Critical Audit Matters Research Articles

The Effect of Nature of Critical Audit Matters and Outcome Indication on Investors’ Decisions

ABSTRACT Two aspects of critical audit matter (CAM) disclosure are (1) whether it relates to complexity in audit judgments (complex CAM) or uncertainty in underlying management estimates (uncertain CAM) and (2) whether an indication of the outcome of audit procedures performed to address the CAM is included in the disclosure. We use two controlled experiments to examine the joint effects of CAM nature and the presence of a CAM outcome indication on investors’ judgments of investment attractiveness. In the first (second) experiment, we used a stronger (weaker) outcome indication, which provides stronger (weaker) conclusions about the audit procedures performed to address the CAM. We find that the provision of a stronger (weaker) outcome indication increases investment attractiveness judgments to a greater (an equal) extent for an uncertain CAM than for a complex CAM. Data Availability: Please contact the authors.

Can Critical Audit Matters Be a Signal of Poor Accruals Quality?

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.

Does Goodwill-Related Critical Audit Matters Disclosure Influence Firms’ Financial Reporting Decisions? Evidence from Goodwill Impairment

SUMMARY We investigate whether the new critical audit matters (CAMs) disclosure requirement for auditors under the PCAOB Standard AS 3101 affects audited firms’ financial reporting decisions in the context of goodwill impairment recognition. We argue that an auditor's intense engagement with management and the audit committee in the CAMs determination and evaluation process improves management's information sets. Specifically, we report that the propensity to recognize goodwill impairment loss increases for firms with goodwill-related CAM disclosure relative to those without. This result is more pronounced when the likelihood of expected impairment is higher, suggesting that CAMs reporting lowers managers’ discretion in delaying impairment loss recognition. Additionally, we find that goodwill-related CAM disclosure increases the length and use of uncertain words in goodwill-related footnote disclosure by management but has no significant impact on audit costs. Overall, these findings suggest that adopting CAMs requirements can reduce management's discretion in financial reporting decisions. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M41; M42.

Early Evidence on Critical Audit Matters regarding Environmental, Social, and Governance Sustainability: Trends in ESG Reporting

ABSTRACT This study investigates the contents and trends of critical audit matters (CAMs) as they relate to ESG matters (ECAMs). Our examination of the description of ESG matters in ECAMs suggests that the majority of ECAMs fall under measurement issues from environmental liabilities and loss contingencies. To address ECAMs, auditing procedures must assess managerial assumptions by making frequent use of an environmental specialist. Our descriptive analysis suggests that firms that receive ECAMs are more profitable, more likely to have a Big 4 auditor, and have higher litigation risk. Our cross-country comparison suggests a similar trend between ECAMs and their equivalent reports in Europe, as both focus mainly on environmental matters rather than social or governance matters. Overall, our analysis suggests that the issuance of ECAMs represents an important source for discerning a portion of firms’ ESG standings. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M4.

Auditor communication on critical audit matters: Timing, inspection likelihood, and the audit committee

AbstractIn response to the extended audit report regulations implemented in the United States and internationally, both audit firms and regulators have increased scrutiny over critical audit matters/key audit matters (collectively referred to as CAMs) through internal and external inspections. At the same time, auditors and audit committees (ACs) have altered the content and timing of CAM‐related discussions by communicating specific planned audit procedures earlier in the audit process. This study explores the effect of early communication of CAM‐related audit procedures to the AC and increased scrutiny from inspections on auditors' propensity to adjust planned audit procedures in the presence of newly identified audit risks. Based on self‐justification theory, we predict and find that early communication of planned audit procedures to the AC causes auditors to be less likely to adjust planned audit procedures even when additional risks arise that necessitate change, especially when inspection is likely. This has the potential for diminished audit quality. Interviews with audit partners provide context for how these findings relate to the current auditing environment.

