Eyes wide open: strategic alliances and the disclosure of critical audit matters*

The Effects of Critical Audit Matter Removal and Duration on Jurorss Assessments of Auditor Negligence

SUMMARY We investigate the relationship between critical audit matters (CAMs) and accruals quality. We find that companies with a higher number of CAMs in their audit reports are associated with poorer accruals quality, and this association appears to be driven by recurring rather than nonrecurring CAMs. An examination of specific CAM topics shows that revenue CAMs are associated with lower revenue-related accruals quality, and tax CAMs are associated with poorer tax-related accruals quality, suggesting that CAMs are indicators of poor accruals quality. A cross-sectional analysis shows that the CAM signal about poor accruals quality is attenuated for companies when the information environment is richer, suggesting that a rich information environment restrains the use of discretion in accruals estimation such that CAMs no longer indicate poor accruals quality. Overall, our findings suggest that CAMs can provide a relevant signal of financial reporting quality in certain circumstances. JEL Classifications: M41; M42; M48.

Using manually collected data on the number and category of critical audit matters (CAMs) in the period 2016–2017, we investigate the hitherto unexplored questions of whether CAMs affect firm-specific crash risk, how CAMs influence crash risk in the Chinese capital market, and recognize CAMs that contain incremental information. Our findings are as follows: (1) Crash risk decreases after implementing the new audit standard requiring the disclosure of CAMs; (2) CAMs release negative information and change the capital market information environment; (3) only corporate-idiosyncratic CAMs contain incremental information; (4) crash risk is mitigated only by CAMs disclosed by companies with a high shareholding of institutional investors. The main conclusion of our study is a positive assessment of the new audit standard and of CAMs in terms of protecting the interests of investors and strengthening the stability of the capital market to provide a new perspective for supervising the implementation of the new audit standard.

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.

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

Purpose The purpose of this study is to examine the relationship between Silent critical audit matters (CAMs) and corporate financial misconduct. Auditing Standard 3101 (AS 3101) mandates US auditors to disclose CAMs in audit reports, thereby enhancing transparency regarding material and high-risk accounts. However, in accordance with AS 3101, auditors have the discretion to declare the absence of identified CAMs, termed “Silent CAMs” herein. These reports are labeled as such because they essentially remain “silent” on CAMs, offering no additional information. We direct our focus toward Silent CAMs due to the limited research available on them, and their implications remain uncertain. Design/methodology/approach Utilizing data from US public companies spanning 2019–2021, we assess corporate financial misconduct with Benford Score (Amiram et al., 2015) and address endogeneity concerns through robustness tests employing entropy balancing, extended postpandemic sample period and propensity score matching. Findings The analyses reveal a significant positive association between Silent CAMs and a client firm’s likelihood of engaging in corporate financial misconduct, particularly evident in cases of prolonged audit firm tenure. Although a large portion of Silent CAMs were issued by non-Big 4 auditors, the relationship between Silent CAMs and corporate financial misconduct is consistent across all firms. Originality/value This research sheds light on the inherent risks associated with an auditor’s assertion of no CAMs and answers the call for further research on CAMs (Klevak et al., 2023). It provides financial statement users with valuable insights into risks potentially overlooked by auditors. Furthermore, it draws regulators’ attention to the issuance of Silent CAMs in their reviews of audits, providing an additional investigation criterion. Moreover, this study contributes to the literature by underscoring a potential drawback of extended auditor tenure.

