• The Cost of Disclosure: Audit Fees and Liability Claims May Be on the Rise

    The Cost of Disclosure: Audit Fees and Liability Claims May Be on the Rise

    The Public Company Accounting Oversight Board (PCAOB) has solicited public comments on a new proposed auditing standard that would provide previously undisclosed information to financial statement users regarding the audit and the auditor’s determinations.

    Analysis Group Principal Elizabeth Eccher spoke with academic affiliate and accounting expert Douglas Skinner about how this standard could potentially affect disclosure issues in litigation.

    Could this standard offer potential benefits to users of financial statements?

    Yes, the standard would provide additional information to financial statement users, including the identification and discussion of critical audit matters (CAMs) as determined by the auditor, and would retain the pass/fail model in the existing auditor’s report.

    The PCAOB believes that communicating CAMs will make the auditor’s report more relevant and useful. Because CAMs often require difficult, subjective, or complex auditor judgments, this type of information would likely enhance investors’ reliance on the ultimate pass/fail opinion issued by the auditor. Theoretical work in economics shows, generally, that increased disclosure of relevant information reduces information asymmetries in capital markets and can result in improvements in market liquidity and improved pricing, including a lower cost of capital. These benefits accrue to both investors and firms.

    Auditors already collect CAM information. Would you anticipate additional costs as a result of the new standard?

    I would. Because the proposed CAM disclosures could result in additional disclosure about companies beyond what is currently required in SEC filings, the rule could impose additional disclosure costs on companies and auditors. These costs, including potential litigation costs, are difficult to quantify but could be very significant. Academic research shows that expected litigation costs are a big driver of audit fees. By expanding the auditors’ role and disclosures, we are likely to see increases in both the extent to which auditors are held liable for client firm problems and the magnitude of the associated damages claims. It’s hard to imagine a world in which audit fees will not increase if these proposals go forward.

  • “It’s hard to imagine a world in which audit fees will not increase if these proposals go forward.”

    — Professor Douglas Skinner

  • Are there other potential consequences?

    By requiring auditors to report CAMs, the audit report could become a disclosure mechanism in its own right, giving rise to proprietary costs. These are the costs of additional disclosures that provide important competitive information about the firm’s operations and strategies to competitors, suppliers, customers, or other entities with which it conducts business.

    Research on the “real effects” of disclosures suggests that mandated disclosures can affect the actions taken by the affected parties. Will that be the case?

    Yes. The implication of “real effects” is straightforward: once auditors and client firm personnel know that the auditors will be reporting additional, detailed information about the CAMs and how auditors have addressed those matters, it will likely change their incentives going into the audit. Managers may be less open and forthcoming in providing information to the auditor, and may even change how they make certain operating and financing decisions. Precisely how the actions of firms and auditors will change under the new requirements is difficult to predict ex ante and is likely to vary across firms, particularly if there is uncertainty and lack of clarity about the definition of CAMs. ■ 

    Douglas J. Skinner is the Eric J. Gleacher Distinguished Service Professor of Accounting at the University of Chicago Booth School of Business. He was invited to present remarks on these proposed changes at a PCAOB public meeting in April 2014 in Washington, D.C.; his written comments are available here. Elizabeth Eccher is a principal in Analysis Group’s Chicago office.