The Role of Audit Risk Disclosure in Financial Reporting Precision and the Quality of Audited Financial Reports

Abstract

We study the impact of audit risk disclosure in a model in which a client company privately spends corporate resources to improve its financial reporting precision. The financial reporting precision represents the audit risk associated with measurement uncertainty. Without audit risk disclosure, the capital market cannot observe the precision and must price the client value based on its conjecture. With audit risk disclosure requirements, an auditor is mandated to disclose the precision, in addition to an audited financial report, to the market. Thus, audit risk disclosure provides the client another channel to influence the market's perceptions. Contrary to the conventional wisdom, we find that the client tends to spend fewer corporate resources on precision with audit risk disclosure. As a result of lower precision, audit risk disclosure may lower the informativeness of audited financial reports, albeit ex-post communicating more information to the market. We also find that audit risk disclosure reduces the client's ex-ante payoff when the auditor bears a high misstatement cost due to audit failure. This paper provides empirical implications for recent reforms of audit risk disclosure.

Keywords: Audit Risk Disclosure; Audit fee; Audit quality; Audit Reform

JEL Classification: M41, M48