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

Transcription

1 Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability Kelsey Brasel, Ball State University Marcus Doxey, The University of Alabama Jonathan Grenier, Miami University Andrew Reffett, Miami University

2 Summary We examine the impact of critical audit matters on jurors auditor negligence judgments. Comparing current practice with three instances of the proposed standards We find NO evidence that CAMs increase the likelihood of juror negligence assessments. We find some evidence that CAMs reduce the likelihood of juror negligence assessments. Consistent with Decision Affect Theory, negative reactions to the auditors are reduced by CAM disclosures. 2

3 Background FRC (UK) - Extensive Communication IAASB KAMs - From a limited subset of information PCAOB CAMs Critical Audit Matters the areas of an audit that involved the most difficult, subjective, or complex judgments OR posed the greatest difficulty in obtaining sufficient appropriate evidence OR posed difficulty in forming an opinion (PCAOB 2013) 3

4 Sources to consider Background Engagement Completion Memo Items communicated to the AC Items considered by the quality control reviewer Required Disclosure Define a CAM and reiterate scope of assurance Identify the CAM Describe the basis for the CAM identification Refer to applicable accounts and disclosures 4

5 Motivation: Litigation Barrier Richard Murray former head of legal affairs at a Big 4 firm Wave of litigation (Katz 2014) Russell Kranzler chair of NYSSCPAs litigation services committee Will increase lawsuits with auditors being secondguessed (Gaetano 2014) U.S. Chamber of Commerce (Rapoport 2013), various others (PCAOB 2011, 2014) have expressed similar concerns. 5

6 Background Prior research shows that when auditors identify and document areas of concern, but do not subsequently modify the opinion, negligence assessments increase: Reffett 2010 (fraud) Backof 2014 (alternative accounting treatments) Key distinction modification of the opinion Decision Affect Theory 6

7 Research Questions Will disclosing CAMs change evaluators assessments of auditor liability when auditors fail to detect a material misstatement? Compared to current practice Compared to No CAM statement When the CAM directly relates to the misstatement (Match) When the CAM is unrelated to the misstatement (Mismatch) 7

8 Theory and Hypotheses Decision Affect Theory (Mellers et al. 1997, Shepperd and McNulty 2002) indicates that affective reactions to negative outcomes are less severe when given advance warning. Evaluators affective reactions to the auditors are a key determinant of liability judgments (Kadous 2000, 2001, Reffett 2010, Reffett et al. 2012). Volenti fit non injuria (to the consenting, no harm is done) 8

9 Hypotheses - Affect Affective reactions to negative outcomes are less severe with advance warning. H1a: When auditors fail to detect a material misstatement, evaluators affective reactions to the auditors will be less negative when the audit report discloses a CAM that relates to the undetected misstatement compared to when the audit report is silent regarding CAMs. H1b: explicitly states that the auditors did not identify any CAMs. 9

10 Hypotheses - Responsibility Volenti fit non injuria H2a: When auditors fail to detect a material misstatement, evaluators assessments of the plaintiff s responsibility for losses incurred will be greater when the audit report discloses a CAM that relates to the undetected misstatement compared to when the audit report is silent regarding CAMs. H2b: explicitly states that the auditors did not identify any CAMs. 10

11 Hypotheses End Result H3a: When auditors fail to detect a material misstatement, evaluators assessments of auditor liability will be less severe when the audit report discloses a CAM that relates to the undetected misstatement compared to when the audit report is silent regarding CAMs. H3b: explicitly states that the auditors did not identify any CAMs. 11

12 Formal Research Questions Richard Murray argued at a PCAOB panel discussion that: if the company s problem (i.e., misstatement) doesn t concern any previously reported CAMs, shareholders can claim that many concerns were expressed by the auditor but not the right one, leaving the auditor and the company to defend a multitude of judgments that have none of the established decision criteria that exist for the single pass/fail judgment (Katz 2014). 12

13 Formal Research Questions RQ1a: When auditors fail to detect misstatements, how do evaluators assessments of auditor liability compare when the audit report discloses CAMs unrelated to the undetected misstatement versus when the audit report is silent regarding CAMs? RQ1b: explicitly states that the auditors did not identify any CAMs. 13

14 Design and Methods 4x2 CAM Control (current practice) CAM (Inventory) CAM (Liability) No CAM (allowed under the proposal) Misstatement (fraud) Inventory Liability for Land Restoration (LLR) Based on Kadous (2000, 2001) Big Time Gravel case and Reffett s (2010) adaptation of the case (LRL) 14

