Risk disclosure preceding negative outcomes: The effects of reporting critical audit matters on judgments of auditor liability

Abstract

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 study’s motivation, method, results, and implications for both audit reporting and risk disclosure in general.