On Controlling for Misstatement Risk

Abstract

Ex ante misstatement risk confounds nearly all settings relying on restatements as a measure of audit quality, but researchers continue to debate how to effectively control for this construct. In this study, we consider a recent approach that involves controlling for prior period restatements (“Lagged Restatements”). Using a controlled simulation as well as a basic archival analysis, we show that a lagged restatement control can significantly bias coefficient estimates. We demonstrate this bias using audit fees as a variable of interest but also show the same issue persists for other constructs that respond to the identification of a restatement (i.e., internal control material weaknesses and auditor changes). We conclude by discussing alternative approaches for controlling for ex ante misstatement risk and providing guidance for future research. Taken together, this study provides an important methodological contribution to the broad literature using restatements as a measure of audit quality.

Keywords: Misstatement Risk, Restatements, Audit Quality

JEL Classification: M40, M41, M42