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

Abstract

SUMMARY:The PCAOB and the IAASB recently proposed several significant changes to the audit reporting model, including requiring auditors to disclose critical audit matters (CAMs) in their audit reports. While investors appear to support such additional disclosures, some audit practitioners, academics, and attorneys contend that requiring auditors to disclose CAMs will make it easier for plaintiffs' attorneys to successfully sue auditors when audits fail to detect material misstatements. A recent study, ''Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability'' (Brasel, Doxey, Grenier, and Reffett 2016), reports results of an experiment that inform this issue. Contrary to the above concerns, results of the study indicate that disclosing CAMs, either related or unrelated to an undetected material misstatement, likely will not increase, and could decrease (depending on the type of misstatement), the probability of jurors holding auditors liable when audits fail to detect material misstatements. Further, results indicate that explicitly stating in the audit report that there were no CAMs, an option allowed within the PCAOB's proposal, would increase negligence verdicts against audit firms. The following article summarizes the We acknowledge the anonymous reviewers and editor for their helpful comments throughout the review process.Editor's note: Accepted by J. Gregory Jenkins. Submitted: February 2016Accepted: July 2016 Published Online: July 2016 1 study's motivation, method, results, and implications for both audit reporting and risk disclosure in general.

Research on Influencing Factors of Key Audit Matters Disclosure in China

“…Christensen (2014) found that KAM would reduce the relevance, usefulness, and quality of investment decision-making of investors using standard audit reports, therefore reducing the quality of financial statements. Kachelmeier et al (2014) further explained this reason through experimental research. They found that if the auditor issued KAM, investors would think that the auditor was absolved from the responsibility of searching and disclosing similar and related matters, increasing the opportunistic behavior of CPAs and making CPAs lazy in strictly carrying out the audit business.…”

“…Katz (2014) pointed out that if the auditor disclosed the information on key audit matters, the possibility of prosecution would significantly increase. However, Brasel et al (2016), Carver andTrinke (2015), andKachelmeier et al (2014) all think that reporting key audit matters can decrease the litigation risk. Phillips (2015) takes public companies using ISA700 for a case study and found that under certain circumstances, additional information disclosure will reduce the risk of legal liability of auditors.…”

Insight of ISA 701: Key Audit Matter Disclosure in Extended Audit Report?

“…This concern may undermine the intended benefits outlined in ISA 701. Brasel et al (2016) oppose the idea that the disclosure of principal audit matters serves as a warning to financial statement users, potentially reducing the auditor's litigation risk. Additionally, the auditor's sectoral specialization is anticipated to influence their ability to identify and disclose KAM positively (Pinto & Morais, 2019).…”

Has it become more readable? Empirical evidence of key matters in independent audit reports,

“…Abdullatif and Al-Rahahleh (2020) and Segal (2019) highlighted that, despite the obligation to record KAMs, such disclosure depends on the professional's judgment regarding the relevance or not for external users. Brasel et al (2016) observed that the disclosure of KAMs can increase the risk of litigation in circumstances in which the auditors omit or incompletely disclose a KAM that is subsequently associated with fraud or material error. Sirois et al (2018) added that KAMs have the potential to increase the informational content of IARs; however, there is concern that some users may use them inappropriately as substitutes for reading the financial statements in full (Segal, 2019).…”