Image of Business Instructional Facility

Nov 11, 2019 2019-11 Accountancy Faculty

Auditor commentary reveals high value investors place on high financial reporting quality

When investors buy stock in a company, they value two major factors above and beyond the fiscal valuation of that company: high financial reporting quality and auditor insights that help investors read between the lines of those financial statements. New research by three Gies College of Business professors provides evidence that high financial reporting quality (FRQ) significantly increases investors’ willingness to pay, and that auditor commentary can magnify that effect by enabling investors to understand when a firm is being more cooperative with investors by using higher FRQ.

Peecher audit“We find that investors view the use of higher quality financial reporting practices as a form of cooperation, and when investors are able to discern that firms are using higher quality reporting, they’re willing to pay more for shares of those firms,” said co-author Kirsten Fanning, assistant professor of accounting at Gies College of Business.

In their paper “Do Investors Value Higher Financial-Reporting Quality, and Can Expanded Audit Reports Unlock This Value?” corresponding author Mark Peecher and colleagues Brooke Elliott and Kirsten Fanning show that investors inherently and intentionally value a firm’s use of higher financial reporting quality. Additionally, they show that independent auditor commentary – which is more common in the UK than in the US – enables investors to more strongly act on that perception, essentially unlocking its added value.

“It shows that there’s more value to the audit and accounting function of financial statements than we probably realized to date. That’s because the auditor can in a variety of ways show that certain firms are providing credible, cooperative financial reporting,” said Peecher, the Deloitte Professor of Accountancy at Gies College of Business. “The auditor commentary serves as an independent, learned voice about whether an estimate may be optimistic, aggressive, or conservative.”

For their experiment, the participants were nonprofessional investors, who considered investing portions of a $100,000 inheritance in two firms. The study found that auditor commentary increased investors’ willingness to pay more for shares of a high FRQ firm than a low FRQ firm. The researchers also measured participants’ affective responses and cognitive beliefs, offering evidence that investors perceive high FRQ as cooperative behavior.

There are lessons to be learned for both managers and auditors. Managers should be aware that if they choose higher quality financial reporting practices, investors may be willing to pay more for shares of their firm. Auditors should be encouraged of the fact that their audit report could unlock greater value for investors than their traditional pass-fail reports do.

“In the real world, one of the problems is that it’s hard to sort out who is really cooperating and who is not,” said Peecher. “But in this world where we’re changing the auditor’s report, auditors have new opportunities to add value by shedding new light on who really is cooperating, and who is not.”

“Stakeholders need managers to truthfully reveal firm performance so they can make decisions about how to most efficiently allocate their capital,” added Elliott, who is head of the Department of Accountancy at Gies. “This is the bedrock of our well-functioning capital market system.”

“Do Investors Value Higher Financial-Reporting Quality, and Can Expanded Audit Reports Unlock This Value?” has been accepted for publication in the March 2020 issue of The Accounting Review.