Quarterly Footnote Disclosures as a Leading Indicator of Audit Risk

Abstract

Using a large sample of financial statement notes obtained from XBRL data, we investigate the role of quarterly footnote disclosures as a leading audit risk indicator. Existing requirements suggest quarterly footnotes are required when information in the footnotes exhibits significant changes from the prior annual filing. Yet, assurance requirements of interim reviews are limited. If auditors promptly respond to risk indicators in quarterly filings, we expect to see an increase in annual audit quality. In contrast to this expectation, we find that the proportion of quarterly footnotes disclosed is associated with lower audit quality, as measured by restatements, material weakness errors, abnormal accruals and the receipt of comment letters. The decline in audit quality is exacerbated during busy season audits and among new auditors. Consistently, investors appear to provide a more muted reaction to earnings announced by companies with more quarterly footnote disclosures. To strengthen identification, we examine specific footnotes and observe a positive association between quarterly mergers and acquisitions and income taxes footnotes and topic-related restatements and comment letters. Our results collectively suggest that quarterly footnote disclosures serve as risk signals that appear to be insufficiently addressed in the interim review process. These findings suggest that the PCAOB should consider recommending additional audit work during the interim reviews in the presence of elevated risk.

Keywords: Footnotes, quarterly reports, restatements, comment letters, material weakness errors, discretionary accruals, audit quality, XBRL

JEL Classification: M41,M42