Critical audit matters and internal control quality: The disciplining effects of CAM reporting on auditors and clients

Abstract

We examine whether critical audit matter (CAM) reporting in audit reports improves issuers’ internal controls over financial reporting. We propose that CAM reporting can improve internal control quality through (1) early identification and remediation of material weaknesses in internal control (ICMWs), and (2) increased work, focus and attention paid to high-risk areas to prevent ICMWs. Analyses show that compared to control companies, companies with CAM reporting experience a statistically significant decrease in both the likelihood of having an ICMW and the number of ICMWs. This result is driven primarily by account-level ICMWs rather than entity-level ICMWs. We find that issuers with the disclosure of revenue-recognition CAMs experience a significant decrease in revenue-recognition related ICMWs, suggesting that ICMWs related to revenue recognition are remediated or prevented through the CAM reporting process. In addition to improving internal control quality, we also find that CAM reporting significantly lowers the likelihood of accounting misstatements. Cross-sectional analyses suggest that the benefit of CAM reporting on internal control quality is conditional on audit committee quality and auditor efforts. Overall, our evidence suggests that by focusing managers and auditors’ attention on areas of potential concern, CAM reporting leads to improvements in internal control quality. Our findings have important policy implications as they show that CAM reporting improves internal control quality by changing auditor and management behavior.