Understanding barriers to Critical Audit Matter effectiveness: A qualitative and experimental approach

The value of the current pass/fail version of the standardized audit report has been criticized as not providing stakeholders with much information beyond the qualified vs. unqualified opinion (Cohen Commission 1978; Church et al. 2008; Gray et al. 2011; Mock et al. 2013). In 2013, the Public Company Accounting Oversight Board (PCAOB) proposed addition of Critical Audit Matters (CAMs) to the standardized audit report in the hopes that the auditor further highlighting key areas of risk information will reduce the information asymmetry between financial statement users and management (PCAOB 2013). Current CAM research demonstrates investors (Christensen et al. 2014) and jurors (Kachelmeier et al. 2015; Brasel et al. 2016) incorporate CAM information into their decisions to invest or hold auditors responsible for future misstatements. However, it is unclear if this is because users incorporate the underlying risk information or have misconceptions about auditor ability to substantiate management's assertions related to that risk even in the presence of an unqualified opinion. In this study, I apply the Mental Models Approach to risk communication outlined by Morgan et al. (2002) to investigate this issue. Qualitatively, I use a combination of interviews and surveys with investors and auditors to specifically identify areas where auditor and investor views of CAMs and overall audit reporting diverge. I find auditors are skeptical of the potential effectiveness of CAMs and of investor ability to interpret CAM information. I also find that while many investors in this study have a working knowledge of some audit terms such as reasonable assurance and materiality, they do not understand that even in the presence of CAMs an unqualified opinion means sufficient audit evidence has been obtained related to the statements as a whole, including CAM items. This misconception results in the investor belief CAMs serve as a tool to highlight areas for which the auditor is not comfortable. In light of these findings, I suggest language making this relationship clear be included with the presented CAM to improve its effectiveness. Next experimentally, I attempt to evaluate the effectiveness of various versions of the CAM risk disclosure, including versions with such clarifying language and the language recommended by the PCAOB. As one of the goals of the disclosure is to highlight risk disclosure, I measure the effectiveness of CAMs by evaluating how well each disclosure assists investors in aligning their investment choices and personal preferences for or aversion to risk. I find that although not better than having no CAM at all, CAM disclosure is most effective in creating alignment of investment decisions and risk preferences when there is language that makes clear the sufficiency of the auditor's efforts to substantiate management's assertions related to the CAM area.