Less is More: Does Audit Risk Disclosure Improve Financial Reporting Precision and the Quality of Audited Financial Reports?

Abstract

We study the impact of audit risk disclosure in a model where a client privately spends corporate resources to improve the precision of its financial reporting system. The precision of the financial system 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 audit risk, in addition to an audited financial report, to the market. Thus, the market price is contingent on both the audited report and the disclosed precision. Audit risk disclosure provides the client another channel to influence the market's perceptions. Anticipating audit risk disclosure, the client spends fewer corporate resources on precision due to the negative impact of precision costs on its market price. 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. If the auditor bears a high misstatement cost due to audit failure, audit risk disclosure reduces the client's ex-ante payoff. This paper provides empirical implications for recent reforms of audit risk disclosure.