Critical Audit Matters: Recurring, Nonrecurring, and Intermittent

SYNOPSIS The Public Company Accounting Oversight Board (PCAOB) Auditing Standard (AS) 3101 requires auditor’s reports to include the communication of critical audit matters (CAMs). This study investigates the recurrence of CAM topics following the standard’s implementation to determine which CAM topics could be considered recurring, nonrecurring, and intermittent. We provide descriptive evidence that the average number of CAMs reported by auditors decreased over the first three years and then show occurrence patterns for CAM topics during our sample period (June 2019 to June 2022). Using the occurrence rates and the PCAOB’s descriptions in the CAM implementation guidance, we propose a method for classifying CAM topics as recurring, nonrecurring, and intermittent. Based on our proposed CAM topic recurrence categorization, we find that approximately 68 percent of auditor’s reports include at least one recurring CAM topic. Our findings should help practitioners and other financial reporting stakeholders refine expectations for the recurrence of CAMs. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M42; M48.

The impact of critical audit matters on audit report lag and audit fees: evidence from the United States

Purpose This paper aims to investigate the impact of the implementation of the critical audit matters (CAMs) disclosure requirement and the subsequent relationship between CAM disclosures and audit report lag, as well as audit fees in the USA. Design/methodology/approach This study used difference-in-differences analyses to investigate the impact that the implementation of the requirement for auditors to report CAMs on their audit report has on the audit process. It also used levels regression models to examine the relationship that CAM disclosures have with audit report lag and audit fees. Findings This study found that the implementation of the CAM disclosure requirement in the USA reduced audit report lag while not significantly affecting audit fees. This suggests that the CAM disclosure requirement may increase the cooperation between auditors and managers and improve the efficiency of the audit process. Practical implications This study’s results are informative for assessing the economic impact of requiring CAM disclosures, which should be of importance to regulators, auditors and accounting researchers. Originality/value This study used different approaches to investigate two aspects of the CAM disclosure requirement – the effect of the implementation of the disclosure requirement and the subsequent effects related to CAM reporting outcomes. Unlike many previous studies investigating CAM disclosures, which relied on experiments and questionnaires, this study used actual CAM disclosure data in the USA to investigate the impact on audit report lag and audit fees.

Disclosure of tax‐related critical audit matters and tax‐related outcomes

AbstractGiven that tax‐related critical audit matters (tax CAMs) were prevalent among accelerated filers (18.5% of observations) during the initial year of CAM disclosures, we examine whether an auditor's disclosure of tax CAMs is associated with variation in tax‐related financial reporting quality, tax avoidance, and tax‐related earnings management. Finding an association between tax CAMs and one of these tax outcomes would indicate that the new auditor reporting standard has indirectly affected investors. Examining the first year of CAM disclosures, we do not find that tax CAMs are associated with broad proxies of tax‐related audit or financial reporting quality (e.g., restatements, internal control weaknesses, comment letters) or tax avoidance (e.g., effective tax rates or book‐to‐tax differences). We do find that tax CAMs are associated with a modest increase in tax accrual quality, an increase in the reserve for unrecognized tax benefits, and a reduction in the likelihood of tax‐related earnings management. However, we do not find these tax CAM effects persist into the second year of CAM reporting. Our evidence is consistent with tax CAM disclosures having a modest but short‐lived effect on companies' reporting of tax accounts. Our findings should inform the PCAOB as they conduct their post‐implementation review of the new audit reporting standard.

How Management Disclosure and Auditor Disclosure Affect Auditor Liability: The Case of the Going Concern Financial Accounting Standard

SUMMARY A current FASB standard requires management to assess the ability of the entity to continue as a going concern (GC) and disclose any substantial doubt about such. Using contextualized experiments wherein the auditor does not issue a GC opinion for an entity that subsequently fails, we study the effects of management disclosure, increased management disclosure responsibility, and auditor disclosure on auditor blame, a proxy for auditor liability. Consistent with predictions based on the Culpable Control Model, we find (1) management disclosure of substantial doubt increases auditor liability; (2) when management has not disclosed substantial doubt, auditor liability is greater under higher management disclosure responsibility; and (3) including a GC-related critical audit matter (CAM) in the audit report mitigates auditor liability. These findings provide insights regarding consequences to auditors of management disclosure practices, specifically regarding the FASB’s GC standard and the efficacy of auditor disclosure via CAMs to mitigate those consequences. Data Availability: Data are available upon request.