PurposeThis study aims to address the following four research questions: first, whether auditors report critical audit matters (CAMs) to shield themselves against possible litigation; second, whether reporting quality affects auditors’ propensity to report CAMs; third, whether auditors’ tenure length – reflecting familiarity with clients’ financial reporting – affects their likelihood to report CAMs; and fourth, whether auditors’ conservatism increases the likelihood of CAMs reporting.Design/methodology/approachData are manually collected from audit reports including CAMs in 10-K, then financial data are collected from the Capital IQ database, and market data are collected from the CRSP database. Using propensity score matching, the initial sample of companies with CAMs is matched with companies without reported CAMs. Performance adjusted discretionary accruals, real earnings management proxy, Khan and Watts’ (2009) C-score, propensity to issue a going concern opinion, Dechow et al.’s (2011) F-Score, Rogers and Stocken’s (2005) model and Houston et al.’s (2010) model are used to measure reporting quality, auditor conservatism, misstatement risk and litigation risk, respectively.FindingsThe results do not show that auditors report CAMs opportunistically to shield themselves from litigation risk. However, the results do suggest that auditors have a greater tendency to report CAMs when reporting quality is low and when they are more conservative. On the other hand, they have less tendency to report CAMs in their first year of engagement.Research limitations/implicationsThe findings of this study have important implications for the auditor behavior literature as it shows that, when it comes to reporting CAMs, auditors actually behave objectively and do not report in a trite way. This study also provides early archival evidence on a standard that relates to the first major change to the auditor’s report in decades. To the best of the author’s knowledge, it is the first to provide evidence on the association between auditor conservatism and auditors tendency to report CAMs and the first to triangulate prior research on auditor litigation risk by providing the first archival evidence on the auditors “litigation-shielding” concern.Practical implicationsThis study examines whether auditors attempt to meet the stated objective of reporting CAMs by signaling information about reporting quality. This study demonstrates that reporting CAMs is not a “boilerplate” communication. This study has implications for standards setters, as it shows that CAMs are reported in a way consistent with the objectives of the new standard, namely, via signaling information in the audit report on the quality of the financial statements.Originality/valueIn terms of originality, this paper uses a manually collected sample and, to the best of the author’s knowledge, is the first to focus on auditor’s behavior rather than on investors or clients reactions to CAMs. Also, this paper addresses a recently issued standard using US data and archival approach, rather than experimental. This paper also provides relevant evidence related to concerns raised earlier but were not empirically examined, such as reporting CAMS as “boilerplate” expectations. This paper provides new evidence on the auditors’ behavior with regard to litigation risk.

This study contributes to the audit reporting literature by examining how disclosure of critical audit matters (CAMs) in the audit report varies with perceived litigation risk and financial reporting quality. Consistent with the litigation hypothesis (Skinner, 1994), I find a positive association between litigation risk and the number of CAMs in the audit report, suggesting that auditors try to preempt negative consequences from shareholder lawsuits by reporting more CAMs when litigation risk is higher. The results also show the number of reported CAMs increases when financial reporting quality decreases, suggesting that audit reports reflect the inherent quality of financial statements. Further, in presence of high litigation risk, the CAM language exhibits lower readability as the quality of financial reporting decreases. A detailed examination shows the lower readability is driven by the auditor response rather than CAM description, consistent with the obfuscation hypothesis (Bloomfield, 2008). Overall, these results are consistent with auditors touching upon issues they are legally obligated to without necessarily providing clarity to financial statement users. This study also contributes to audit fees literature by showing that audit fees and audit report delays are positively associated with the number of reported CAMs, suggesting that CAMs increase auditor effort and costs.

ABSTRACTChinese auditing standards mandate the disclosure of critical audit matters (CAMs) in audit reports for all listed companies since 2017. Risk-oriented auditing requires auditors to assess material misstatement risks and provide reasonable assurance on financial statements that should reflect the firm’s underlying economics, regardless whether a CAM is disclosed. However, given a material misstatement risk, if some auditors effectively identify it as a CAM while others do not, the financial information with a CAM would exhibit higher quality than that without a CAM, leading to a positive association between CAM disclosure and the audited information quality. Using asset impairment-related CAMs, we show the relation between asset impairment and worsened economics is notably stronger for companies with an impairment-related CAM than those without any. Further, this association is more pronounced in smaller audit firms. Our findings reveal inadequate implementation of risk-oriented auditing, particularly in audit firms with greater resource constraints.

