Using textual analysis of the explanatory notes in auditor reports, we examine whether these notes are informative in identifying financial misstatement risks as captured by client restatements. Based on a Chinese sample of 22,850 firm-years from 2003 to 2015, we find that auditors are generally effective in conveying the risks of financial misstatements through their opinions and that such risks increase as the severity of audit opinions increases. We also find that modified audit opinions containing explanatory notes have robust predictive power for subsequent restatements. Specifically, “emphasis of matter” notes referencing contingencies and uncertainties and issues related to audit scope limitations signal useful incremental information about future restatements. Finally, we find that the financial statement accounts identified in auditor explanatory notes match the accounts subsequently restated. Overall, our study provides some evidence consistent with the recent regulatory initiative to improve the usefulness of audit reports by drawing financial statement user attention to key audit matters.

Do Auditors Convey Financial Misstatement Risks through Audit Opinions? A Textual Analysis of Modified Audit Reports in China.

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