Does Audit Risk Disclosure Improve or Impair Audit Quality and Investment Efficiency?

This study investigates the effects of mandatory audit risk disclosure on audit quality, audit fees, and investment efficiency. We consider a two-period model wherein an auditor acquires private information about a company’s risk of material misstatement, thereby reducing the detection risk. On the one hand, mandatory audit risk disclosure facilitates an investor’s decision-making and improves investment efficiency. On the other hand, the disclosure takes away the incumbent auditor’s information advantage obtained through her information acquisition, which impairs audit quality and reduces investment efficiency. This tradeoff drives our main result: the non-disclosure regime dominates the disclosure regime for low business risk, low risk of material misstatement, and high detection risk. Our analysis sheds light on the PCAOB’s proposal to increase audit risk disclosure.