Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk?

Keith Czerney, Jaime J. Schmidt, Anne M. Thompson

Research output: Contribution to journalArticlepeer-review

Abstract

According to auditing standards, explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client's financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000-2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) "emphasis of matter" language that discusses mergers, related-party transactions, and management's use of estimates predicts restatements related to these matters, and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.

Original languageEnglish (US)
Pages (from-to)2115-2149
Number of pages35
JournalAccounting Review
Volume89
Issue number6
DOIs
StatePublished - Nov 1 2014

Keywords

  • Audit opinions
  • Explanatory language
  • Financial misstatements

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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