15 Participants Design and Methods Recruited through Mechanical Turk N=528 Previous juror studies have used Mechanical Turk workers to proxy for jurors (Grenier, Pomeroy, and Stern 2014; Grenier et al. 2014; Maksymov and Nelson 2014; Peecher, Reffett, and Zimbleman 2014) More diverse and representative than undergrads (Paolacci et al. 2010, Horton et al. 2011, Buhrmester et al. 2011, Farrell et al. 2014) 15

16 Design and Methods Primary DV: Verdict (Negligent or Not) Other Measures: Gross negligence, auditor fraud, punitive damages Process variables Affect (H1) Plaintiff fault (H2) Counterfactual thoughts (Reffett 2010) 16

17 Manipulation checks Results CAM identification (combined 93% pass rate) Misstatement Identification (96.6% pass rate) Comprehension: Clean Opinion (97.9% pass rate) Participants failing one manipulation check do not affect the inferences from the results. 17

18 Results H1a & H1b (Affect) Contrast Value Misstatement (+ = less negative) F 1,520 p H1a Control vs. Match Inventory (-1.21 vs. 8.97) (5.97 vs. 1.14) (2.30 vs. 4.70) Restoration Liability Either H1b None vs. Match Inventory (2.73 vs. 8.97) (-4.29 vs. 1.14) (-0.78 vs. 4.70) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-1.21 vs. 7.24) (5.97 vs. 3.54) (2.30 vs. 5.32) Restoration Liability Either RQ1b None vs. Mismatch Inventory (2.73 vs. 7.24) (-4.29 vs. 3.54) (-0.78 vs. 5.32) Restoration Liability Either

19 Results H1a & H1b (Affect) Contrast Value Misstatement (+ = less negative) F 1,520 p H1a Control vs. Match Inventory (-1.21 vs. 8.97) (5.97 vs. 1.14) (2.30 vs. 4.70) Restoration Liability Either H1b None vs. Match Inventory (2.73 vs. 8.97) (-4.29 vs. 1.14) (-0.78 vs. 4.70) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-1.21 vs. 7.24) (5.97 vs. 3.54) (2.30 vs. 5.32) Restoration Liability Either RQ1b None vs. Mismatch Inventory (2.73 vs. 7.24) (-4.29 vs. 3.54) (-0.78 vs. 5.32) Restoration Liability Either

20 Results H1a & H1b (Affect) Contrast Value Misstatement (+ = less negative) F 1,520 p H1a Control vs. Match Inventory (-1.21 vs. 8.97) (5.97 vs. 1.14) (2.30 vs. 4.70) Restoration Liability Either H1b None vs. Match Inventory (2.73 vs. 8.97) (-4.29 vs. 1.14) (-0.78 vs. 4.70) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-1.21 vs. 7.24) (5.97 vs. 3.54) (2.30 vs. 5.32) Restoration Liability Either RQ1b None vs. Mismatch Inventory (2.73 vs. 7.24) (-4.29 vs. 3.54) (-0.78 vs. 5.32) Restoration Liability Either

21 Results H1a & H1b (Affect) Contrast Value Misstatement (+ = less negative) F 1,520 p H1a Control vs. Match Inventory (-1.21 vs. 8.97) (5.97 vs. 1.14) (2.30 vs. 4.70) Restoration Liability Either H1b None vs. Match Inventory (2.73 vs. 8.97) (-4.29 vs. 1.14) (-0.78 vs. 4.70) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-1.21 vs. 7.24) (5.97 vs. 3.54) (2.30 vs. 5.32) Restoration Liability Either RQ1b None vs. Mismatch Inventory (2.73 vs. 7.24) (-4.29 vs. 3.54) (-0.78 vs. 5.32) Restoration Liability Either

22 Results RQ1a & RQ1b (Affect) Contrast Value Misstatement (+ = less negative) F 1,520 p H1a Control vs. Match Inventory (-1.21 vs. 8.97) (5.97 vs. 1.14) (2.30 vs. 4.70) Restoration Liability Either H1b None vs. Match Inventory (2.73 vs. 8.97) (-4.29 vs. 1.14) (-0.78 vs. 4.70) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-1.21 vs. 7.24) (5.97 vs. 3.54) (2.30 vs. 5.32) Restoration Liability Either RQ1b None vs. Mismatch Inventory (2.73 vs. 7.24) (-4.29 vs. 3.54) (-0.78 vs. 5.32) Restoration Liability Either

