Do Firms Respond to Auditors’ Red Flags? Evidence from the Expanded Audit Report

Abstract

We investigate the link between the expanded audit report and firms’ financial disclosure decisions, focusing on auditors’ mentions of goodwill impairment as a key audit matter (KAM). Drawing from a sample of UK Premium Listed companies with goodwill on their balance sheets during 2013-2019, we identify instances where goodwill impairment is flagged as a KAM and contrast firms’ disclosure level on goodwill impairment using textual measures constructed from information in their annual reports. We find that managers increase (decrease) disclosure on goodwill impairment when auditors start (stop) mentioning goodwill impairment as a KAM. The increase in disclosure is more pronounced in the presence of stronger external information demand and better internal governance. Finally, firms are more likely to impair goodwill in the next period when auditors flag goodwill impairment as a KAM. Overall, this paper establishes the role of the expanded audit report for firms’ disclosure.

Keywords: disclosure, goodwill impairment, expanded audit report

JEL Classification: M41, M42, M48