Managerial Ability and the Tone of Emphasis of Matter Paragraphs in Auditor Reports: A Natural Language Processing Approach

ObjectiveAuditors have a degree of flexibility in choosing the wording and phrasing of Emphasis of Matter (EOM) paragraphs in audit reports, and their content is often influenced by interactions between auditors and client managers during the drafting process. This study examines the relationship between management ability and the tone of EOM paragraphs. The primary objective is to provide empirical evidence on the extent to which auditors utilize the tone of their reports to convey their perspectives on financial statement items to financial statements users and how client characteristics, particularly managerial ability, influence the tone adopted in audit reports.MethodsThe study analyzes the tone of 2,104 EOM paragraphs from audit reports issued for 179 firms listed in Tehran Stock Exchange (TSE) over the period 2016 to 2023. It applies Natural Language Processing (NLP) approach leveraging the GPT-4 API and a Python-based script specifically developed for this purpose. This script and the GPT prompt were configured to output the percentages of positive, negative, and neutral tones for each paragraph, as well as classify each paragraph into one of the three categories: positive, negative, or neutral. To measure firms efficiency and managerial ability, the study uses the Demerjian, Lev, and McVay (2012) model. The research hypotheses are tested using Tobit and logistic regression models. ResultsThe results indicate that 31% of EOM paragraphs exhibit a 'negative' tone, while 10% are classified as 'positive,' resulting in 41% of EOM paragraphs being classified as non-neutral overall. Regression analysis reveal that auditors are less likely to employ a negative tone for firms with higher efficiency, as as the EOM paragraphs for such firms predominantly exhibit a neutral tone. Conversely, auditors tend to adobt a more negative tone in cases where client firms are managed by highly capable managers and demonstrate a reduced inclination toward neutrality. Additionally, the Audit Organization and Mofid Rahbar Audit Institute, compared to other audit firms, employ a more negative tone in the emphasis paragraphs of their audit reports.ConclusionThe inverse and significant relationship between the negative tone of EOM paragraphs and firm efficiency suggests that auditors perceive lower financial reporting risks in more efficient firms. As a result, they feel less need to use a negative tone in emphasis of matter paragraphs as a safeguard against potential future uncertainties. In contrast, auditors appear to associate higher managerial ability with an increased likelihood of opportunistic financial reporting, prompting them to employ a more negative tone in emphasis paragraphs as a means of signaling potential risks to report users and protecting themselves against future liabilities. This study aimed to provide evidence that auditors strategically use tone in emphasis paragraphs as a communicative tool to reflect their assessment of financial information, evaluate managerial behavior, and mitigate perceived financial reporting risks.