23 Results H2a & H2b (Plaintiff Responsibility) Contrast Value Misstatement (+ = more responsible) F 1,520 p H2a Control vs. Match Inventory < (-0.34 vs. 0.30) Restoration Liability (0.18 vs. 0.24) (-0.09 vs. 0.27) Either H2b None vs. Match Inventory (-0.19 vs. 0.30) (0.01 vs. 0.24) (-0.09 vs. 0.27) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-0.34 vs ) (0.18 vs. 0.00) (-0.09 vs ) Restoration Liability Either RQ1b None vs. Mismatch Inventory (-0.19 vs ) (0.01 vs. 0.00) (-0.09 vs. 0.10) Restoration Liability Either

24 Results H2a & H2b (Plaintiff Responsibility) Contrast Value Misstatement (+ = more responsible) F 1,520 p H2a Control vs. Match Inventory < (-0.34 vs. 0.30) Restoration Liability (0.18 vs. 0.24) (-0.09 vs. 0.27) Either H2b None vs. Match Inventory (-0.19 vs. 0.30) (0.01 vs. 0.24) (-0.09 vs. 0.27) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-0.34 vs ) (0.18 vs. 0.00) (-0.09 vs ) Restoration Liability Either RQ1b None vs. Mismatch Inventory (-0.19 vs ) (0.01 vs. 0.00) (-0.09 vs. 0.10) Restoration Liability Either

25 Results H2a & H2b (Plaintiff Responsibility) Contrast Value Misstatement (+ = more responsible) F 1,520 p H2a Control vs. Match Inventory < (-0.34 vs. 0.30) Restoration Liability (0.18 vs. 0.24) (-0.09 vs. 0.27) Either H2b None vs. Match Inventory (-0.19 vs. 0.30) (0.01 vs. 0.24) (-0.09 vs. 0.27) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-0.34 vs ) (0.18 vs. 0.00) (-0.09 vs ) Restoration Liability Either RQ1b None vs. Mismatch Inventory (-0.19 vs ) (0.01 vs. 0.00) (-0.09 vs. 0.10) Restoration Liability Either

26 Results RQ1a & RQ1b (Plaintiff Responsibility) Contrast Value Misstatement (+ = more responsible) F 1,520 p H2a Control vs. Match Inventory < (-0.34 vs. 0.30) Restoration Liability (0.18 vs. 0.24) (-0.09 vs. 0.27) Either H2b None vs. Match Inventory (-0.19 vs. 0.30) (0.01 vs. 0.24) (-0.09 vs. 0.27) Restoration Liability Either RQ1a Control vs. Mismatch Inventory (-0.34 vs ) (0.18 vs. 0.00) (-0.09 vs ) Restoration Liability Either RQ1b None vs. Mismatch Inventory (-0.19 vs ) (0.01 vs. 0.00) (-0.09 vs. 0.10) Restoration Liability Either

27 Results H3 27

28 Results H3 (Verdicts) 28

29 Results H3a & H3b (Verdicts) Contrast Misstatement Value Chi-Square p H3a Control vs. Match Inventory -16.8% (39.7% vs. 23.0%) (43.9% vs. 39.7%) (41.8% vs. 32.1%) Restoration Liability -4.2% Either -9.7% H3b None vs. Match Inventory -24.0% (47.0% vs. 23.0%) (53.0% vs. 39.7%) (50.0% vs. 32.1%) Restoration Liability -13.3% Either -17.9% RQ1a Control vs. Mismatch Inventory -7.4% (39.7% vs. 32.3%) (43.9% vs. 40.3%) (41.8% vs. 36.4%) Restoration Liability -3.6% Either -5.4% RQ1b None vs. Mismatch Inventory -14.7% (47.0% vs. 32.3%) (53.0% vs. 40.3%) (50.0% vs. 36.4%) Restoration Liability -12.7% Either -13.6%

30 Results H3a & H3b (Verdicts) Contrast Misstatement Value Chi-Square p H3a Control vs. Match Inventory -16.8% (39.7% vs. 23.0%) (43.9% vs. 39.7%) (41.8% vs. 32.1%) Restoration Liability -4.2% Either -9.7% H3b None vs. Match Inventory -24.0% (47.0% vs. 23.0%) (53.0% vs. 39.7%) (50.0% vs. 32.1%) Restoration Liability -13.3% Either -17.9% RQ1a Control vs. Mismatch Inventory -7.4% (39.7% vs. 32.3%) (43.9% vs. 40.3%) (41.8% vs. 36.4%) Restoration Liability -3.6% Either -5.4% RQ1b None vs. Mismatch Inventory -14.7% (47.0% vs. 32.3%) (53.0% vs. 40.3%) (50.0% vs. 36.4%) Restoration Liability -12.7% Either -13.6%

