The Differential Effects of Management and Auditor Disclosures of Estimation Uncertainty on Nonprofessional Investor Judgments

• In Event: Auditor Impact on Investor Decisions

Abstract

In this study, we examine whether auditor inclusion of an emphasis of matter paragraph in the audit report interacts with management’s disclosure of uncertainty to influence investor judgments and decisions as evidenced via their perceptions of investment risk. This study is motivated by heavy regulatory interest in reducing the expectations gap that arises when investors hold an “illusion of precision” in their view of audited financial statements. Consistent with our expectations, we find that there is indeed an interaction between auditor and management disclosures of uncertainty, such that the form of management’s disclosure can mitigate the intended benefit of the auditor’s emphasis on uncertainty. Specifically, when management’s uncertainty disclosure does not include a reasonable range, the auditor’s emphasis of matter paragraph signals estimation uncertainty to investors as evidenced by an increase in investors’ perceptions of investment risk. We find, however, that when management’s uncertainty disclosure includes a reasonable range, the auditor’s provision of an emphasis of matter paragraph decreases investors’ perceptions of investment risk. Our results have important implications for regulators and standard setters as we find that expanded uncertainty disclosures by both management and auditors will not necessarily (as intended) decrease the expectations gap that exists with regard to investors’ illusions of precision.

Authors

• Norma Ramirez Montague, Wake Forest University

• Andrea Seaton Kelton, Wake Forest University