Measuring Misreporting Risk in Firms’ 10-K Disclosures and the Auditor’s Role in Mitigating Misstatements

The purpose of public company audits is to increase the integrity of firms' financial statements. However, research provides mixed evidence on whether better auditors mitigate misstatement risk embedded in the financial reporting process. A challenge in previous studies is the lack of a powerful measure of inherent, “pre-audit” reporting risk. We overcome this issue by developing a novel, powerful measure of accounting misstatement risk (AMR) from 10-K text. We validate this measure by documenting economically significant associations with both audit fees and misstatements. We then empirically test whether relatively higher quality audits, measured using a variety of characteristics, attenuate the association between AMR and subsequent restatements. Contrary to our prediction, however, we find minimal evidence that better auditors mitigate the association between AMR and the likelihood of subsequent restatement. Further analysis supports the notion that AMR inhibits auditors' ability to mitigate reporting risk through increased audit fees and that AMR captures innate reporting risk rather than managerial obfuscation. Overall, we expect our results to be of interest to managers, accountants, and regulators, all of whom seek to minimize negative consequences of misreporting