The Forewarning Effect of Critical Audit Matter Disclosures Involving Measurement Uncertainty*

Abstract

We present experimental evidence suggesting that critical audit matter (CAM) disclosures in the auditor's report involving areas of high measurement uncertainty forewarn users of misstatement risk. Specifically, in our first study with MBA students, financial analysts, and attorneys, we find that CAMs (i) lower premisstatement assessments of confidence in the financial statement area disclosed as a CAM, and (ii) lower assessments of auditor responsibility for a subsequently revealed misstatement in a CAM-related area. In our second study with student participants proxying as mock jurors, we find that the responsibility-mitigating effect of CAM disclosure is driven by CAM disclosures involving measurement uncertainty, as opposed to CAM disclosures involving categorical determinations. Combined, our findings help reconcile mixed evidence from prior research, supporting the view that the forewarning effect of CAM disclosures involving measurement uncertainty could mitigate perceived auditor responsibility for CAM-related material misstatements.

Impact of Auditor Report Changes on Financial Reporting Quality and Audit Costs: Evidence from the United Kingdom

“…Experimental studies have examined potential effects of the disclosure of CAMs on auditor legal exposure and investor decisions. For example, Kachelmeier et al () find that attorneys, financial analysts, and MBA students perceive auditors to be less responsible for a misstatement that occurs in the same area as the CAM disclosure. Gimbar et al (), on the other hand, find that auditor liability is perceived to be greater when CAMs are included in audit reports in a rules‐based setting but not a principles‐based setting.…”

Investigating recent audit reform in the Australian context: An analysis of the KAM disclosures in audit reports 2017–2018

“…However, the regulators and standards setters have expressed their fears that the users may rely on KAMs as substitutes for other available information in the financial statements (IAASB, 2012; PCAOB, 2014), thus this is when the “substitution effect” comes into play (Sirois et al, 2018). For example, Kachelmeier, Rimkus, Schmidt, and Valentine (2019) examined the effect of KAMs on the areas of high measurement uncertainty of audit misstatement risk. Their study supports the view that the forewarning effect of KAM disclosures related to measurement uncertainty could mitigate perceived auditor responsibility for KAM‐related material misstatements.…”

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

“…Some research suggests that under certain circumstances, CAMs may increase auditor negligence verdicts (e.g., Backof, Bowlin, and Goodson 2018). 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.…”