Effect of Audit Quality on the Readability of Auditor Preferability Letters: An Empirical Study

The Securities and Exchange Commission requires that a registrant who makes a voluntary accounting change with material effects should provide a letter by its independent auditors assessing whether the alternative accounting method(s) is (are) preferable (preferability letter). This study examines the readability of 420 preferability letters enclosed in 10-K filings across small (5%), medium (6.43%), and large (88.57%) size audit firms from 1994-2008. Readability is assessed using the Fog Index following computational linguistic literature and prior studies. Regressing size, as a proxy for audit quality, onto readability as measured by the fog index, we find that preferability letters generated by large audit firms are the hardest to read. Letters generated by medium-size audit firms are the easiest to read. Our major contribution to the literature is identifying a lexical feature in the auditor letters that potentially affects audit quality through the readability of auditor communications. We find that medium-size audit firms are doing a better job of making their preferability letters readable, and thus providing more understandable information to decision-makers outside the firm.Introduction and BackgroundThe process of communicating financial information of a firm through the timely reporting of its financial condition and performance has come under increasing scrutiny. Part of the concern centers on whether the information regarding a firm's financial condition is written in such a way that the financial information user can understand what is being communicated. Complexities in both the types of business transactions which form the basis of the financial information and the significant increases in the amount of disclosures required in financial reporting make communicating a firm's financial information ever more difficult. Both the Securities Exchange Commission (SEC) and the popular press have voiced concern as to whether financial information users can comprehend the complicated financial information provided by firms and their auditors (Schroeder 2002). There is a growing extant literature base considering the readability of financial statements and disclosures as presented by a firm's management as well as the communications issued by the firm's independent auditors. Jones and Shoemaker (1994) review thirtytwo empirically based readability studies and conclude that financial reporting from the 1940's through the 1 990 's decreased in readability, being either difficult or very difficult to read. They further concluded that the readability decline was primarily due to the increased complexity of the language used.Some of the early research found that readability of financial communication differed greatly depending on the auditor firm generating the report (Smith and Smith 1971, Barnett and Leo finer 1 979). Later studies found managers to be more forthcoming in their financial reports when the firm performed better (Bloomfield 2002, Schrand and Walther 2000). Conversely, the literature has also created the label "incomplete revelation" to describe management strategically hiding adverse information through less transparent disclosure (Grossman and Stiglistz 1980). Li (2008) further supports differences in management's use of language with evidence that the annual reports of firms with lower earnings are more difficult to read and firms with more persistent positive earnings are easier to read. Auditors may also have incentives to benefit from the use of complex language in their reports on the firm's financial information. The question arises as to whether information producers use the lack of readability strategically.When considering the impact of the readability of the various letters written by auditors, it is challenging to isolate an instance of uniquely worded communication that conveys specific information to the end-user. The most typically studied communication is the annual report. …