Auditor Responses to Estimation Uncertainty in Financial Statements

Abstract

Estimation uncertainty around accounting estimates poses unique challenges for auditors when conducting their audits. Moreover, auditors face heightened expectations from investors and regulators to improve audit quality of accounting estimates and better communicate risks related to material accounting estimates. Given these challenges and expectations, we examine auditor responses to estimation uncertainty. We find that auditors increase communication to financial statement users in the form of topic-specific explanatory langue and, in more recent years, critical audit matters in response to estimation uncertainty. This association is more pronounced when investor information needs are higher. Further, we demonstrate that auditors also charge higher risk premiums and extend more effort in response to estimation uncertainty. We believe this study can provide insights to regulators, investors, and other financial statement users by demonstrating that auditors respond to the overall level of estimation uncertainty in the financial statements in response to investor information needs and regulatory standards.