SUMMARY A primary concern facing the PCAOB's requirement of disclosing critical audit matters (CAMs) is increased auditor litigation risk. Evidence with Key Audit Matters from the U.K. indicates auditors may subsequently remove a CAM or continue to report the same CAM for several years. Therefore, we investigate the effects of CAM removal and duration on jurors' assessments of auditor negligence when there is a subsequent material misstatement due to fraud in the account related to the CAM. Using the Culpable Control Model, we predict jurors will assess higher auditor negligence when a CAM is removed than when a CAM is reported and when a CAM is reported for multiple years than for one year. Results from two experiments support our expectations, although results vary depending on complexity of the misstated account. Overall, our findings highlight a quandary for audit firms, where subsequent removal of a CAM increases auditor liability.

SUMMARY The addition of critical audit matters (CAMs) to the audit report is a significant change intended to provide investors greater information that is useful for decision making, however, there were also concerns about unintended consequences. This article summarizes Carver, Muriel, Trinkle (2023), who find that the disclosure of a CAM enhances perceived auditor credibility and in turn, perceived audit quality, which then leads to a decrease in perceived investment risk. However, a CAM also increases feelings of information overload, partially offsetting the positive effect on auditor credibility. Auditors should balance the volume and complexity of information in CAMs to lessen the potential negative effects of information overload. However, auditors can also view CAMs as an opportunity to enhance transparency and credibility. These findings are timely for auditors, audit committees, financial statement preparers, and regulators, who must consider the impact CAMs can have on the information environment. Data Availability: Data are available from the authors upon request.

In 2017, the PCAOB announced its new audit standard, AS 3101. One requirement is reporting critical audit matters (CAMs), starting June 30, 2019, for large accelerated filers. Using US data of CAM, we investigate whether the reporting of CAMs is informative for investors using a difference-in-differences approach and we use as proxies for investors’ informativeness, absolute abnormal returns and abnormal trading volume. Our motivation is to assess the relevance and the effectiveness of a new regulation aiming to improve audit quality. Overall, our findings provide some indications that the first-time implementation of CAMs might lead to investors avoiding those companies presumably because of uncertainty about the information being released. We also investigate the content of the CAM paragraph and do not find that the number, categories, or firm-specific/industry-common CAMs are value-relevant for investors. The results of this study provide insight into the new US auditor standard and the value-relevance of CAMs for investors. We suggest that standard setters should aim to improve the auditor report to make it more informational. Overall, our paper provides some evidence on the implementation and communicative value of the new CAM reporting, suggesting that CAMs are not informative for investors. We argue that this is the case potentially due to the additional information from CAMs which leads to complex information or information overload making investors less reluctant to invest on the companies with a significant number of CAMs reported.

The Disclaimer Effect of Disclosing Critical Audit Matters in the Auditorrs Report

This study explores the alignment between auditors' critical audit matters (CAMs) and the issues raised in SEC comment letters. CAMs highlight areas involving significant auditor judgement, whereas SEC comment letters address concerns related to compliance and the quality of financial disclosure. When deficiencies are identified, the SEC issues comment letters requesting clarification or additional information, a resolution process that reflects investor priorities. We find that SEC comment letters are more likely to reference the same financial statement note numbers referenced in CAMs. Additionally, we document strong associations between the accounting topics addressed in SEC comment letters and those disclosed in CAM reports. Furthermore, firms exhibiting higher uncertainty sentiment in CAMs are more likely to receive SEC comment letters on related issues. Our results support the informational validity and credibility of CAMs, suggesting that these reports highlight salient financial reporting issues that are relevant to investors.

The PCAOB adopted critical audit matters (CAMs) to meet public demand for informative audit disclosure, but stakeholders are concerned this goal has not been achieved. We explore this disconnect via interviews with 30 highly experienced auditors. We find that audit firms expended considerable resources to implement CAM best practices. However, overwhelming institutional pressure gave rise to informal rules of thumb that prioritize symbolic comfort over substantive change. The first is don’t be an outlier , so auditors defer to the national office to ensure conformity and avoid PCAOB scrutiny. The second is report the “right” number of CAMs by never reporting zero and reporting at least one recurring CAM. The third is avoid surprises by communicating with the client to ensure that CAMs do not contain original information and allowing management to preempt auditor disclosures. Collectively, these rules yield CAMs that comply with PCAOB standards but do not provide new information and instead maintain the status quo.