The Effects of Critical Audit Matter Paragraphs and Accounting Standard PDF

THE ACCOUNTING REVIEW American Accounting Association
Vol. 91, No. 6 DOI: 10.2308/accr-51382

November 2016
pp. 1629–1646
The Effects of Critical Audit Matter Paragraphs and

Accounting Standard Precision on Auditor Liability
Christine Gimbar
DePaul University
Bowe Hansen
Virginia Polytechnic Institute and State University
Michael E. Ozlanski
Susquehanna University
ABSTRACT: The Public Company Accounting Oversight Board recently proposed amendments to the standard
audit report that would require the disclosure of critical audit matters (CAMs), and the Securities and Exchange
Commission continues to evaluate the use of principles-based (imprecise) accounting standards within U.S.
generally accepted accounting principles. We assert that jurors perceive precise accounting standards to constrain
auditors’ control over financial reporting outcomes, resulting in a lower propensity for negligence verdicts when the
accounting treatment conforms to the precise standard. However, we hypothesize that the use of either imprecise
standards or CAMs reduces the extent to which jurors perceive this constraint to exist, leading to increased auditor
liability. We present experimental evidence supporting this argument. Our results highlight the similarities between
the effects of imprecise accounting standards and CAMs on negligence assessments. These results provide insight
for regulators and the auditing profession about the potential consequences of the proposed regulatory changes.
Keywords: PCAOB; audit reporting; auditor litigation; critical audit matter (CAMs); accounting standard precision.
I. INTRODUCTION
T
he Public Company Accounting Oversight Board (PCAOB) is currently considering substantial changes to the audit
reporting model that would require auditors to disclose critical audit matters (CAMs) in the audit report. CAMs discuss
areas of the audit that required a significant amount of professional judgment to evaluate appropriately or that posed the
most difficulty in obtaining and evaluating evidence (PCAOB 2013). Although this additional disclosure is expected to increase
the information content of the audit report for investors (e.g., Christensen, Glover, and Wolfe 2014), several interest groups
have expressed concerns that CAMs will also increase the audit profession’s liability risks (e.g., Deloitte 2013; Gaetano 2014).
In addition, the Securities and Exchange Commission (SEC) continues to evaluate the role of principles-based (imprecise)
accounting standards within U.S. generally accepted accounting principles (GAAP), and the Financial Accounting Standards
Board (FASB) and the International Accounting Standards Board (IASB) continue with their efforts to converge accounting
standards.1 These changes to both accounting and auditing standards have the potential to significantly impact assessments of
We appreciate helpful comments and suggestions from two anonymous reviewers, Kathryn Kadous (editor), Andrew Newman, Donna Bobek Schmitt,
Aaron Zimbelman, and workshop participants at Virginia Polytechnic Institute and State University and the University of South Carolina. We are grateful
for the research support of Virginia Polytechnic Institute and State University and University of New Hampshire.
Editor’s note: Accepted by Kathryn Kadous.
Submitted: January 2015
Accepted: January 2016
Published Online: January 2016
1
Although the Sarbanes-Oxley Act specifically refers to a ‘‘principles-based’’ system of accounting (§108(d)), as discussed in Schipper (2003) and
Nelson (2003), it is inappropriate to refer to an accounting system as ‘‘rules-based’’ because accounting standard setting is guided by the underlying
conceptual framework. Therefore, we use the terms ‘‘precise’’ and ‘‘imprecise’’ to delineate accounting standards that provide more, or less, detailed
guidance to practitioners and auditors.
1629
1630 Gimbar, Hansen, and Ozlanski
auditor liability. The purpose of this study is to investigate how jurors’ perceptions of auditor liability are affected by CAMs,
accounting standard precision, and the interaction between CAMs and accounting standard precision.
Kadous and Mercer (2012, 2016) find that when a client’s accounting conforms to a precise standard (i.e., meets the ‘‘letter
of the law’’), jurors rely on the consistency of the client’s accounting treatment with precise standards as a primary determinant
of negligence and are less likely to second-guess auditors under precise than under imprecise accounting standards. We posit
that this result holds for two reasons. First, when the accounting treatment conforms to a precise standard, jurors perceive the
precise standard as having constrained the auditor’s control over financial reporting outcomes (Jamal and Tan 2010). In
contrast, the flexibility inherent in imprecise standards reduces jurors’ perceptions that the auditor was constrained, leading
jurors to increase their assessment of the auditor’s control over the financial reporting outcome and increase their second-
guessing of the auditor (Kadous and Mercer 2016). Second, jurors are likely to view compliance with GAAP as indicating that
the auditor performed a high-quality audit. However, under an imprecise accounting standard, jurors will find it difficult to
determine the extent to which the accounting treatment conforms to the standard and will be less able to rely on compliance
with accounting standards to guide their assessment of audit quality (Kadous and Mercer 2016).
The effects of jurors’ perceptions of auditor control and audit quality on their assessment of auditor liability are consistent
with the culpable control model of blame attribution.2 The culpable control model asserts that perceived control is a critical
factor in blame attributions and is a product of an evaluator’s assessment of a party’s (i.e., the auditor’s) perceived causal role in
the outcome, the foreseeability of the outcome, and the party’s intention (Alicke 2000; Alicke, Buckingham, Zell, and Davis
2008). Based on these three criteria, we posit that CAMs will influence juror assessments of the auditor’s culpable control over
a financial reporting outcome and assessments of blame for the alleged misstatement in a manner that is similar to the effects of
imprecise standards.
Specifically, we hypothesize that a CAM related to a litigated issue will highlight the fact that judgments and estimates
were made in the application of the precise standard and that the auditor had concerns regarding those judgments and estimates.
This will reduce jurors’ perceptions that the precision of the accounting standard limited the auditor’s ability to influence the
financial reporting. These consequences of a related CAM will increase jurors’ perceptions that the auditor could have foreseen
the negative outcome and therefore played a causal role in its occurrence. In addition, we expect unrelated CAMs to bring into
question the auditor’s intent to provide a high-quality audit because they indicate that the auditor ‘‘missed’’ the litigated
accounting issue, leading to higher assessments of culpable control and liability. Finally, since the perceived constraint on the
auditor’s culpable control generated by precise standards is already removed under imprecise standards, we expect that the
association between CAMs and auditor liability will be weaker under imprecise standards than under precise standards. In
essence, we propose that with regard to auditor liability, CAMs convert precise accounting environments into imprecise
accounting environments, in which auditors are perceived to have greater culpable control over financial statement outcomes.
We test our predictions using an experiment in which participants, acting in the role of jurors, evaluate auditor liability for
an alleged misstatement of financial statements due to inaccurate lease reporting and the subsequent bankruptcy of an audit
client. We use a 3 3 2 experimental design in which we manipulate CAM disclosure (no CAM, related CAM, or unrelated
CAM) and standard precision (precise or imprecise). We use the propensity of jurors to issue a verdict against the auditor as our
primary dependent variable. In addition, we measure several variables related to the culpable control model, including jurors’
perceptions of the extent to which the auditor caused the loss, the foreseeability of the loss, and the auditor’s intent to conduct a
high-quality audit.
Consistent with prior results in Kadous and Mercer (2016), we find that when no CAM is present, our participants have a
lower propensity to issue verdicts against the auditor when the client’s accounting conforms to a precise standard than under an
imprecise standard with the same accounting treatment. We use these results as a baseline to evaluate the impact of related and
unrelated CAMs on assessments of auditor liability under each accounting standard regime. As hypothesized, we find that
under precise standards and an accounting treatment that meets the letter of the law, both related and unrelated CAMs increase
auditor liability. Finally, we observe an interaction between standard precision and CAMs such that CAMs increase auditor
liability by a lesser amount under imprecise standards than precise standards.
We then use mediation analysis to provide additional evidence regarding participants’ decision making underlying the
hypothesized and observed significant associations between auditor liability under precise accounting standards and both
related and unrelated CAMs. The results support our argument that, under precise standards, related CAMs increase jurors’
assessments of the auditor’s control over financial reporting, and this increased level of perceived control mediates the
relationship between related CAMs and jurors’ assessments of the auditor’s liability. Similarly, we find that unrelated CAMs
2
The applicability of the culpable control model to auditor litigation is supported by prior literature (Lowe, Reckers, and Whitecotton 2002; Kadous and
Mercer 2012; Backof 2015).
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The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability 1631
are significantly associated with a decrease in participants’ evaluation of the quality of the audit performed, and this result
mediates the relationship between unrelated CAMs and auditor liability under precise standards.
Finally, in supplementary analyses, we validate the robustness of our results by investigating the potential impact of
participants’ affective reactions and demographic covariates by examining a subsample of our participants more likely to
identify with auditors and by applying an alternative measure of blame attribution. In addition, we explore the influence of
CAMs on participants’ assessments of damages as a more pragmatic measure of the expected costs of litigation to auditors.3
Consistent with our main analysis, we find that when the client’s accounting conforms to a precise standard, both blame and
damage assessments are heightened in the presence of either a related or an unrelated CAM. In contrast, neither assessment is
significantly associated with the presence of a CAM under imprecise standards using an equivalent accounting treatment.
Our results provide new insight into conflicting results in contemporaneous studies that investigate the relationship
between CAMs and auditor liability. Brown, Majors, and Peecher (2015) and Brasel, Doxey, Grenier, and Reffett (2016) find
that auditor liability is reduced when a related CAM is disclosed using experimental cases involving a financial statement fraud.
Kachelmeier, Schmidt, and Valentine (2014) find similar, although statistically weaker, results using a case in which a
company is discovered to have materially misstated its financial statements. These cases differ from ours in that each includes a
clear indication that the applicable accounting standards were violated. Further, Backof, Bowlin, and Goodson (2014) provide
an environment in which the proper accounting treatment is ambiguous, similar to our imprecise accounting standard setting,
and find no direct relationship between related CAMs and auditor liability.4
Further, our results contribute to the literature examining the effects of standard precision on auditor liability (e.g., Kadous
and Mercer 2012, 2016; Donelson, McInnis, and Mergenthaler 2012) by highlighting the interaction between CAMs and
accounting standard precision. These results will be informative to the PCAOB and the SEC because they highlight a potential
unintended consequence of the proposed audit reporting model, and reinforce the importance of the two oversight bodies
considering the relationship between their regulatory actions.
II. BACKGROUND AND HYPOTHESES DEVELOPMENT