What Does the Auditor Say? Auditors’ Disclosures of Critical Audit Matters and Audit Fees

SYNOPSIS We examine whether critical audit matter (CAM) disclosures contain information about material misstatement risks that is priced in audit fees. We find that textual features of auditors’ risk descriptions and the types of risks identified capture fee-relevant information. Further, the results are incremental to other determinants of audit fees considered in prior research and to managements’ disclosures in the related notes to the financial statements. Overall, we provide evidence that auditors’ perceptions of audit risks revealed in the newly expanded audit opinion capture information relevant for understanding audit pricing decisions. Data Availability: All data are publicly available from the sources identified in the paper. JEL Classifications: M41; M42; M48.

Critical Audit Matters: Possible Market Misinterpretation

SUMMARY The Public Company Accounting Oversight Board recently expanded audit reports to disclose Critical Audit Matters (CAMs) and the audit procedures used to address them. We study the first wave of CAM disclosers from July 2019 through May 2020, which included large accelerated filers reporting on their 2019 fiscal year results. We examine whether market participants erroneously perceive firms with more extensive CAM disclosures to be riskier than firms with less extensive CAM disclosures. Consistent with possible market misinterpretation, we find that firms with more extensive CAM disclosures are associated with increased perceived uncertainty: Stock prices of these firms are significantly more volatile and analyst forecasts are significantly more dispersed than those of firms with less extensive CAM disclosures. Data Availability: Data used in this study are available from public sources identified in the study. JEL Classifications: G12; G14; M41.

Do auditor changes affect the disclosure of critical audit matters? Evidence from China

Do auditor changes affect the disclosure of critical audit matters? Evidence from China

Critical audit matters: litigation, quality and conservatism

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.

Does the Reporting of Critical Audit Matters Affect Nonprofessional Investors’ Perceptions of Auditor Credibility, Information Overload, Audit Quality, and Investment Risk?

ABSTRACTA new Public Company Accounting Oversight Board (PCAOB) standard requires the reporting of critical audit matters (CAMs) within the audit report. This change has lengthened the audit report but may provide investors with cues about auditor credibility and audit quality. Utilizing an experiment and 140 nonprofessional investors, we find evidence that the disclosure of a CAM improves perceived auditor credibility, but the disclosure also has the unintended consequence of increasing feelings of information overload. More importantly, the disclosure of a CAM has a significant, positive total effect on perceived audit quality. This effect, in turn, lowers investors’ perceptions of investment risk. These findings highlight the potential for CAMs to impact investor perceptions and, possibly, subsequent decision making.Data Availability: Data are available from the authors upon request.

Disclosure of auditor risk assessments in expanded audit reports

PurposeThis rich descriptive study examines auditors' client risk assessment (i.e. “key audit matters”/critical audit matters) disclosures in expanded audit reports of 328 Financial Times Stock Exchange (FTSE) 350 companies. The study compares auditor-identified client risks with corporate risk disclosures identified in audit committee reports, in terms of number and type of risks. The research also compares variation in auditor-identified client risks between individual Big 4 audit firms. In addition, the study examines auditor ranking of their client risks disclosed.Design/methodology/approachThe study manually content analyses disclosures in audit reports and audit committee reports of a sample of 328 FTSE-350 companies with 2015 year-ends.FindingsAudit committees identify more risks than auditors (23% more risks). However, auditor-identified client risks and audit-committee-identified risks are similar (80% similar), as are auditor-identified client risks between the individual Big 4 audit firms. Only ten (3%) audit reports rank the importance of auditor-identified client risks.Research limitations/implicationsSample is restricted to one year, one jurisdiction, large-listed companies and companies audited by Big 4 auditors.Practical implicationsThe study provides important insights for regulators, auditors and users of financial statements by identifying influences on disclosure of auditor-identified client risks.Originality/valueThe paper mobilises institutional theory to interpret the findings. The findings suggest that auditor-identified client risks in expanded audit reports may demonstrate mimetic behaviour in terms of similarity with audit-committee-identified risks and similarity between individual Big 4 audit firms. The study provides important insights for regulators, auditors and users of financial statements by identifying influences on disclosure of auditor-identified client risks.

