Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?

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 a 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.

Keywords: explanatory language, audit opinions, financial misstatements

JEL Classification: M41, M49