The PCAOB recently proposed changes to the existing audit reporting model that would require the auditor to disclose
CAMs in the audit report. CAMs are described as audit areas that required significant judgment by the auditor when performing
the audit or posed the most difficulty in obtaining audit evidence and are expected to have a higher risk of material
misstatement. The proposed auditing standard would require auditors to discuss the identified matters and include explanations
as to why the matters were considered appropriate for disclosure (PCAOB 2013). Several interest groups have expressed
concerns that these additional auditor disclosures could increase the audit profession’s liability risk (e.g., Deloitte 2013;
Gaetano 2014; Katz 2014).
Contemporaneous studies investigating the effect of CAM disclosures on auditor liability provide mixed results, which
suggests that jurors’ reactions to CAMs vary as a function of aspects of the accounting issue associated with the alleged
misstatement and the nature of the case (Backof et al. 2014; Brasel at al. 2016; Brown et al. 2015; Kachelmeier et al. 2014). Our
study differs from these studies in that we explicitly consider how the impact of a CAM on auditor liability may differ when the
litigated issue is governed by either a precise or an imprecise accounting standard. CAMs highlight areas of the audit that were the
most difficult or that required significant judgment on the part of the auditor (PCAOB 2013). Similarly, the application of
imprecise accounting standards requires a high level of professional judgment and expertise (Maines et al. 2003; Schipper 2003).
Further, prior evidence indicates that imprecise standards impact jurors’ decision making (Kadous and Mercer 2012, 2016;
Sennetti, Becker, and Lawrence 2011). Therefore, studying the interaction between CAMs and standard precision allows us to
provide valuable insight into the mechanisms underlying the relationship between CAM disclosures and auditor liability.
Blame Attribution and the Culpable Control Model

Although jurors should make assessments of auditor liability based on the level of care and skill exhibited during the
engagement and not on the outcome of the audit (D. Causey and S. Causey 1991a), jurors often consider outcomes when assessing
auditor negligence (e.g., Lowe and Reckers 1994; Anderson, Jennings, Lowe, and Reckers 1997; Kadous 2000). Existing auditing
3
Prior research indicates that the factors influencing jurors’ damage assessments are not necessarily the same factors as used in verdict assessments
(Lowe et al. 2002). Therefore, this portion of the analysis is less clearly supported by our underlying theory. However, we believe that the expected cost
of litigation is a primary concern to practicing auditors (Pratt and Stice 1994); therefore, we include this supplementary analysis to inform that concern.
4
Backof et al. (2014) extend their study to investigate the impact of including a discussion of additional auditing procedures performed to respond to the
CAM in the auditor’s report and find that CAMs including this discussion are associated with increased auditor liability. This result is outside the scope
of our hypotheses, but is important in that it indicates that additional disclosures made by the auditor may have incremental effects on liability
assessments.

research specifically investigates the role of counterfactual reasoning in assessments of auditor negligence (Reffett 2010).
Counterfactual reasoning theory posits that individuals use negative affective reactions to conceive alternative actions that the actor
(in our case, the auditor) might have taken to prevent the negative outcome (Kahneman and Miller 1986; Roese 1997).
The culpable control model extends counterfactual reasoning theory by identifying conditions under which counterfactual
reasoning leads to increased blame assessments. The model states that evaluators’ blame assessments are based both on their
negative affective reactions and on their perceptions of the actor’s ability to control the adverse outcome (Alicke 2000). An
evaluator’s use of counterfactual reasoning will increase assessments of blame only when the evaluator perceives that the actor
had control over the outcome and did not take the appropriate precautions to prevent the harmful action (Alicke et al. 2008).
Further, the culpable control model posits that perceived control is a function of an actor’s intention related to the event,
role in the causation of the event, and the perceived foreseeability of the event (Alicke 2000; Alicke et al. 2008). These
assessments are made consciously and deliberately by evaluators and lead to the determination of blame and liability
judgments. Intention relates to voluntary control over a behavior. In the case of an alleged misstatement, if jurors perceive that
the auditor intended to provide a high-quality audit, then this indicates that the auditor took precautions to minimize the
potential for an audit failure and decreases perceptions of control and liability. Causation refers to the ability to influence or
control an outcome. Higher levels of perceived causation increase personal control and liability assessments. Finally,
foreseeability relates to the auditor’s ability to anticipate harmful outcomes. Increased foreseeability suggests that the auditor
had more personal control over the outcome and, therefore, leads to greater blame assessments. Collectively, the model
suggests that greater perceptions of causation and foreseeability and lower perceptions of intent to perform a high-quality audit
result in greater perceptions of control, blame, and liability (Alicke 2000).
Standard Precision, CAMs, and Auditor Liability

