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    Risk Disclosure Preceding Negative Outcomes: The Effects of...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, last edited March 1, 2017, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
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    Title:
    Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability
    Practical Implications:

    The results of this study are important for both regulators and auditors alike.  Despite auditor concerns that a requirement to disclose CAMs would increase litigation risk, the results of this study indicate that they may actually reduce, or at the very least, have no effect on litigation risk.  This is the case even when the subsequently identified misstatement is not related to the risks documented in the CAM.  Furthermore, standard setters should take comfort in these findings as they weigh the potential benefits of adopting a CAM disclosure requirement because the results indicate that the implementation of CAMS would not increase the risk of litigation to auditors. 

    Citation:

    Brasel, K., M. M. Doxey, J. H. Grenier, and A. Reffett. 2016. Risk Disclosure Preceding Negative Outcomes: The Effect of Reporting Critical Audit Matters on Judgments of Auditor Liability.  The Accounting Review 91 (5): 1345-1362.

    Keywords:
    audit litigation, audit report, negligence, liability, critical audit matters, disclosure
    Purpose of the Study:

    The PCAOB has proposed a change to the standard audit reporting model to include the disclosure of critical audit matters (CAMs).  While there is evidence that investors support additional auditor disclosures like CAMs, many other stakeholders oppose the implementation of a requirement to produce such ex ante risk disclosures.  The opposition, which includes audit firms, academics, and attorneys, assert that this type of requirement would increase litigation against auditors.

    However, CAMs require disclosure of increased risk prior to a subsequently revealed misstatement.  This feature of the proposed disclosure also makes it possible that CAMs may reduce litigation risk because jurors will view the plaintiff as being forewarned of an increased risk.  To the extent that jurors view a misstatement as having been more foreseeable to the plaintiff, this study predicts that jurors will experience less negative affect when considering plaintiff losses because the plaintiff was forewarned.  Below are two objectives the authors address in their study:

    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is related to a subsequently revealed misstatement.
    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is unrelated to a subsequently revealed misstatement.
    Design/Method/ Approach:

    The authors conducted an experiment with jury-eligible participants to examine their research questions.  The study included four different disclosure conditions: (1) control – no mention of CAMs, (2) disclosure of a CAM related to the subsequently revealed misstatement, (3) disclosure of a CAM that is unrelated to the misstatement, (4) an explicit statement that the auditors did not identify any CAMs.  Additionally, two different types of misstatements were examined to determine whether the type of misstatement affected the jurors’ propensity to find the auditor negligent: (1) an overstatement of inventory, (2) an understatement of an environmental restoration liability.  Participants read a case study about an audit that failed to detect a material financial statement fraud and then assessed auditor negligence.

    Findings:
    • When auditors failed to detect an overstatement of inventory, participants were less likely to find the auditor negligent when the auditor disclosed a related CAM, relative to both when there was no mention of CAMs and to when the auditor explicitly stated that there were no CAMs.  However, when auditors failed to detect the understatement of the client’s environmental restoration liability, participants were neither more nor less likely to find the auditors negligent when the auditor disclosed a related CAM.  This difference in outcomes was due to participant perceptions that the understatement of the client’s environmental restoration liability was more foreseeable than the inventory misstatement in the control condition thereby reducing the impact of the CAM.
    • Disclosing a CAM that was unrelated to the undetected misstatement did not affect jurors’ auditor liability judgments relative to current reporting standards.  However, disclosure of an unrelated CAM did reduce jurors’ negligence assessments relative to a condition in which the auditor explicitly stated there were no CAMs.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Litigation Risk