Derek K. W. CHAN
Prof. Derek K. W. CHAN
Accounting and Law
Associate Dean (Undergraduate)
Associate Professor

3917 8357

KK 1203

The Effects of Critical Audit Matter Disclosure on Audit Effort, Investor Scrutiny, and Investment Efficiency

We study the effects of the disclosure of critical audit matters (CAMs) on an auditor’s audit effort and an investor’s scrutiny effort decisions and on investment efficiency. Both the auditor and the investor can prevent a bad investment by respectively auditing and scrutinizing the firm’s financial reports to detect misstatements about the investment value. Investment efficiency is determined by the investor’s total mix of information. The disclosure of CAMs helps the investor assess investment risk and infer the auditor’s effort and thus enables the investor to fine-tune scrutiny effort, which can in turn adversely influence the auditor’s effort decision. We show when and why the disclosure of CAMs increases or decreases ex ante audit effort, ex ante investor scrutiny, and investment efficiency. Our analyses have both testable empirical implications and policy implications.

Financial Reporting, Auditing, Analyst Scrutiny, and Investment Efficiency

This paper presents an economic framework to study strategic interactions along the analyst-auditor-owner disciplinary chain, in which the auditor examines the financial reports prepared by the owner, and the analyst uncovers financial misreporting as well as audit failure. We find that although analyst scrutiny ex post detects misreporting, it ex ante aggravates the owner's misreporting behavior and further impairs financial statement reliability if the legal penalties for the auditor and the owner are small. We also show how the effects of a regulation depend on its target's disciplinarian(s). Specifically, (i) although enhancing the auditor's legal liability always increases audit quality and financial statement reliability, it decreases investment efficiency if and only if the analyst is highly independent; and (ii) increasing the owner's misreporting penalty decreases investment efficiency if and only if either of (but not both) the regulations on the auditor and the analyst is strict.