Risk Disclosure Preceding Negative Outcomes: The Effects of - PowerPoint PPT Presentation

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

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

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

Background • Sources to consider – 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

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 second- guessed (Gaetano 2014) • U.S. Chamber of Commerce (Rapoport 2013), various others (PCAOB 2011, 2014) have expressed similar concerns. 5

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

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

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

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

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

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

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

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

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

Design and Methods • Participants – 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

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

Results • Manipulation checks – 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

Results – H1a & H1b (Affect) Contrast Value (+ = less negative) Misstatement F 1,520 p H1a Control vs. Match Inventory 10.17 9.01 0.002 (-1.21 vs. 8.97) Restoration Liability -4.83 2.17 0.141 (5.97 vs. 1.14) 2.40 1.28 0.129 Either (2.30 vs. 4.70) H1b None vs. Match Inventory 6.24 3.34 0.034 (2.73 vs. 8.97) 5.42 2.76 0.049 Restoration Liability (-4.29 vs. 1.14) Either 5.48 6.10 0.007 (-0.78 vs. 4.70) RQ1a Control vs. Mismatch Inventory 8.45 6.27 0.013 (-1.21 vs. 7.24) Restoration Liability -2.43 0.53 0.468 (5.97 vs. 3.54) Either 3.02 1.60 0.206 (2.30 vs. 5.32) RQ1b None vs. Mismatch Inventory 4.51 1.76 0.185 (2.73 vs. 7.24) Restoration Liability 7.83 5.51 0.019 (-4.29 vs. 3.54) Either 6.10 6.72 0.010 (-0.78 vs. 5.32) 18

Results – H1a & H1b (Affect) Contrast Value (+ = less negative) Misstatement F 1,520 p H1a Control vs. Match Inventory 10.17 9.01 0.002 (-1.21 vs. 8.97) Restoration Liability -4.83 2.17 0.141 (5.97 vs. 1.14) 2.40 1.28 0.129 Either (2.30 vs. 4.70) H1b None vs. Match Inventory 6.24 3.34 0.034 (2.73 vs. 8.97) 5.42 2.76 0.049 Restoration Liability (-4.29 vs. 1.14) Either 5.48 6.10 0.007 (-0.78 vs. 4.70) RQ1a Control vs. Mismatch Inventory 8.45 6.27 0.013 (-1.21 vs. 7.24) Restoration Liability -2.43 0.53 0.468 (5.97 vs. 3.54) Either 3.02 1.60 0.206 (2.30 vs. 5.32) RQ1b None vs. Mismatch Inventory 4.51 1.76 0.185 (2.73 vs. 7.24) Restoration Liability 7.83 5.51 0.019 (-4.29 vs. 3.54) Either 6.10 6.72 0.010 (-0.78 vs. 5.32) 19

Results – H1a & H1b (Affect) Contrast Value (+ = less negative) Misstatement F 1,520 p H1a Control vs. Match Inventory 10.17 9.01 0.002 (-1.21 vs. 8.97) Restoration Liability -4.83 2.17 0.141 (5.97 vs. 1.14) 2.40 1.28 0.129 Either (2.30 vs. 4.70) H1b None vs. Match Inventory 6.24 3.34 0.034 (2.73 vs. 8.97) 5.42 2.76 0.049 Restoration Liability (-4.29 vs. 1.14) Either 5.48 6.10 0.007 (-0.78 vs. 4.70) RQ1a Control vs. Mismatch Inventory 8.45 6.27 0.013 (-1.21 vs. 7.24) Restoration Liability -2.43 0.53 0.468 (5.97 vs. 3.54) Either 3.02 1.60 0.206 (2.30 vs. 5.32) RQ1b None vs. Mismatch Inventory 4.51 1.76 0.185 (2.73 vs. 7.24) Restoration Liability 7.83 5.51 0.019 (-4.29 vs. 3.54) Either 6.10 6.72 0.010 (-0.78 vs. 5.32) 20

Results – H1a & H1b (Affect) Contrast Value (+ = less negative) Misstatement F 1,520 p H1a Control vs. Match Inventory 10.17 9.01 0.002 (-1.21 vs. 8.97) Restoration Liability -4.83 2.17 0.141 (5.97 vs. 1.14) 2.40 1.28 0.129 Either (2.30 vs. 4.70) H1b None vs. Match Inventory 6.24 3.34 0.034 (2.73 vs. 8.97) 5.42 2.76 0.049 Restoration Liability (-4.29 vs. 1.14) Either 5.48 6.10 0.007 (-0.78 vs. 4.70) RQ1a Control vs. Mismatch Inventory 8.45 6.27 0.013 (-1.21 vs. 7.24) Restoration Liability -2.43 0.53 0.468 (5.97 vs. 3.54) Either 3.02 1.60 0.206 (2.30 vs. 5.32) RQ1b None vs. Mismatch Inventory 4.51 1.76 0.185 (2.73 vs. 7.24) Restoration Liability 7.83 5.51 0.019 (-4.29 vs. 3.54) Either 6.10 6.72 0.010 (-0.78 vs. 5.32) 21