31 Results H3a & H3b (Verdicts) Contrast Misstatement Value Chi-Square p H3a Control vs. Match Inventory -16.8% (39.7% vs. 23.0%) (43.9% vs. 39.7%) (41.8% vs. 32.1%) Restoration Liability -4.2% Either -9.7% H3b None vs. Match Inventory -24.0% (47.0% vs. 23.0%) (53.0% vs. 39.7%) (50.0% vs. 32.1%) Restoration Liability -13.3% Either -17.9% RQ1a Control vs. Mismatch Inventory -7.4% (39.7% vs. 32.3%) (43.9% vs. 40.3%) (41.8% vs. 36.4%) Restoration Liability -3.6% Either -5.4% RQ1b None vs. Mismatch Inventory -14.7% (47.0% vs. 32.3%) (53.0% vs. 40.3%) (50.0% vs. 36.4%) Restoration Liability -12.7% Either -13.6%

32 Results H3a & H3b (Verdicts) Contrast Misstatement Value Chi-Square p H3a Control vs. Match Inventory -16.8% (39.7% vs. 23.0%) (43.9% vs. 39.7%) (41.8% vs. 32.1%) Restoration Liability -4.2% Either -9.7% H3b None vs. Match Inventory -24.0% (47.0% vs. 23.0%) (53.0% vs. 39.7%) (50.0% vs. 32.1%) Restoration Liability -13.3% Either -17.9% RQ1a Control vs. Mismatch Inventory -7.4% (39.7% vs. 32.3%) (43.9% vs. 40.3%) (41.8% vs. 36.4%) Restoration Liability -3.6% Either -5.4% RQ1b None vs. Mismatch Inventory -14.7% (47.0% vs. 32.3%) (53.0% vs. 40.3%) (50.0% vs. 36.4%) Restoration Liability -12.7% Either -13.6%

33 Results H3a & H3b (Verdicts) Contrast Misstatement Value Chi-Square p H3a Control vs. Match Inventory -16.8% (39.7% vs. 23.0%) (43.9% vs. 39.7%) (41.8% vs. 32.1%) Restoration Liability -4.2% Either -9.7% H3b None vs. Match Inventory -24.0% (47.0% vs. 23.0%) (53.0% vs. 39.7%) (50.0% vs. 32.1%) Restoration Liability -13.3% Either -17.9% RQ1a Control vs. Mismatch Inventory -7.4% (39.7% vs. 32.3%) (43.9% vs. 40.3%) (41.8% vs. 36.4%) Restoration Liability -3.6% Either -5.4% RQ1b None vs. Mismatch Inventory -14.7% (47.0% vs. 32.3%) (53.0% vs. 40.3%) (50.0% vs. 36.4%) Restoration Liability -12.7% Either -13.6%

34 Implications/Contributions Within the settings studied, legal liability does not increase under the PCAOB s currently proposed CAM regime. We find no reason to strategically report CAMs Match (helps in some instances) Mismatch (never hurts, and helps compared to None) No CAM (no different than control) Generally, results suggest evaluators do not punish, and sometimes reward, professionals for disclosing difficulties encountered 34

35 Thank You! 35

36 Addendum Slides 36

37 Participant requirements: 18 yrs old U.S. Citizens Design and Methods Not employed in banking, mining, accounting, law, EPA Had not served as a juror for a financial case Mean earnings of $1.46/hour > $1.38 reservation wage (Horton and Chilton 2010) Mean age 37, 89% attended some college, employed with mean income of $55,246) Included comprehension and attention checks. 37

38 Results Summary H1a Partial Support (Inventory driven) H1b Full Support H2a Partial Support (Inventory driven) H2b Full Support H3a Partial Support (Inventory driven) H3b Full Support 38

39 RQ1a Results Summary Compared to the Control, Mismatch is associated with less negative affect for inventory. Do not differ in assessments of plaintiff responsibility or liability judgments. RQ1b Compared to None, Mismatch is associated with less negative affect for LRL. Do not differ in assessments of plaintiff responsibility. Associated with fewer negligence judgments. 39

40 Misstate. Results H1a & H1b CAM Control Match Mismatch None Inventory Mean Std Dev n Restoration Mean Liability Std Dev n Either Mean Std Dev n

41 Results H2a & H2b Plaintiff Resp. Misstate. CAM Control Match Mismatch None Inventory Mean Std Dev n Restoration Mean Liability Std Dev n Either Mean Std Dev n

