Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability

Abstract

Audit practitioners, academics, and attorneys have expressed concern that disclosing critical audit matters (CAMs) will increase jurors' auditor liability judgments when auditors fail to detect misstatements. In contrast, this study provides theory and experimental evidence that CAM disclosures, under certain conditions, reduce auditor liability judgments as jurors perceive that undetected fraudulent misstatements were more foreseeable to the plaintiff (i.e., the financial statement user suing the auditor). However, we find that CAM disclosures only reduce auditor liability for undetected misstatements that, absent CAM disclosure, are relatively difficult to foresee. Finally, CAM disclosures that are unrelated to subsequent misstatements neither increase nor reduce auditor liability judgments relative to the current regime (i.e., where CAMs are not disclosed), but reduce liability judgments relative to reporting that there were no CAMs. As such, we find that, relative to stating there were no CAMs, disclosure of any CAM (i.e., related or unrelated) provides litigation protection in cases of undetected fraud. Consequently, the CAM requirement could incentivize auditors to disclose innocuous boilerplate CAMs, thereby diluting the impact of more warranted CAM disclosures. Data Availabliity: Available from authors upon request.

Updates and Comparisons Regarding Changes to the Audit Reporting Model in the United States, United Kingdom, and European Union

“…There are at least four studies that provide evidence regarding this issue. Similar to the findings of Kachelmeier et al (2015), Brasel, Doxey, Grenier, and Reffett (2016a) find that CAM disclosures did not increase-and in some settings even decrease-the probability of jurors holding auditors liable when audits fail to detect material misstatements. Brown, Majors, and Peecher (2015) use law students and lay jurors as participants and find that CAM information in the audit report reduced negligence verdicts by both groups.…”

Real effects of reporting key audit matters on auditors' judgment and choice of action

“…While similar reporting requirements are obligatory in the EU for public interest entities, the PCAOB also introduced the reporting on critical audit matters (PCAOB, 2017). Our results show that the KAM requirement can have unintended consequences not only in the form of a "disclaimer effect" on the side of the financial statement users or in the form of a liability protection (Brasel, Doxey, Grenier, & Reffett, 2016), but also in the form of a moral licensing effect on the auditors' JDM as well. That is, auditors showed a lower probability of insisting on an adjustment and also assessed a smaller adjustment amount as necessary when the accounting estimate evaluated was also determined to be reported as a KAM.…”

The Sound of Silence: What Does a Standard Unqualified Audit Opinion Mean Under the New Going Concern Financial Accounting Standard?

“…Other studies suggest that CAMs may decrease auditor negligence verdicts (e.g., Kachelmeier, Rimkus, Schmidt, and Valentine 2018;Gimbar et al 2016). Brasel et al (2016) find that when the auditor discloses a CAM related to a misstatement, jurors see the misstatement as more foreseeable to the investor and are less likely to find the auditor negligent.…”

“…Finally, our research contributes to the growing body of research related to CAMs. Prior studies suggest that the inclusion of CAMs may improve auditor outcomes in negligence lawsuits under certain circumstances (e.g., Brasel, Doxey, Grenier, and Reffett 2016) and may have the opposite effect under other circumstances (e.g., Gimbar, Hansen, and Ozlanski 2016).…”