When Silence is Golden : Audit Risk Disclosure, Information Acquisition and Investment Efficiency

Conventional wisdom suggests that audit risk disclosure improves the overall efficiency because investors are more informed of a client's financial performance. This view, while intuitive, ignores a potential externality of audit risk disclosure on auditor competence. We consider a two-period model wherein an auditor exerts costly effort to acquire private information of the client-specific audit risk to avoid audit failure and induce more efficient investment decisions. Despite conveying more information to investors, mandatory audit risk disclosure reduces the incumbent auditor's information advantage over other entrant auditors, thus discouraging the auditor's information acquisition effort in the first period. As a result, mandatory disclosure may impair audit quality, escalate total audit fees, and reduce investment efficiency, making the client worse off ex-ante. We further offer regulatory and empirical implications to the recent audit reform