Litigation Risk, Financial Reporting Quality, and Critical Audit Matters in the Audit Report: Early U.S. Evidence

Abstract

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.