Legal liability and auditor reporting behavior: evidence from critical audit matters

This study examines how auditors adjust critical audit matter (CAM) reporting in response to expected legal exposure, which is characterised by the joint effect of state-level auditor liability regimes and client-specific litigation risk. CAMs aim to improve transparency by revealing issues related to significant accounts, particularly those involving complex or subjective judgments. Utilising the disparity in U.S. state liability standards – from limited privity to extensive reasonable foreseeability – and incorporating established client-specific litigation risk measures, we evaluate auditor disclosure results, encompassing the number of CAMs, readability, procedural detail, and coverage of restatement-related or contingent issues. Our findings show that auditors produce more detailed, readable, and informative CAMs when both legal stringency and client-specific litigation risk are high; however, neither factor alone consistently predicts the disclosure quality. Robustness checks using alternative measures of liability regimes, litigation risk, and including auditor characteristics confirm our results. This study contributes to the literature by highlighting that the refinement of legal standards could encourage more comprehensive CAM disclosures and enhance the informational value of audit reports.