The application of the culpable control model to an audit litigation setting implies that jurors will determine an auditor’s
liability based on their perceptions of the auditor’s culpable control over the litigated financial reporting outcome. Furthermore,
perceived culpable control is a function of jurors’ perceptions regarding the auditor’s intent to perform a high-quality audit,
causal role in the negative outcome, and ability to foresee the negative outcome (Alicke 2000; Backof 2015). We expect that
when the disputed accounting issue conforms to a precise standard and no CAM is disclosed, jurors will assess auditors as
having had little culpable control over the alleged misstatement.
The low level of perceived culpable control is driven by two factors. First, jurors are likely to view the client’s compliance
with the precise standard as evidence that the auditor intended to, and did, perform a high-quality audit (Kadous and Mercer
2016). Although legal precedent indicates that compliance with GAAP is not a sufficient defense against negligence (D. Causey
and S. Causey 1991b; Ball 2009), consistency with authoritative guidance and, in particular, with a precise accounting standard,
plays a primary role in juror decision making (Buckless and Peace 1993; Kadous and Mercer 2012). Second, independent of their
assessments of audit quality, jurors will perceive that the auditor had a limited ability to require the client to alter financial
reporting that met the letter of the law, even if the auditor disagreed with management’s accounting treatment. The perception of
limited control is consistent with Jamal and Tan’s (2010) argument that precise standards constrain the ability of auditors to
negotiate with clients when they disagree with a proposed accounting treatment that conforms to a precise standard.
In contrast, imprecise standards amplify the importance of business judgment and auditor skill (Carmona and Trombetta
2008). This emphasis on judgment and skill can increase jurors’ counterfactual thoughts related to the audit, particularly when
the audit client’s reporting is conservative (Cornell, Magro, and Warne 2012). Specifically, imprecise standards remove jurors’
perceptions that the auditor’s control over the alleged misstatement was constrained by the accounting standard. The removal of
this constraint enables jurors to question whether the auditor intended to provide a high-quality audit (e.g., did the auditor
adequately consider the issue in question and recognize it as a potential concern?) and whether alternative auditor judgments
could have prevented the alleged misstatement. Consistent with this argument, Kadous and Mercer (2016) find that when the
client’s reporting complies with a precise standard, jurors have a lower propensity to return verdicts against the auditor than
under imprecise standards, holding the client’s reporting constant. Similarly, we expect to find in our case that, absent CAM
disclosures, auditor liability will be higher under an imprecise standard than under a precise standard.
These relationships will change, however, with the introduction of the proposed CAM disclosures, which are intended to
highlight those areas of the audit that required the most professional judgment or that posed the most difficulty to the auditor in
evaluating or obtaining evidence (PCAOB 2013). The emphasis on judgment and difficulty as determining factors of CAM
disclosures mirrors the emphasis that is placed on auditor judgment and skill under imprecise standards (Maines et al. 2003;
Carmona and Trombetta 2008).5 This similarity allows us to leverage prior evidence on the relationship between imprecise
5
We acknowledge that there is a subtle difference between difficulty and skill. Some audit matters will be difficult for even the most skilled auditors.
However, the two are strongly related. A given audit task should be less difficult for a more skilled auditor.

standards and auditor liability (Kadous and Mercer 2012, 2016; Sennetti et al. 2011) to provide insight into the potential
relationship between CAM disclosures and auditor liability.
The disclosure of a related CAM in a precise standard environment will emphasize the importance of judgment and
estimates in the application of the accounting standard (e.g., estimating the useful life of a leased asset, determining the
appropriate discount rate to use to calculate the pension benefit liability, calculating the fair value of stock options). We expect
that the revelation that the accounting issue was open to judgment will reduce jurors’ perceptions that the precise accounting
standard constrained the auditor’s ability to exercise control over the financial statements. Similar to the effect of imprecise
standards, this will increase jurors’ assessments that the auditor could have required the client to alter the accounting treatment.
Therefore, the auditor will be perceived as having played a causal role in the misstatement by not obligating the client to change
the reporting. In addition, the disclosure of a CAM related to the litigated issue indicates that the auditor was aware of the
heightened risk associated with the accounting treatment and will increase jurors’ assessments that the auditor could have
foreseen the eventual negative outcome (Katz 2014). Consistent with the culpable control model, we expect these increased
perceptions of causation and foreseeability and, therefore, control, which result from a related CAM, to increase jurors’
assessments of auditor liability (Alicke 2000). Formally stated, our first hypothesis is:
H1: When a client’s accounting treatment complies with a precise standard, the inclusion of a related CAM will be
associated with increased auditor liability.
An unrelated CAM is unlikely to influence jurors’ assessment of the auditor’s causal role or ability to foresee the negative
outcome. However, we posit that, similar to an imprecise accounting standard, an unrelated CAM will impact jurors’ perceptions
of the third component of the culpable control model, the auditor’s intent to perform a high-quality audit, thus increasing jurors’
perceptions of the auditor’s culpable control. The disclosure of an unrelated CAM will result in jurors’ doubting the auditor’s
intent to perform a high-quality audit because the auditor failed to include the financial statement account related to the
misstatement in the disclosure of high-risk areas of the audit (Gaetano 2013). This failure will lead jurors to perceive that the
auditor did not identify this audit risk and, therefore, did not take the necessary precautions to prevent the negative outcome. This
perception will be amplified by hindsight bias, which will lead jurors to overestimate the ex ante risk associated with the account
(Fischhoff 1975; Hawkins and Hastie 1990), thus facilitating counterfactual thoughts such as, ‘‘if the auditor had only identified
the correct risk, the auditor could have prevented the outcome.’’ Therefore, we expect that an unrelated CAM will also increase
jurors’ assessments of the auditor’s culpable control and liability when the accounting standards are precise and the client’s
financial reporting meets the bright-line requirement of the standard. Formally stated, our second hypothesis is:
H2: When a client’s accounting treatment complies with a precise standard, the inclusion of an unrelated CAM will be
associated with increased auditor liability.
Our first two hypotheses are based on the argument that in the auditor liability setting, the impact of CAMs is comparable
to the transition from precise to imprecise standards. Specifically, we posit that both a related CAM and imprecise standards
remove jurors’ perceptions that the auditor’s control over the negative outcome was constrained by the precise standard.
Additionally, both an unrelated CAM and imprecise standards lead jurors to question the extent to which the auditor intended
to, and did, conduct a quality audit. Therefore, we expect that the incremental effects of CAMs, whether related or unrelated,
will be weaker under imprecise standards than under precise standards. This leads to our final hypothesis:
H3: The inclusion of either a related or an unrelated CAM will increase auditor liability less under imprecise standards
than under precise standards.
III. EXPERIMENTAL METHODOLOGY

To test our hypotheses, we conducted an experiment using students enrolled in introductory accounting courses at a large
U.S. public university. Prior research suggests that judgments of students are not significantly different from those of
individuals who report for jury duty, both in general and specifically in an audit litigation setting (Bornstein 1999; Kadous
2001). In addition, we required that our participants meet the criteria of eligible jurors, who are defined as individuals at least 18
years of age and U.S. citizens (e.g., Kadous and Mercer 2012).
Experimental Materials and Procedures

The case used in the experiment examines jurors’ assessments of auditor negligence related to a bankruptcy and an alleged
audit failure of an internet hosting company. The plaintiff is a large pension fund investor that alleges that the auditor allowed
the company’s equipment leases to be inappropriately classified as operating instead of capital. The plaintiff alleges that this
accounting treatment resulted in the financial statements not accurately portraying the risk profile of the company.

We utilize a lease accounting setting to manipulate accounting standard type (precise versus imprecise), while holding
constant management’s estimated useful life of the underlying assets. This setting allows us to manipulate the accounting standard
type without manipulating the underlying economics of the leasing transactions. In all of the experimental cells, the lease term is
seven years, and management’s estimated useful life of the assets is ten years. Therefore, the lease covers 70 percent of the asset’s
estimated useful life, which would not violate the bright-line standard included in U.S. GAAP.6 However, the plaintiff argues that
a shorter estimated useful life should have been assigned to the underlying equipment, resulting in the leases being capitalized,
thereby more accurately representing the risk profile of the company. As described in Agoglia, Doupnik, and Tsakumis (2011),
lease classification is an ideal setting in which to examine precise and imprecise standards, as bright-line thresholds exist in the
precise environment, while judgment is more clearly required when imprecise standards are applied.
The experimental instrument begins with instructions for participants and company background information. Participants
then received the facts undisputed by both parties, excerpts from applicable lease accounting standards, which are manipulated
as precise versus imprecise, and arguments from both the plaintiff (the pension fund investor) and the defendant (the auditor).
Finally, participants received a copy of the audit report, which accompanies the financial statements related to the fiscal year
that directly preceded the bankruptcy. The audit report is manipulated at three levels: no CAM, a CAM related to the alleged
misstatement, and a CAM unrelated to the alleged misstatement. After reading the case, participants received instructions from
the trial judge, assessed the auditor’s role in the plaintiff’s loss, responded to our measures of culpable control, and answered
manipulation check and demographic questions.
Independent Variables
Within the audit report, we manipulate CAM disclosure at three levels: no CAM, related CAM, or unrelated CAM. The
manipulations are adapted from exposure drafts from the PCAOB’s (2013) and the International Auditing and Assurance
Standards Board’s (IAASB 2013) proposed auditing standards. In the no CAM condition, participants were provided with the
standard four-paragraph audit report as currently defined by PCAOB auditing standards. In both CAM conditions, the audit
report includes a section discussing ‘‘Critical Audit Matters,’’ described as ‘‘those matters addressed during the audit that (1)
involved our most difficult, subjective or complex judgments; (2) posed the most difficulty to us in obtaining sufficient
appropriate evidence; or (3) posed the most difficulty to us in forming our opinion on the financial statements.’’7 The related
CAM condition states that the company’s lease arrangements are classified as operating, and the classification of leases
involves significant judgment and estimates. The unrelated CAM condition, alternatively, discusses the company’s allowance
for doubtful accounts, which is identified as a CAM because the account requires a significant amount of audit judgment.
Appendix A presents the CAM manipulation.
We also manipulate standard precision at two levels: precise and imprecise, both of which are manipulated within the
case’s ‘‘facts undisputed by both parties.’’ The imprecise condition provides the criteria under International Accounting
Standard 17 that discriminate a capital lease from an operating lease. These criteria are qualitative and include the lease term
being a ‘‘major part of’’ the useful life of the asset, and the present value of minimum lease payments being ‘‘at least
substantially all of’’ the fair value of the leased asset (IASB 2001). In contrast, the precise condition provides the criteria for
lease classification in accordance with U.S. GAAP under Accounting Standards Codification 840. This standard requires
capitalization when the lease term is ‘‘equal to or greater than 75 percent of the life of the asset’’ or when the present value of
minimum lease payments is ‘‘equal to or greater than 90 percent of the fair value of the leased asset’’ (FASB 1976). Appendix
B provides the standard precision manipulation.
Dependent and Mediating Variables

