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

Abstract

We investigate the impact of the expanded audit report on firm disclosure, focusing on auditors’ mentions of goodwill impairment as a risk of material misstatement. Using a sample of U.K. Premium listed companies with goodwill on their balance sheets, we identify instances where goodwill impairment is (versus is not) flagged as a risk and contrast firms’ disclosure level on goodwill impairment. We find that managers increase goodwill impairment disclosure when auditors initiate the mention of this risk but do not react to the elimination of the mention. The increase in disclosure is stronger when firms are perceived to be riskier, and firms make more timely goodwill impairment decisions when auditors mention goodwill impairment as a risk. Overall, this paper establishes the role of the expanded audit report as a credible channel for revealing corporate financial reporting risks to financial statement users, as well as a trigger of enhanced corporate disclosure.