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

Abstract

ABSTRACT 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.