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

51 Pages Posted: 7 Apr 2013 Last revised: 29 May 2014

Keith Czerney

University of Nebraska-Lincoln

Jaime J. Schmidt

University of Texas at Austin

Anne Thompson

University of Illinois at Urbana-Champaign

Date Written: March 25, 2014

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

Suggested Citation

Czerney, Keith and Schmidt, Jaime J. and Thompson, Anne, Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? (March 25, 2014). Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2245855 or http://dx.doi.org/10.2139/ssrn.2245855

Keith Czerney

University of Nebraska-Lincoln ( email )

1240 R Street
P.O. Box 880405
Lincoln, NE 68588-0405
United States

HOME PAGE: http://cba.unl.edu/people/kczerney

Jaime J. Schmidt

University of Texas at Austin ( email )

Austin, TX 78712
United States

Anne Thompson (Contact Author)

University of Illinois at Urbana-Champaign ( email )

360 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States

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