The Auditor’s Response to the Lexical Complexity of 10-K Disclosures

• In Event: Continental Breakfast and Research & Education Forum
  In Paper Session: Table 1: Audit Risk I

Abstract

In this study, we examine the auditor’s response to lexical financial reporting complexity (FRC) as measured by the volume and understandability of disclosures made in annual reports (10-Ks). We begin by investigating the relation between lagged FRC and audit fees conditional on firm and auditor characteristics. As predicted, we find a strong, positive relation between FRC and audit pricing, indicating that auditors respond to the volume and understandability of financial disclosures. Further, the relation between FRC and fees is economically significant relative to other determinants of fees (e.g., firm size). This sensitivity of audit pricing to FRC may represent increased auditor effort to mitigate the risk of misstatement associated with FRC or additional risk pricing to insure against future litigation losses. Our second analysis attempts to disentangle these two possibilities. Evidence suggests the relation between audit fees and the likelihood of misstatement increases with FRC, indicating that auditor pricing of the risk component of audit fees increases as FRC increases. In sum, our evidence suggests that FRC is an important determinant of audit pricing and significantly affects the relation between audit fees and misstatement risk.

Authors

• James Robert Moon, Georgia State University

• Quinn Thomas Swanquist, Georgia State University