these findings, the authors conducted several interviews with auditors, who confirmed the plausibility of the results. 

Having established that auditors have a significant influence on their clients’ narrative disclosures, they further analysed how this involvement affects the objectivity of audits, and ultimately, the quality of narrative disclosures. In this regard, the study has good news for stakeholders and regulators.

For a start, the analyses suggest that management reports that are strongly influenced by audit partners tend in fact to be of higher quality. Specifically, these reports had fewer redundancies and more forward-looking information.

Furthermore, the narratives were also found to be more useful for predicting the future profitability of client firms, and not biased or misleading. 

In addition, many, and particularly smaller client firms, do not have the expertise and resources to prepare high-quality narrative disclosures, and often rely on their auditor for that task.

Don't fear the auditor 

Overall, it seems the role of auditors extends way beyond simply auditing financial reports, and they play a crucial role in the preparation of the narrative sections, thereby ensuring authentic and fundamentally useful narrative disclosures.

In this regard, the fear that auditor involvement jeopardises the quality of narrative disclosures seems unjustified, at least in the case of narrative disclosures.

Nienhaus comments that these auditors in fact have a strong ethical orientation. It requires a lot of effort and commitment to become a certified auditor, so that few of them, he argues, would be willing to breach codes of ethics and the law in this context. 

This is an encouraging revelation, as it seems we can rely more on auditor integrity and honesty than recent scandals might imply.

Although there are always black sheep out there, and there will always be breaches of laws and ethics, this study paints a less bleak picture than the Wirecards, Enrons and Lehmans of this world would lead us to believe.  

Brian Bloch is a freelance journalist based in Germany