We perform our primary tests using participants’ binary verdict decision either in favor of or against the audit firm, which
we label Verdict. This allows us to determine the effect that CAMs and accounting standard precision may have on the
probability of a successful defense by the auditor. To perform our mediation analyses, we also collect participants’ assessments
of the underlying constructs of the culpable control model. We include questions designed to measure perceived causation,
foreseeability, and intention to assess participants’ perception of the auditor’s culpable control over the negative outcome.
Specifically, to measure participants’ perceptions of the auditor’s control, we asked them to rate the extent to which the auditor
caused the plaintiff’s loss (0 ¼ Not at all caused, 10 ¼ Completely caused) and the foreseeability of the alleged misstatement
6
Since the imprecise standard is subject to the judgment of participants, we do not strictly hold the lease capitalization threshold constant between the
precise and imprecise conditions. However, this should only impact the main effect of standard precision. Since this effect is constant across our
principles-based manipulations, it cannot drive our observed results regarding the interactive effect of standard precision and CAMs.
7
This is consistent with proposed auditing standards issued by both the PCAOB (2013) and IAASB (2013).

TABLE 1
Participant Demographics by Cell
Precise Imprecise
CAM CAM
No Unrelated Related No Unrelated Related Total
(n ¼ 37) (n ¼ 40) (n ¼ 41) (n ¼ 38) (n ¼39) (n ¼ 39) (n ¼ 234)
Gender* 0.432 0.325 0.366 0.526 0.462 0.410 0.418
(0.502) (0.474) (0.488) (0.506) (0.505) (0.498) (0.494)
Age*,** 19.541 20.025 19.878 19.737 19.641 19.462 19.718
(1.043) (1.641) (1.706) (1.155) (1.112) (1.189) (1.342)
Year** 1.622 1.700 1.683 1.868 1.821 2.154 1.808
(0.758) (0.823) (0.722) (0.963) (0.970) (0.875) (0.865)
Politics 5.905 6.150à 5.573 5.421 5.282 5.231 5.594
(2.024) (1.889) (2.229) (1.840) (2.259) (1.912) (2.040)
This table reports the mean and standard deviation (shown in parentheses) for each demographic measure for each cell.
* Age and Gender have a Pearson correlation of 0.184, which is significant at the 1 percent level.
** Age is positively correlated with Year at the 1 percent level with a correlation of 0.319.

The mean for Gender is significantly lower in the Precise-Unrelated CAM cell than in the Imprecise-No CAM cell, p-value ¼ 0.074.

The mean for Age is significantly higher in the Precise-Unrelated CAM cell than in the Imprecise-Related CAM cell, p-value ¼ 0.084.

The mean for Year is significantly higher in the Imprecise-Related CAM cell than in the Precise-No CAM cell, p-value ¼ 0.006; the Precise-Related
CAM cell, p-value ¼ 0.020; and the Precise-Unrelated CAM cell, p-value ¼ 0.011.
à The mean for Politics is significantly higher in the Precise-Unrelated CAM cell than in the Imprecise-No CAM cell (p-value ¼ 0.0883), the Imprecise-
Unrelated CAM cell (p-value ¼ 0.0682), and the Imprecise-Related CAM cell (p-value ¼ 0.0348).
Variable Definitions:
Gender ¼ a binary variable taking the value of 1 for females, and 0 for males;
Age ¼ the participants’ reported age;
Year ¼ an ordinal variable taking the following values: 1 if the participant is a freshman, 2 if the participant is a sophomore, 3 if the participant is a junior, 4
if the participant is a senior, and 5 if the participant is a graduate student; and
Politics ¼ an ordinal variable based on the participant’s response to the following question: ‘‘How would you classify your political beliefs?’’ with 0
indicating extremely liberal, and 10 indicating extremely conservative.
given the facts available at the time of the audit (0 ¼ Not at all foreseeable, 10 ¼ Completely foreseeable). In addition, to
measure perceived audit quality, we asked participants to evaluate the auditor’s intention to conduct a quality audit (0 ¼ Not at
all intended, 10 ¼ Completely intended) and the quality of the audit work performed by the auditor (0 ¼ Extremely low audit
quality, 10 ¼ Extremely high audit quality).
Research Participants
Our sample contains responses from 234 students.8 Each participant was randomly assigned to an experimental condition.
Table 1 provides summary demographic data for the participants by each experimental cell and also in the aggregate. The mean
age is 19.7 years, and females represent 42 percent of the sample. Approximately 54 percent (38 percent) of the sample are
sophomores (freshmen).
IV. RESULTS
Manipulation Checks
To evaluate the effectiveness of our manipulations, we asked participants if the accounting standard specified that the lease
term must cover a certain percentage of the asset’s life to be classified as a capital lease, and if the audit report specifically
mentioned the company’s leases or the company’s allowance for doubtful accounts as subject to a higher risk of material
8
The experiment was administered during regular class sessions. Participation was voluntary and had no impact on the students’ course grade.
Participants did, however, have the option to enter into a drawing for various gift cards.

