Internal Control Quality: The Role of Critical Audit Matters Reporting

Abstract

We examine whether critical audit matter (CAM) reporting in audit reports improves issuers’ internal controls over financial reporting. We propose that increased scrutiny by auditors on CAM-related matters lead to early identification and remediation of material weaknesses in internal control (ICMW). 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 also find that issuers with revenue-recognition CAMs have significantly fewer revenue-related ICMWs, suggesting that ICMWs related to revenue recognition are identified and remediated through the CAM evaluation process. For those that reported ICMW at year end, we find a positive and significant association between CAM reporting and the likelihood of disclosing ineffective internal control in SOX 302 reports. This finding supports that CAM reporting leads to early identification of internal control problems. Overall, our evidence suggests that by focusing auditor 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 financial reporting quality by affecting auditor and management behavior.