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    Does Auditor Explanatory Language in Unqualified Audit...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
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    Title:
    Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
    Practical Implications:

    The results suggest that explanatory language modifications, although less apparent than opinion qualifications, are informative of misstatement risk.  Under the present-day audit reporting requirements, auditors do communicate some risk-related information to financial statement users.  This finding had implications for standard-setters who are currently considering revising the audit reporting model to make future audit reports more informative.  The authors also highlight that auditors use unqualified audit reports to indicate heighted risk, building upon findings from prior research showing that auditors use going concern explanatory language to communicate risk.

    Citation:

    Czerney, K., J. Schmidt, and A. Thompson. 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk? The Accounting Review, 89 (6): 2115–2149.

    Keywords:
    explanatory language; audit opinions; financial misstatements
    Purpose of the Study:

    Investor advocates believe the present-day auditor’s report is boilerplate and uninformative.  However, over 60% of audit opinions in the authors’ sample make use of explanatory language within an unqualified audit opinion to emphasize matters to financial statement users.  According to professional standards, explanatory language should not affect the auditor’s unqualified opinion on the financial statements and theoretically should not be indicative of increased financial statement risk.  But because the Securities and Exchange Commission (SEC) precludes publicly traded companies from releasing financial statements with any audit opinion except unqualified, adding explanatory language is the auditor’s only practical mechanism to communicate risk, and often is the only distinguishing feature among audit reports.  The purpose of this study is to:

    • Determine if financial statements accompanied by unqualified audit reports with explanatory language are more likely to be subsequently restated than those without explanatory language,
    • Investigate whether the likelihood of subsequent restatement differs based on the type of explanatory language, and
    • Examine whether the financial statement accounts referenced in auditor explanatory language are the financial statement accounts subsequently restated.
    Design/Method/ Approach:

    Using data from publicly-traded companies in the United States over the time period from 2000-2009, the authors investigate the association between opinions with explanatory language and the likelihood that the corresponding financial statements are subsequently restated.  The authors then classify audit opinions by the type of explanatory language based on Auditing Standard AU Section 508 into four categories: (1) Inconsistency with previously issued financial statements, (2) ‘‘Emphasis of matters’’ in financial reports, (3) Audit-related information, and (4) Other language to determine if the likelihood of subsequent restatement differs based on the type of explanatory language.  Finally, the authors conduct an additional analysis to examine whether the financial statement accounts referenced in the explanatory language are those most likely to be subsequently restated.

    Findings:

    The authors report the following findings:

    • Financial statements that have audit opinions with explanatory language are more likely to be subsequently restated than those with audit reports without explanatory language, but this association is limited to certain types of explanatory language.
    • Specifically, they find that a subsequent restatement is more likely if the auditor emphasizes inconsistency with previously issued financial statements by referencing changes in accounting principles and previous restatements in the audit report.
    • However, financial statements whose audit reports include other types of inconsistencies, such as references to fresh-start accounting or use of a non-GAAP accounting basis, are less likely to be subsequently restated.
    • The likelihood of subsequent restatement is higher for financial statements with audit reports that include ‘‘emphasis of matter’’ language referencing mergers, related-party transactions, and management’s use of estimates, but only if the restatement relates to the same account referenced in the explanatory language.
    • A subsequent restatement is more likely if the auditor divides responsibility for the opinion, but not for any other type of audit-related explanatory language.
    • The authors do not find an association between subsequent restatements and explanatory language that references supplemental information, going concern, and/or financial distress.
    • The financial statement accounts discussed in the explanatory language correspond to the financial statement accounts subsequently restated.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Restatements