misstatement. In response, 65 percent of the participants answered the first question correctly, and 60 percent answered the
second question correctly. We verify that responses by participants who failed the manipulation checks are not systematically
different from those who passed by re-performing our analyses including indicator variables for both manipulation checks. The
results of this analysis are directionally and statistically consistent with our primary findings.9 We, therefore, report the results
including all participants in our primary analyses.
Primary Analyses
We formally test our hypotheses using the following logit regression:
Verdict ¼ a þ b1 Related CAM þ b2 Unrelated CAM þ b3 Imprecise þ b4 Imprecise 3 Related CAM þ b5 Imprecise
3 Unrelated CAM þ e; ð1Þ
where:
Verdict ¼ an indicator variable that takes a value of 1 if the participant returns a verdict against the auditor, and 0 otherwise;
Related CAM ¼ an indicator variable that takes the value of 1 if the participant is in either of the related CAM conditions,
and 0 otherwise;
Unrelated CAM ¼ an indicator variable that takes the value of 1 if the participant is in either of the unrelated CAM
conditions, and 0 otherwise; and
Imprecise ¼ an indicator variable that takes the value of 1 if the participant is in any of the three conditions that include
imprecise accounting standards.
Positive and significant results for b1 and b2 would support H1 and H2, respectively. Negative and significant results for b4
and b5 would support H3.10
Descriptive statistics regarding the proportion and percentage of verdicts against the auditor and the results of our logit
regression are shown in Table 2. Consistent with our expectations and prior findings in Kadous and Mercer (2016), we find that
in the absence of a CAM, auditor liability is greater under imprecise standards than under precise standards when the client’s
accounting treatment conforms to the precise standard. The direct effect of the Imprecise indicator variable is positive and
significant (v12 ¼ 6.99, one-tailed p ¼ 0.004).
H1 predicts that under precise accounting standards, the disclosure of a related CAM will be associated with increased
liability. Supporting this hypothesis, in Table 2, Panel B, we find a positive and significant direct effect for our Related CAM
indicator variable (v12 ¼ 3.79, one-tailed p ¼ 0.026). We also find support for H2 that under precise accounting standards,
auditor liability will be positively associated with the disclosure of an unrelated CAM. The association between the Unrelated
CAM indicator and Verdict is significantly positive (v12 ¼ 3.35, one-tailed p ¼ 0.034). Finally, we find negative and significant
coefficients on the interaction of Imprecise with both the Related CAM (v12 ¼ 2.75, one-tailed p ¼ 0.049) and Unrelated CAM
(v12 ¼ 3.55, one-tailed p ¼ 0.030) indicator variables. This result is consistent with H3, which predicts that CAMs will increase
auditor liability to a lesser extent under imprecise standards.
While we make no formal prediction regarding the impact of CAMs under imprecise standards, the mean of Verdict,
presented in Panel A of Table 2, is lower in the presence of either a related or an unrelated CAM than in the no CAM case
under imprecise standards. Therefore, it is possible that our results may indicate that CAMs reduce legal liability in an
imprecise standard setting. To investigate this possibility, we test the sum of the coefficients on each of the Related CAM and
Unrelated CAM indicators plus the coefficient on the same CAM indicator interacted with Imprecise. In both the related and
unrelated CAM cases, we find that the difference in cell means is not statistically significant.11
9
In addition, in separate analyses we re-performed our analysis excluding, in turn, participants that responded incorrectly to the first manipulation check
question, participants that responded incorrectly to the second manipulation check question, and participants that responded incorrectly to either, and
including all participants and an indicator variable for participants that failed either manipulation check and interactions of this indicator variable with
each of our independent variables. In these separate analyses, the coefficients lose statistical significance in most cases. However, they are directionally
consistent with our primary findings in all cases, indicating that this loss of significance is likely driven by the substantially reduced power of these
tests.
10
Tests of significance on the coefficients, or linear combinations thereof, are nearly identical to tests of simple effects between individual cells.
Therefore, we do not present such results separately.
11
Although outside the scope of our hypotheses, in additional analyses, we also evaluated the impact of a shift from precise to imprecise standards
holding constant the presence of either a related or an unrelated CAM by testing the sum of the coefficient on the Imprecise indicator variable and the
coefficient on its interaction with each of the CAM variables. We find no significant effect in either case (v12 ¼ 0.20, two-tailed p ¼ 0.651 in the related
CAM case, and v12 ¼ 0.01, two-tailed p ¼ 0.914 in the unrelated CAM case).

TABLE 2
Descriptive Statistics and Hypothesis Tests
Verdict Judgments
Panel A: Proportion of Verdicts Against the Auditor

Critical Audit Matter
Collapsed Across
Standard Type None Related Unrelated Critical Audit Matter Types
Precise 10/37 20/41 19/40 49/118
27% 49% 48% 42%
Imprecise 22/38 21/39 19/39 62/116
58% 54% 49% 53%
Collapsed Across Standards 32/75 41/80 38/79
43% 51% 48%
Panel B: Logistic Regression Results

Test Source of Variation df Chi-square p-value
H1 Related CAM 1 3.79 0.026
H2 Unrelated CAM 1 3.35 0.034
Imprecise 1 6.99 0.004
H3 Related CAM 3 Imprecise 1 2.75 0.049
H3 Unrelated CAM 3 Imprecise 1 3.55 0.030
This table presents our analysis of participants’ assessed verdicts. We manipulate the presence of either a related CAM, an unrelated CAM, or no CAM,
and accounting standard specificity.
The dependent variable in this regression is an indicator variable that takes the value of 1 if the participant returned a verdict against the auditor, and 0 if
the participant returned a verdict in favor of the auditor. All p-values are based on one-tailed tests.
Mediation Analysis
To test the applicability of the theory that motivated our hypothesized effects of CAMs on auditor liability under precise
accounting standards, we perform mediation analysis procedures established by Baron and Kenny (1986). Given our predicted
and observed effects, we present mediation analyses using only those cells that received the precise accounting standard
treatments.12
The theory motivating H1 predicts that related CAMs increase participants’ perceptions that the auditor had control over
the financial reporting outcome, and these elevated perceptions of control increase assessments of auditor negligence. To
measure perceived control, we asked participants to evaluate the foreseeability of the alleged misstatement given the facts
available at the time of the audit, and whether the actions of the auditor caused the plaintiff’s losses (Backof 2015). Participants
rated each measure on an 11-point scale, with larger values representing greater control. We then create a composite variable,
Perceived Control, equal to the sum of participants’ responses to these two questions.13
To perform our mediation analyses related to H1, we first document a significant main effect of related CAMs on verdicts
against the auditor (v12 ¼ 3.80, one-tailed p ¼ 0.026), such that related CAMs increase auditor liability in a precise
environment. Second, we establish a significant relationship between related CAMs and perceived control (F1,76 ¼ 2.81, one-
tailed p ¼ 0.049). The mean assessment of control when a related CAM is included (excluded) is 9.46 (8.14), which indicates
that perceived control is greater under related CAMs, consistent with the argument underlying H1. Third, we establish a
12
Although we find no significant association between either an unrelated or a related CAM and auditor liability assessments under imprecise accounting
standards, we also performed the steps of a mediation analysis in that setting for completeness. The results indicate that our mediating variables,
assessments of auditor’s control and perceived audit quality, are significantly associated with participants’ assessment of auditor liability in the
imprecise standards setting. Further, the associations between both an unrelated CAM and a related CAM remain insignificant after controlling for the
mediator variables both separately and jointly.
13
Participants provided responses to the questions used to create the mediating variables for both related and unrelated CAMs after providing their verdict
assessments. One cost of this design choice is that it is possible that these evaluations are biased to provide justification for their prior decisions. The
benefit of the design choice is that we were able to obtain unbiased assessments of our primary variable of interest, Verdict.

FIGURE 1
Consideration of Perceived Control as Mediating the Relationship between Related CAMs and Auditor Liability under
Precise Accounting Standards
***, **, * Indicate p , 0.01, p , 0.05, and p , 0.10, respectively; p-values represent one-tailed tests.
Figure 1 presents the effects of a related CAM on auditor liability under precise accounting standards. It also shows that perceptions of the auditor’s control
over the financial reporting outcome mediate the relationship between related CAMs and auditor liability. To assess participants’ perceptions of auditor
control, we created a composite variable equal to the sum of participants’ responses to the following two items: (1) Did Baylor & Grimble’s (the auditor)
actions cause Delta Pension Fund’s (the plaintiff ) loss? (2) Was the alleged misstatement of the company’s leases foreseeable given the facts available at
the time of the audit? Responses were on an 11-point scale, with larger values representing higher control.
significant relationship between Perceived Control and Verdict (v12 ¼ 20.10, one-tailed p , 0.000), indicating that greater
perceived control is associated with higher liability assessments. Finally, we include Perceived Control in the logit regression
on Verdict, and the significance of Related CAM is fully mediated (v12 ¼ 0.97, one-tailed p ¼ 0.163). Consistent with the theory
underlying H1, these results suggest that related CAMs increase perceptions that the auditor was able to exert higher control
over the financial reporting outcome, which then increases the likelihood of verdicts against the auditor.14 These mediation
analyses are summarized in Figure 1.
H2 predicts that the inclusion of an unrelated CAM under a precise accounting standard is associated with a higher
proportion of verdicts against the auditor because the disclosure decreases participants’ perceptions that the auditor intended to
conduct a quality audit. To measure perceived audit quality, we asked participants to evaluate both the auditor’s intent to
conduct a high-quality audit by identifying the risks of material misstatement and performing audit work to specifically address
the identified risks (Backof 2015), and to evaluate the quality of the audit work performed (Kadous and Mercer 2012). We sum
participants’ responses to these two questions to create a composite measure of perceived audit quality.
Following the same mediation procedures (Baron and Kenny 1986), we first establish that auditor liability under precise
accounting standards is higher in the presence of an unrelated CAM than when no CAM is present (v12 ¼ 3.36, one-tailed p ¼
0.034). Second, we observe that the mean of perceived audit quality is 10.45 (11.76) when an unrelated CAM is included
(excluded), and perceived quality is significantly lower with the inclusion of an unrelated CAM (F1,75 ¼ 2.78, one-tailed p ¼
0.050). Third, we establish that lower perceptions of audit quality are associated with higher auditor liability (v12 ¼ 17.36, one-
tailed p , 0.000). Finally, we include perceived audit quality in the logit regression of Unrelated CAMs on Verdict, and the
significance of Unrelated CAM is mitigated (v12 ¼ 1.00, one-tailed p ¼ 0.160). Consistent with the theory underlying H2, the
results suggest that unrelated CAMs are associated with lower perceptions of audit quality, which then increases the likelihood
of verdicts against the auditor.15 These mediation analyses are summarized in Figure 2.
Since our hypotheses are based on the assertion that similar mechanisms underlie the relationship between auditor liability
assessments for both CAMs (related and unrelated) and imprecise standards, we also consider whether perceptions of control
and audit quality mediate the relationship between imprecise accounting standards and auditor liability in the no CAM
condition. The results suggest that when no CAM is disclosed, imprecise accounting standards are associated with higher
perceptions of auditor control and lower perceptions of audit quality (both statistically significant at the 5 percent level or better
14
Consistent with our argument that related CAMs, but not unrelated CAMs, influence participants’ assessments of the auditor’s Perceived Control, we
find in untabulated analyses that unrelated CAMs are not significantly associated with Perceived Control, and the association between Unrelated CAM
and Verdict remains positive and significant after controlling for Perceived Control.
15
Again, consistent with our argument that unrelated CAMs, but not related CAMs, influence perceived audit quality, we find in untabulated analyses that
related CAMs are not significantly associated with perceived audit quality, and the association between Related CAM and Verdict remains positive and
significant after controlling for perceived audit quality.

