Internal Control Quality: The Role of Critical Audit Matters Reporting
54 Pages Posted: 12 Jul 2021
Date Written: July 8, 2021
We examine whether the 2019 introduction of critical audit matter (CAM) reporting in audit reports in the United States is associated with improvements in issuers’ internal controls over financial reporting. We propose that increased scrutiny by auditors on CAM-related matters may lead to early identification and client remediation of material weaknesses in internal control (ICMW). Analyses show that compared to control companies, treatment companies (those with CAM reporting) experience a statistically significant decrease in both the likelihood of having an ICMW and the number of ICMWs after the CAM is reported. This result is driven primarily by account-level ICMWs rather than entity-level ICMWs. We also find that issuers with revenue-recognition CAMs have significantly fewer revenue-related ICMWs compared to other issuers, consistent with the notion that ICMWs related to revenue recognition are identified and remediated through the auditor’s CAM evaluation process. Results show that the positive association between CAM disclosure and internal control quality—that is, the negative association between CAMs and ICMWs—is more pronounced when more auditor effort is involved in CAM reporting. We conclude that by focusing auditor attention on areas of potential concern, CAM reporting leads to improvements in the quality of internal control over financial reporting.
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