The Challenge of Transparency

Audit reports are supposed to enhance transparency. However, research I carried out with Xiaoxi Wu, Shuai Yuan and Vincent Zhang shows that state-owned enterprises (SOEs) in China systematically report less information – known as key audit matters (KAMs) – about areas of high-risk of material misstatement that involve significant auditor and management judgment. Besides, they tend to use ambiguous language to obscure financial risks. This raises serious concerns about the reliability of financial disclosures in politically influenced entities.

One would expect SOEs – given their complexity and public accountability – to disclose more KAMs. Instead, they report 4.3% fewer than non-SOEs and are 7.2% more likely to omit KAMs in high-risk areas like revenue recognition, inventory valuation and especially the so-called related-party transactions (RPTs), i.e. dealings between the SOE and entities closely linked to it, like subsidiaries or major shareholders. The study suggests that SOEs leverage their government ties to influence how financial risks are presented, effectively controlling their own narrative.

This manipulation goes beyond omission. Our study finds that SOEs also use vaguer language in audit reports – less specificity, fewer numerical details and a more sanitized presentation of risks. This strategy allows them to comply with reporting requirements while avoiding disclosures that might raise investor concerns.

Auditors are supposed to be independent, but when dealing with SOEs they face significant pressure to avoid confrontation. Our research reveals that SOE audit reports tend to be shorter, less detailed and contain fewer risk-related terms, suggesting a reluctance to highlight problematic areas. This raises a crucial question: If KAMs are meant to flag complex or high-risk areas, what does it mean when SOEs systematically underreport them?

For investors, this means extra vigilance is required. The absence of expected KAMs should not be mistaken for an absence of risk – it may indicate an effort to downplay or conceal it. Related-party transactions, in particular, deserve closer scrutiny, as they often involve dealings between SOEs and politically connected entities, raising the risk of conflicts of interest and misallocation of resources.

To be sure, our findings carry broader implications beyond China. They underscore the fact that financial disclosures are not neutral documents – they can be shaped by political influence, regulatory pressures and corporate incentives. Investors must learn to read between the lines, paying close attention to not just what audit reports say, but what they fail to mention.

Regulators, too, must recognize the limitations of existing audit frameworks. KAMs were introduced to enhance transparency, but their effectiveness is undermined when state-linked firms can manipulate reporting with minimal pushback. Stronger oversight is needed to ensure that audits remain a tool for accountability rather than a mechanism for controlled disclosure.

We have to face the facts: in SOEs, transparency is often a challenge. Investors should treat vague audit reports and missing KAMs as warning signs, not reassurances. If KAMs are meant to highlight complexity and risk, their absence may be more telling than their presence.

Ultimately, financial disclosures are only as reliable as the systems that enforce them. When those systems are compromised – by political influence, regulatory gaps or auditor pressure – investors must rely on their own skepticism to uncover the full financial picture.