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

Abstract

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, as well as 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.