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

Conventional wisdom suggests that audit risk disclosure improves the quality of audited financial reports because the disclosure reduces information asymmetry between investors and companies. In contrast, we show that audit risk disclosure provides companies with another channel to influence investors' perceptions, potentially impairing the quality of audited financial reports. In our model, a company can choose the precision (risk) of its financial reporting system and hires an auditor to issue an audited report. Without risk disclosure, the market value is solely based on the audited report. Intending to inflate its market price, the company may bias the audited report upward resulting in a higher misstatement cost. But with risk disclosure, the market price is based on both the audited report and the disclosed precision of the financial reporting system. In anticipation of the risk disclosure, the firm ex-ante chooses lower precision of its financial reporting system because with lower precision the market pricing is less responsive to the audited report, thereby discouraging the ex-post inflation decision and reducing the misstatement cost. As a result of lower precision, risk disclosure may lower the overall quality of audited financial reports albeit ex-post communicating more information to investors. This paper provides some regulatory and empirical implications for recent reforms of audit risk disclosure