The Disclosure and Consequences of U.S. Critical Audit Matters

ABSTRACT This study uses difference-in-differences (DiD) analyses to examine the consequences of adopting the U.S. critical audit matter (CAM) disclosure requirement for preparers and users of financial reports. The CAM requirement is one of the largest expansions of the U.S. audit report since the 1940s. We document significant changes to financial statement footnotes referenced by CAMs, which suggests an indirect consequence where management disclosure changes in areas that are expected to be scrutinized following auditor-provided disclosure. Results also suggest that, on average, CAM disclosures do not provide incremental information to the market. To further examine market reaction, we develop well-specified prediction models for the expected number and subject areas of CAMs. We find limited initial evidence that the market reacts negatively when unexpected CAMs are disclosed. Overall, our findings provide insights on the new CAM standard and particularly demonstrate its relevance to management disclosure decisions and to the market.

The Effects of Critical Audit Matter Disclosure on Audit Effort, Investor Scrutiny, and Investment Efficiency

ABSTRACTWe study the effects of the disclosure of critical audit matters (CAMs) on an auditor’s audit effort and an investor’s scrutiny effort decisions and on investment efficiency. Both the auditor and the investor can prevent a bad investment by respectively auditing and scrutinizing the firm’s financial reports to detect misstatements about the investment value. Investment efficiency is determined by the investor’s total mix of information. The disclosure of CAMs helps the investor assess investment risk and infer the auditor’s effort and thus enables the investor to fine-tune scrutiny effort, which can in turn adversely influence the auditor’s effort decision. We show when and why the disclosure of CAMs increases or decreases ex ante audit effort, ex ante investor scrutiny, and investment efficiency. Our analyses have both testable empirical implications and policy implications.JEL Classifications: M42; M48.

Costs and benefits of auditors' disclosure of critical audit matters: Initial evidence from the United States

In an effort to make audit reports more informative to financial statement users, the Public Company Accounting Oversight Board (PCAOB) requires an expanded audit report in which auditors are required to disclose critical audit matters (CAMs). The new standard (AS 3101) became effective for audits of financial statements of large accelerated filers for fiscal years ending on or after June 30, 2019. Using a sample of annual reports of large accelerated filers with and without CAM disclosures, we examine the costs and benefits of the mandatory disclosure of CAMs in auditors' reports. Our evidence suggests that compared to auditor reports reporting no CAMs, the presence of a single CAM disclosure in the auditor's report provides incremental information to equity investors without a significant increase in audit costs. However, using the benchmark of a single CAM disclosure, multiple CAMs in an auditor's report results in higher audit fees and longer audit delays.

Do Critical Audit Matters (CAMs) Provide a Road Map for Litigation? Evidence from Revenue CAMs

Do Critical Audit Matters (CAMs) Provide a Road Map for Litigation? Evidence from Revenue CAMs

Does industry audit risk similarity affect auditor expertise? Evidence from China

ABSTRACT This study examines whether auditors develop expertise in audit risk homogenous industries. Using critical audit matters (CAMs) disclosed in audit reports of Chinese listed companies, we construct a homogeneity measure that captures the similarity of audit risks in a client industry. We find that individual partner expertise occurs in industries with high levels of CAM similarity. We also find that industry expert partners provide fee discounts in more homogenous industries, whereas audit quality is unchanged. These results suggest that auditors benefit from achieving economies of scale rather than providing quality-differentiated audits, by specializing in industries with similar audit risks.