The Effects of Ambiguity on Loss Contingency Evaluation by Auditors and Investors

Abstract

The objective of this study is to provide additional evidence regarding the effect of ambiguity on auditors’ and investors’ judgments when they evaluate managers’ disclosures about loss contingencies. Inspired by Nelson and Kinney (1997), we conducted an experiment where auditors and investors evaluate managements’ loss disclosures. We manipulate the probability of loss at three levels and the uncertainty about the ambiguity at two levels. Our results show that both auditors and investors appear to be aggressive towards financial reporting choices, and are less willing to recommend a loss contingency disclosure when there is ambiguity. Our results extend prior accounting literature and highlight the importance of understanding imprecise estimates in financial reporting. We found that auditors and investors reacted very similarly towards ambiguity in loss disclosures. This result may reflect a narrowing of the expectations gap around reporting accounting estimates and highlight the potential improvements in users’ confidence in accountants.

Keywords: Expectation Gap, Contingency Loss, Disclosure, Auditor, Financial Statement User, Ambiguity, Probability, Uncertainty

JEL Classification: M42