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Auditor Explanatory Language May Boost Odds of a Restatement

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Jul 28th 2015
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It's about that time for second-quarter financial reports, so what could be more pertinent than a study of how an auditor's explanatory language relates to misstatement risk?

In Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? professors at the University of Texas and the University of Illinois reported on their study of 30,825 financial statements with unqualified audit opinions issued from 2000 to 2009.

They discovered that financial statements with audit reports that include explanatory language are “significantly more likely” to be restated compared to statements without the language.

That's prompted by language referring to the division of responsibility for audit performance, adoption of new accounting principles, and prior restatements, according to the study.

Language referring to “emphasis of matter” that addresses mergers, related-party transactions, and managers' use of estimates predicts restatements. And financial statement accounts mentioned in the explanatory language relate to subsequent restatements.

Yet, according to auditing standards, “explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk,” the report states. The authors cited AU Section 508, Reports on Audited Financial Statements, which states that explanatory language shouldn't alter the overall conclusion that the financial statements are fairly stated. Instead, the language should highlight information that managers have already provided.

The authors stated that their findings suggest that current audit reports communicate some information about financial report quality.

But here's the catch-22.

The US Securities and Exchange Commission (SEC) prevents public companies from issuing financial statements with any audit opinion except an unqualified one. The SEC believes that adding explanatory language is the auditor's “only practical mechanism to communicate risk and often is the only distinguishing feature among audit reports,” the report states.

If an auditor is uncertain about the information, explanatory language can be used to attract the attention of financial statement users.

Yet, auditors need to keep clients happy, and clients don't welcome explanatory language, say the authors.

But because explanatory language strains the auditor's relationship with a client, it's likely to indicate misstatement risk.

Got that?

So back to the study's findings that audit reports with explanatory language are more likely to be restated. It depends on the type of explanatory language used, according to the report.

Here are highlights of types of explanatory language.

Inconsistency. Restatements are more likely when an auditor emphasizes inconsistency with prior statements by referring to changes in accounting principles or prior restatements in the audit report. But other inconsistencies, such as fresh-start accounting or non-GAAP measures, aren't as likely to be restated.

Emphasis of matter. Restatements are more likely when language refers to mergers, related-party transactions, and management's use of estimates “but only when the sample is limited to restatements in the same accounts as referenced in the explanatory language,” the report states.

Audit-related. Restatements are more likely if the auditor divides responsibility for the opinion but not for any other type of audit-related explanatory language.

Other. There's no connection between restatements and language that refers to going concerns, supplemental information, or financial distress.

As regulators consider changing audit reporting models to make future reports more informative, the authors believe their findings will help.

The authors of the study were Keith Czerney and Anne Thompson, both in the department of accountancy at the University of Illinois College of Business, and Jaime Schmidt, an assistant professor in the department of accounting at the University of Texas McCombs School of Business.

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