42 Limitations/Future Research We only examine two specific misstatements/cams and we find differences. - Why? We use an audit report with a maximum of one CAM. The effect of multiple matching and/or mismatching CAMs is unknown. Implementation in the U.K. is much more extensive than that proposed in the U.S. and tested herein. Simultaneous changes are proposed (clarifying language, audit partner identification). We don t examine the likelihood of legal action, so the net cost to the firms may still be higher despite lower negligence findings. 42

43 CAM Examples The standards of the PCAOB require that we communicate in our report critical audit matters relating to the audit of the current period's financial statements or state that we determined that there are no critical audit matters. [definition] The critical audit matters communicated below do not alter in any way our opinion on the financial statements, taken as a whole. (PCAOB 2013) 43

44 CAM Examples The standards of the PCAOB require that we communicate in our report critical audit matters relating to the audit of the current period's financial statements or state that we determined that there are no critical audit matters. [definition] We determined that there are no critical audit matters. (PCAOB 2013) 44

45 CAM Examples We determined that our evaluation of the Company's allowance for sales returns was a critical audit matter in the audit of the Company's financial statements as of and for the fiscal year ended January 31, The Company developed a new on-line sales channel. This new sales channel could have significantly different return experience than sales through its more established retail stores. In addition, the Company simultaneously lengthened its return policy. The Company developed new models with different assumptions to reflect these changes in its estimate of the allowance for sales returns, a key element in recording revenue. The lack of historical experience with the new assumptions resulted in a high degree of measurement uncertainty in estimating the allowance for sales returns. 45

46 CAM Examples We determined that our evaluation of the Company's allowance for sales returns was a critical audit matter in the audit of the Company's financial statements as of and for the fiscal year ended January 31, The Company developed a new on-line sales channel. This new sales channel could have significantly different return experience than sales through its more established retail stores. In addition, the Company simultaneously lengthened its return policy. The Company developed new models with different assumptions to reflect these changes in its estimate of the allowance for sales returns, a key element in recording revenue. The lack of historical experience with the new assumptions resulted in a high degree of measurement uncertainty in estimating the allowance for sales returns. 46

47 CAM Examples We determined that our evaluation of the Company's allowance for sales returns was a critical audit matter in the audit of the Company's financial statements as of and for the fiscal year ended January 31, The Company developed a new on-line sales channel. This new sales channel could have significantly different return experience than sales through its more established retail stores. In addition, the Company simultaneously lengthened its return policy. The Company developed new models with different assumptions to reflect these changes in its estimate of the allowance for sales returns, a key element in recording revenue. The lack of historical experience with the new assumptions resulted in a high degree of measurement uncertainty in estimating the allowance for sales returns. 47

48 CAM Examples We determined that our evaluation of the Company's allowance for sales returns was a critical audit matter in the audit of the Company's financial statements as of and for the fiscal year ended January 31, The Company developed a new on-line sales channel. This new sales channel could have significantly different return experience than sales through its more established retail stores. In addition, the Company simultaneously lengthened its return policy. The Company developed new models with different assumptions to reflect these changes in its estimate of the allowance for sales returns, a key element in recording revenue. The lack of historical experience with the new assumptions resulted in a high degree of measurement uncertainty in estimating the allowance for sales returns. 48

49 CAM Examples our audit of the Company's allowance for sales returns (1) involved our difficult and subjective judgments in evaluating whether the Company had a sufficient basis to make a reasonable estimate of sales returns and (2) posed difficulty to us in obtaining sufficient appropriate evidence to support management's adjustments to the allowance for sales returns. We consulted with our national office on (1) the design and performance of audit procedures to test the data underlying management's assumptions used to estimate future sales returns and (2) our evaluation of the results of those procedures, including our assessment of the reasonableness of management's judgments regarding the effect that changes in the Company's return policies and practices, as well as changes in economic and buying trends that affect customer behavior, have on the estimate of future sales returns. The Company's accounting policy for sales returns is discussed in Note 1 to the financial statements. 49

50 CAM Examples our audit of the Company's allowance for sales returns (1) involved our difficult and subjective judgments in evaluating whether the Company had a sufficient basis to make a reasonable estimate of sales returns and (2) posed difficulty to us in obtaining sufficient appropriate evidence to support management's adjustments to the allowance for sales returns. We consulted with our national office on (1) the design and performance of audit procedures to test the data underlying management's assumptions used to estimate future sales returns and (2) our evaluation of the results of those procedures, including our assessment of the reasonableness of management's judgments regarding the effect that changes in the Company's return policies and practices, as well as changes in economic and buying trends that affect customer behavior, have on the estimate of future sales returns. The Company's accounting policy for sales returns is discussed in Note 1 to the financial statements. 50