FIGURE 2
Consideration of Perceived Audit Quality as Mediating the Relationship between Unrelated CAMs and Auditor
Liability under Precise Accounting Standards
***, **, * Indicate p , 0.01, p , 0.05, and p , 0.10, respectively; p-values represent one-tailed tests.
Figure 2 presents the effects of an unrelated CAM on auditor liability under precise accounting standards. It also shows that perceptions of audit quality
mediate the relationship between unrelated CAMs and auditor liability. To assess participants’ perceptions of audit quality, we created a composite
variable equal to the sum of participants’ responses to the following two items: (1) Did Baylor & Grimble (the auditor) intend to conduct a quality audit by
identifying risks of material misstatement and performing audit work to specifically address the identified risks? (2) Rate the quality of Baylor and
Grimble’s audit work related to its audit of SkyView Services. Responses were on an 11-point scale, with larger values representing higher audit quality.
using two-tailed p-values). Additionally, the relationship between imprecise accounting standards and increased liability in the
no CAM condition is fully mediated by both control and audit quality. These results support our argument that the mechanisms
underlying the relationships between auditor liability and related and unrelated CAMs are consistent with the mechanisms
underlying the relationship between auditor liability and imprecise accounting standards.
Supplementary Analyses
We perform several additional tests to provide support for our results and to investigate additional implications that may be
of concern to practicing accountants. First, we replicate our analysis using a continuous measure of participants’ assessment of
auditor fault in place of the Verdict indicator variable. We create this variable, Fault, by averaging participants’ evaluations of
auditor blame, negligence, and the appropriateness of the auditor’s actions (reverse coded). Specifically, we asked participants
how much blame the auditor deserved for the plaintiff’s losses, to what extent the auditor was negligent in its audit, and how
appropriate or inappropriate the actions of the auditor were in the case.
Preliminary tests reject the null hypothesis that this composite variable is normally distributed (Shapiro-Wilk W-test z ¼
3.138, p ¼ 0.0009; Skewness/Kurtosis test v22 ¼ 26.92, p , 0.000). Therefore, we perform our analysis using a quantile
regression with the same specification as Equation (1), substituting Fault in place of Verdict as the dependent variable, and
supplement this analysis with Fisher’s exact tests for differences in medians between cells. Table 3, Panel A presents the
medians and means of Fault for each experimental cell. The results of the quantile regression and Fisher’s exact tests are shown
in Panels B and C of Table 3. The results are consistent with our primary results, with the exception of the Fisher’s exact test
comparing the unrelated CAM treatment group to the no CAM treatment group (both under precise standards), which is
directionally consistent, although somewhat weaker (one-tailed p ¼ 0.160).
Second, we investigate the possibility that our findings may be a result of our proxies for the auditor’s perceived control
and perceived audit quality reflecting the influence of participants’ negative affective reactions toward the auditor relative to the
plaintiff. Brasel et al. (2016) present evidence that the introduction of CAMs may influence affective reactions by altering
perceptions of the foreseeability of an accounting misstatement related to accounting issues where misstatements would not
typically be expected. We do not expect their result to apply to our setting since we provided all participants with reason to
believe that an accounting error is foreseeable (i.e., plaintiff’s argument).16 However, prior evidence establishes a relationship
between negative affect toward the auditor and increased auditor liability assessments (e.g., Kadous 2001; Reffett 2010; Backof
16
In addition, Brasel et al. (2016) argue that related CAMs lead to positive affect toward the auditor, resulting in lower legal liability, contradictory to our
hypotheses and findings. Therefore, if their argument does apply in our case, then it would work against our predictions.

TABLE 3
Descriptive Statistics and Tests of Differences in Auditor Fault Judgments
Panel A: Descriptive Statistics

Collapsed Across
Precise 3.333 4.667 4.333 4.167
(4.049) (4.276) (4.492) (4.278)
n ¼ 37 n ¼ 41 n ¼ 40 n ¼ 118
Imprecise 5.197 4.667 4.333 4.667
(4.658) (4.761) (4.338) (4.585)
n ¼ 38 n ¼ 39 n ¼ 39 n ¼ 116
Collapsed Across Standards 4.333 4.667 4.333
(4.358) (4.513) (4.416)
n ¼ 75 n ¼ 80 n ¼ 79
This panel presents the median and mean (shown in parentheses) of participants’ evaluation of auditor fault for each experimental cell. Fault is measured
as participants’ average response to the following three questions: (1) How much blame does the auditor deserve for the plaintiff’s losses? (2) To what
extent do you think the auditor was negligent in its audit? (3) How appropriate or inappropriate were the actions and decisions of the auditor in this case?
Responses to all questions were made on an 11-point scale (0–10), and the final question is reverse-coded for directional consistency.
Panel B: Quartile Regression Results

Numerator Denominator
Source of Variation df df F-stat p-value
H1 Related CAM 1 228 3.43 0.033
H2 Unrelated CAM 1 228 5.29 0.011
Imprecise 1 228 5.16 0.012
H3 Related CAM 3 Imprecise 1 228 2.66 0.052
H3 Unrelated CAM 3 Imprecise 1 228 5.19 0.012
p-values are based on one-tailed tests.
Panel C: Fisher Exact Tests for Difference in Medians

Comparison Groups Pearson v12 One-Tailed p-value
Precise No CAM versus Imprecise No CAM 2.996 0.067
Precise No CAM versus Precise Related CAM 2.519 0.087
Precise No CAM versus Precise Unrelated CAM 1.496 0.160
2015). In addition, the culpable control model allows for the possibility that participants’ negative affective reactions may lead
to biased assessments of causation, foreseeability, and intent (Alicke 2000; Backof 2015).
Therefore, we asked participants to rate their feelings toward both the audit firm and the plaintiff (0 ¼ Extremely negative,
10 ¼ Extremely positive). Consistent with Reffett (2010), we measure participants’ affective reaction toward the auditor as the
difference between participants’ feelings toward the plaintiff and toward the auditor, such that a positive value for this variable
reflects a more negative view of the auditor relative to the plaintiff. Untabulated analyses indicate that there is no significant
relationship between either a related CAM (two-tailed p ¼ 0.691) or an unrelated CAM (two-tailed p ¼ 0.763) and affect under
precise standards.17 However, we do find a significant difference in affect between imprecise and precise standards when no
CAM was present (F1,73 ¼ 4.80, two-tailed p ¼ 0.032).
To further explore this result, we first perform a mediation analysis to investigate the extent to which affect mediates the
observed relationship between imprecise standards and participants’ propensity to return verdicts against the auditor. Consistent
17
We also find that affect is not significantly related to a related CAM (p ¼ 0.523) or an unrelated CAM (p ¼ 0.580) under imprecise standards.

