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

78 Pages Posted: 12 Jul 2021 Last revised: 16 Oct 2023

See all articles by Carol Callaway Dee

Carol Callaway Dee

University of Colorado Denver

Bing Luo

San Francisco State University

Elaine Wang

University of Massachusetts Amherst

Jing Zhang

university of Colorado Denver

Date Written: October 1, 2023

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.

Suggested Citation

Dee, Carol Callaway and Luo, Bing and Wang, Elaine (Ying) and Zhang, Jing, Critical audit matters and internal control quality: The disciplining effects of CAM reporting on auditors and clients (October 1, 2023). Available at SSRN: https://ssrn.com/abstract=3882399 or http://dx.doi.org/10.2139/ssrn.3882399

Carol Callaway Dee

University of Colorado Denver ( email )

1475 Lawrence St.
Campus Box 165, PO Box 173364
Denver, CO 80217-3364
United States

Bing Luo

San Francisco State University ( email )

1600 Holloway Avenue
San Francisco, 94132
United States

Elaine (Ying) Wang

University of Massachusetts Amherst ( email )

Amherst, MA 01003-4910
United States
413-545-7613 (Phone)

Jing Zhang (Contact Author)

university of Colorado Denver ( email )

1475 Lawrence St
Denver, CO
Denver, CO 80202
United States

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