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New ‘Critical Audit Matters’ Serve as Warning for Investors, According to New Research

The first major change in auditing reports in over 80 years could actually decrease rather than increase auditor litigation risk by serving as an implied disclaimer of auditor responsibility for certain areas. 

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AUSTIN, Texas — The Public Company Accounting Oversight Board (PCAOB) has proposed a new reporting standard aimed at expanding auditors’ reports to make them more informative for investors, but it has caused growing concern among auditors that the new standard will reduce investor confidence in the reports and increase auditor litigation risk. Research from the McCombs School of Business at The University of Texas at Austin finds that the proposed new report wording — the first major change in more than 80 years — could actually decrease rather than increase auditor litigation risk by serving as an implied disclaimer of auditor responsibility for certain areas.

The PCAOB is recommending that all U.S. audit reports contain a new section that focuses on critical audit matters (CAMs). CAMs are matters involving especially challenging, subjective, or complex auditor judgment. By calling attention to CAMs, the PCAOB hopes reports will be more useful and transparent.

McCombs Professor Steven Kachelmeier, Associate Professor Jaime Schmidt and doctoral student Kristen Valentine conducted a series of studies to see what effect, if any, CAM disclosures would have on practicing attorneys, financial analysts and investors.

All groups were asked to view a series of mock audit reports and respond to questions that gauged their comfort level with the report, both with and without CAM disclosures.

They found that when an auditor called attention to a matter as being “critical,” users had lower confidence in that reporting area, a finding that corroborates audit firms’ concerns, says Valentine. But overall, users still had the same level of confidence in the financial statements in general. The presence of critical audit matters serves as a disclaimer effect, meaning that all groups, from investors and analysts to attorneys, feel cautioned but not unduly persuaded, and that was the PCAOB’s intent.

The researchers also found “that auditors are held less responsible when a misstatement occurs in a CAM area” than in a non-CAM area.

“The reaction from most of our participants, on average, is that they view the identified risk area as a warning,” says Schmidt. “It’s something they should pay attention to, but they don’t see it as a sign of auditor negligence, and that’s more good news.”

The researchers found that despite heightened levels of concern regarding financial areas within audit reports with CAM disclosures, the presence of critical audit matters has an overall disclaimer effect, cautioning but not persuading investors.

“It’s a little like a product warning or label for financial statements, shifting the risk of loss a bit from the auditor to the financial statement user,” explained Kachelmeier.

View the full study here