with prior literature, we find a significant relationship between affect and verdict (v12 ¼ 17.61, two-tailed p , 0.000). In
addition, we find that the relationship between imprecise standards and verdict is partially mediated by affect, as evidenced by
an increase in the one-tailed p ¼ 0.004 from our primary analysis, to p ¼ 0.063 when affect is included in the regression. Then,
we re-perform our primary logit regression (untabulated) including Perceived Control, Perceived Audit Quality, and Affect, and
find that all three variables are significantly related to Verdict and that the mediation of Related CAM, Unrelated CAM, and
Imprecise holds in this full model. These results indicate that participants’ affective reactions partially mediate the relationship
between imprecise standards and auditor liability. However, affective reactions do not subsume the effect of perceived control
and perceived audit quality, and affective reactions do not explain our results with regard to CAMs.
Third, we consider the impact of potential covariates on our results. Although we randomly assigned participants to
experimental conditions, some demographic measures vary across conditions, as can be seen in Table 1. Therefore, in
additional (untabulated) analyses, we add Age, Gender, Year, and Politics, both separately and collectively, to our primary test.
In all cases, our primary results remain qualitatively and statistically similar. Fourth, while the participants in our study were
enrolled in introductory-level accounting courses and represented a broad range of majors, just over 15 percent of the
participants indicated that they planned to pursue an accounting major. While we do not believe that at so early a stage in their
education (approximately 92 percent of participants were either freshmen or sophomores) these accounting majors would have
developed any specialized knowledge that would systematically bias their responses, it is possible that they may identify with
the auditor and be more lenient than a member of the general population would be, leading to biased decision making
(Donelson, Kadous, and McInnis 2014). Therefore, we replicate our primary analyses excluding these participants. The results
of this (untabulated) analysis remain qualitatively and statistically similar to our primary results.
Finally, although prior research indicates that the factors influencing jurors’ damage assessments are not necessarily the
same factors used in verdict assessments (Lowe et al. 2002), we believe that the expected cost of litigation is a primary concern
to practicing auditors (Pratt and Stice 1994). Therefore, we also evaluate the association between participants’ damage
assessments and both standard precision and CAM type to inform that concern. We asked participants who select a verdict in
favor of the plaintiff to assign a dollar amount in damages to be awarded to the plaintiff, from $0 to the amount of their loss,
$25 million, and label this measure Damages.18 We perform this analysis using the same specification used in Equation (1),
replacing the dependent variable Verdict with Damages. We employ a Tobit model in this case because the dependent variable
is truncated at zero for participants that find in favor of the auditor and at $25 million for participants that find in favor of the
plaintiff.
The results of this analysis are presented in Table 4. Consistent with our main results, the descriptive statistics shown in
Panel A indicate that assessed damages are lowest in the precise standards, no CAM setting. The results of the Tobit analysis
shown in Panel B indicate a significant direct effect of imprecise standards. In addition, we find a significant association
between damage assessments and the presence of either a related CAM or an unrelated CAM under precise standards. Finally,
we find that the association between CAMs and damage assessments is significantly lower under imprecise standards.
V. DISCUSSION AND CONCLUSION

In this study, we leverage similarities between the attributes of imprecise standards and CAMs to inform the debate
regarding the potential impact of CAM disclosures on auditor liability. Similar to imprecise standards, which elevate the
importance of auditor judgment and skill, we argue that when the accounting treatment meets the letter of the law under a
precise standard, related CAMs elevate jurors’ perceptions that auditors had both a causal role in and an ability to foresee an
alleged audit failure. Furthermore, under precise standards, unrelated CAMs lead jurors to question the quality of the audit and
the auditor’s intent to take the necessary actions to prevent an accounting misstatement. Consistent with the culpable control
model, we argue that these higher perceptions of causation and foreseeability and lower perceptions of the auditor’s intent to
perform a high-quality audit are associated with jurors’ increased assessments of auditor blame and liability.
The results of our experiment support this claim, and mediation analyses provide evidence that increased perceived control
in the case of a related CAM, and lower perceptions of audit quality in the case of an unrelated CAM, underlie participants’
liability judgments. Supplementary analyses indicate that our results are not only isolated to verdict assessments, but also apply
more generally to blame assessments. In addition, our results are not driven by participants’ affective reactions to CAMs,
demographic factors, or the subset of our participants who had declared an accounting major. Finally, in an exploratory
analysis, we find evidence that our results for liability assessments generalize to participants’ damage assessments.
We provide new insight into contemporaneous research, which reports mixed evidence about the effect of CAMs on
auditor liability. Brown et al. (2015) simultaneously manipulate the presence or absence of both a related and unrelated CAM,
18
Participants who found in favor of the auditor assigned $0 in damages to the plaintiff. In our analyses that investigate the effects of our manipulations
on damages, we include these participants because we are interested in investigating the expected cost of litigation.

TABLE 4
Descriptive Statistics and Tests of Differences in Damage Assessments
Panel A: Descriptive Statistics

Collapsed Across
Precise 4.176 6.902 6.013 5.746
(7.407) (8.581) (7.811) (7.979)
Imprecise 9.211 7.731 7.360 8.091
(8.852) (9.181) (9.045) (8.985)
Collapsed Across Standards 6.727 7.306 6.678
(8.503) (8.832) (8.416)
This panel presents the mean and standard deviation (shown in parentheses) of participants’ damage assessments. Damages is the dollar amount (in
millions) the participant awarded to the plaintiff.
Panel B: Tobit Regression Results

Numerator Denominator
Source of Variation df df F-stat p-value
H1 Related CAM 1 229 3.07 0.041
H2 Unrelated CAM 1 229 2.14 0.073
Imprecise 1 229 7.40 0.004
H3 Related CAM 3 Imprecise 1 229 3.02 0.042
H3 Unrelated CAM 3 Imprecise 1 229 2.89 0.045
p-values are based on one-tailed tests.
and find evidence that the presence of CAMs reduces legal liability. Brasel et al. (2016) investigate related and unrelated CAMs
separately and present evidence that the inclusion of a related CAM decreases auditor liability, although their results are
sensitive to the accounting issue underlying the misstatement. They find no significant relationship between the inclusion of an
unrelated CAM and auditor liability. Kachelmeier et al. (2014) also investigate the impact of related and unrelated CAMs
separately and present evidence that auditor liability is lower in the related CAM condition than in the unrelated CAM
condition, although neither case is statistically different from the no CAM baseline.19
These experimental settings differ from ours in that they present scenarios in which the applicable accounting standards
were clearly violated. Specifically, Brown et al. (2015) and Brasel et al. (2016) both use cases involving a fraud, and the case
used in Kachelmeier et al. (2014) clearly indicates that an accounting misstatement occurred. This difference is important in
light of Kadous and Mercer’s (2016) finding that when the client’s accounting treatment violates a precise standard, auditor
liability is greater than when the client chooses the same accounting treatment under imprecise standards. The authors
conclude that this result arises because ‘‘the lack of precision appears to make it more difficult for juries to identify whether
an auditor’s judgment was reasonable or unreasonable’’ (Kadous and Mercer 2016, 25–26). The above studies include a
description of general accounting guidance rather than an explicit accounting standard; therefore, they provide a situation
aligned with imprecise standards. However, the indication that the applicable standards were definitively violated likely
reduced the effect of standard type on jurors’ uncertainty regarding the appropriateness or inappropriateness of the auditor’s
judgments absent a CAM.20 In such cases, a related CAM may serve to emphasize the difficulty associated with the relevant
portion of the audit and reaffirm that, ex ante, compliance with the standard was difficult to establish. That is, when the
client’s accounting clearly violates an accounting standard, related CAMs have consequences similar to those of imprecise
accounting standards.
19
We thank the authors of these studies, as well as Backof et al. (2014), for providing us relevant portions of their experimental instruments or for making
them publicly available.
20
When compared to the clear fraud scenario presented in the Brown et al. (2015) and Brasel et al. (2016) cases, the less egregious restatement in the
Kachelmeier et al. (2014) case may explain its relatively weaker results.

An additional study by Backof et al. (2014) finds that the inclusion of a related CAM does not decrease auditor liability,
and presents evidence that a related CAM increases auditor liability when the observed CAM includes a description of the
procedures performed by the auditor. Backof et al.’s (2014) case is comparable to an imprecise accounting standard
environment, as it includes testimony from expert witnesses explicitly discussing the importance of judgment in the accounting
choice. Therefore, the inference that related CAMs that exclude a description of additional procedures do not increase liability
under imprecise standards is comparable with our results.21
In addition, our results provide insight into the potential impact of CAM disclosures on the effectiveness and efficiency of
audits. An increase in auditor liability specific to the accounting issue addressed in a CAM should lead auditors to increase the
amount of audit work related to that accounting issue more than they would if the litigation risk were not present and could lead
to fewer audit failures.22 In contrast, the potential for increases in auditor liability related to the presence of any CAM in the
audit report (including an unrelated CAM) should lead auditors to increase their assessed engagement risk. Therefore, auditors
will likely have to either expand auditing procedures for all aspects of the audit and consequently increase fees to compensate
for additional testing (Hogan and Wilkins 2008), or include a litigation risk premium in their fees (Choi, Kim, Liu, and Simunic
2008).23 These actions would result in over-auditing or increased audit fees, or both, at the expense of the client’s shareholders.
Our study is subject to certain limitations. First, our experiment uses university student participants to proxy for jurors. Use
of student participants is appropriate for studies, such as ours, that test theoretical relationships about general human judgment
(Donelson et al. 2014). Nonetheless, it is possible that students may make different judgments than a more diverse group of
participants would. Second, the large number of manipulation check failures indicates that our experimental manipulation was
either not salient or was not interpreted precisely as we intended. It is unlikely, but unintended interpretations of our
manipulation could cause us to draw inaccurate conclusions about support for our theory. Third, we based our manipulations on
the IAASB’s and PCAOB’s proposed auditing standards. Our theory does not rely on the precise wording of the standards, but
on their general features. To the extent that the final standard varies from the proposed one, future research should consider
whether our theory generalizes to the new standard.
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21
While the elements of these studies we discuss provide important context to our research, we note that additional factors (e.g., participant type) may
play a role in their findings. As such, our discussion of these papers is neither exhaustive nor definitive.
22
Prior studies provide evidence that greater auditor litigation risk leads to higher-quality or more conservative auditing (e.g., Dye 1993; Firth, Mo, and
Wong 2012; Gaver, Paterson, and Pacini 2012).
23
A third alternative would be not to disclose any CAMs. However, that is not likely to be a viable option since the PCAOB expects that most audit
reports will, in fact, contain CAMs (PCAOB 2013).

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APPENDIX A
Experimental Instrument—Prior-Year Audit Report with CAM Manipulation
The following is a copy of the audit report issued by Baylor & Grimble on SkyView’s most recent financial statements
prior to bankruptcy.
To the Board of Directors and Stockholders of SkyView Services:

We have audited the accompanying balance sheets of SkyView Services (the Company) as of December 31, 2011 and
2010, and the related statements of operations, stockholders’ equity, and cash flows for each of the three years in the period
ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility
is to express an opinion on these financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United
States), SkyView Services’ internal control over financial reporting as of December 31, 2011, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(the COSO criteria) and our report dated February 22, 2012 expressed an unqualified opinion.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the
Company as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in
the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
(CAM Manipulation) Significant Audit Matters

The standards of the PCAOB require that we communicate in our report significant audit matters related to the audit of the
current period’s financial statements or that we determined that there are no significant audit matters. Significant audit matters
are those matters addressed during the audit that (1) involved our most difficult, subjective, or complex judgments; (2) posed
the most difficulty to us in obtaining sufficient appropriate evidence; or (3) posed the most difficulty to us in forming our
opinion on the financial statements. The significant audit matters communicated below do not alter in any way our opinion on
the financial statements, taken as a whole.
(Related CAM)
1) The Company currently leases a substantial portion of its network and server equipment. The leases are classified as
operating leases, and the cash payments are included within rent expense. We include this item as a significant audit
matter because the classification of leases is dependent on the appropriateness and subjectivity of management
judgments and estimates. In particular, the judgments related to the useful lives and future cash payments associated
with the leases was difficult to evaluate because the assets are specific to the company and because technology is

quickly changing within the industry. The Company’s disclosures about lease recognition are included in the summary
of significant accounting policies in Note 1, as well as Note 4.
(Unrelated CAM)
1) The Company maintains an allowance for doubtful accounts for estimated losses that result from the failure of its
customers to make required payments for services previously performed. We include this item as a significant audit
matter because the estimation of the allowance for doubtful accounts is dependent on the appropriateness and
subjectivity of management judgments and estimates. In particular, the allowance was difficult to evaluate because the
calculation considers the probability of future customer payments based on past experience, taking into account
current collection trends as well as general economic factors, including customer bankruptcy rates and customer credit
risks. The Company’s disclosures about its allowance are included in the summary of significant account policies in
Note 1, as well as Note 4.
Baylor & Grimble, LLP
Dallas, Texas
February 22, 2012
APPENDIX B
Experimental Instrument—Standard Precision Manipulation
Facts Undisputed by Both Parties

1. SkyView leased numerous servers from another party to provide website hosting and other data management needs to
its customers. The servers were highly customized for the unique needs of SkyView. All of the lease agreements related
to the servers were recorded in SkyView’s financial statements as operating leases and the company recorded no long-
term liabilities related to these leases. Furthermore, the servers represented a significant portion of the company’s
operating assets that were used in its daily operations.
2. Expert witnesses testify that accounting standards for leases address how leases should be reflected in the company’s
financial statements. The applicable accounting standard states that there are two classifications for leases: capital and
operating. The determination of the lease as operating or capital is based on the criteria below:
(a) (Precise) Whether the lessor transfers ownership of the asset to the lessee at the end of the lease term.
(Imprecise) Whether the lease transfers ownership of the asset to the lessee by the end of the lease term.
(b) (Precise) Whether a bargain purchase option is given to the lessee. This is an option that allows the lessee, upon
termination of the lease, to purchase the leased asset at a price significantly lower than the expected fair market
value of the asset.
(Imprecise) Whether the lessee has the option to purchase the asset at a price which is expected to be sufficiently
lower than fair value at the date the option becomes exercisable and that, at the inception of the lease, it is
reasonably certain that the option will be exercised.
(c) (Precise) Whether the life of the lease is equal to or greater than 75 percent of the useful life of the asset.
(Imprecise) Whether the lease term is for the major part of the useful life of the asset, even if title is not transferred.
(d) (Precise) Whether the present value of the minimum lease payments is equal to or greater than 90 percent of the fair
market value of leased property.
(Imprecise) Whether at the inception of the lease, the present value of the minimum lease payments amounts to at
least substantially all of the fair value of the leased asset.
If the lease meets any of the criteria above, it is treated as a capital lease. The related asset and liability are recorded on the
company’s financial statements, as if the company financed the purchase of the asset. However, if the lease does not meet any
of the criteria above, it is treated as an operating lease. No asset or liability is recognized in the company’s financial statements.
3. SkyView’s CFO testifies that the company recognized the leases for its network and server equipment as operating.
SkyView estimated that the useful life of its server equipment was 10 years and that lease term was 7 years, thus only
covering 70 percent of the asset’s useful life.
4. The auditor from Baylor & Grimble who was in charge of the SkyView audit testifies that he was aware of SkyView’s
lease recognition policies.

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THE ACCOUNTING REVIEW American Accounting Association

Vol. 91, No. 6 DOI: 10.2308/accr-51382

The Effects of Critical Audit Matter Paragraphs and

The Accounting Review

II. BACKGROUND AND HYPOTHESES DEVELOPMENT

Blame Attribution and the Culpable Control Model

The Accounting Review

Standard Precision, CAMs, and Auditor Liability

The Accounting Review

III. EXPERIMENTAL METHODOLOGY

Experimental Materials and Procedures

The Accounting Review

Dependent and Mediating Variables

The Accounting Review

The Accounting Review

The Accounting Review

Panel A: Proportion of Verdicts Against the Auditor

Panel B: Logistic Regression Results

The Accounting Review

The Accounting Review

The Accounting Review

Panel A: Descriptive Statistics

Panel B: Quartile Regression Results

Panel C: Fisher Exact Tests for Difference in Medians

The Accounting Review

V. DISCUSSION AND CONCLUSION

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Panel A: Descriptive Statistics

Panel B: Tobit Regression Results

The Accounting Review

The Accounting Review

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To the Board of Directors and Stockholders of SkyView Services:

(CAM Manipulation) Significant Audit Matters

The Accounting Review

Facts Undisputed by Both Parties

The Accounting Review

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