The impact of critical audit matters on market behaviour: analysing reactions from corporate managers, short-sellers, and social media

Motivated by the recent changes in auditing regulations and the addition of Critical Audit Matters (CAMs) in the audit report, this thesis aims to investigate the impact of CAM disclosure on three groups of users during the first year of the new audit report mandates. Specifically, the thesis examines the reaction of corporate managers as internal users and short-sellers as sophisticated investors through utilising a difference-in-difference research design, and the Twitter investment community as the wider public by focusing on the relevance of CAMs to Twitter users through both textual and regression analyses.

The three user groups have been chosen based on a careful examination of the standard-setter’s communication as well existing literature to identify gaps in existing knowledge, and to contribute to our understanding of the new auditing CAM regulations. In addition to examining the effect of changes in auditing regulations on the three user groups, the thesis also investigates whether the type, topic and number of CAMs are associated with a significant reaction by the users. To begin with, the Public Company Accounting Oversight Board (PCAOB) acknowledges that the changes in auditing regulations are expected to result in changes to management disclosure behaviour as well even though the new disclosures in the audit report are targeted mainly at investors. Recent literature investigating the reaction of management by studying disclosure behaviour suggests that CAMs are associated with significant changes to both financial and non-financial disclosures. Moreover, recent archival literature suggests that CAMs do not offer much in the way of incremental information, as evidenced by insignificant market reactions. Alternatively, experimental research offers a different inference, where it shows that investors with different levels of sophistication, resources and experience react differently to CAM disclosures. This is consistent with literature suggesting that different investors interpret information in the market differently.

Taking this into account, the thesis presents an overview of the institutional background of the development of the auditing regulations for the three standard setters in Chapter Two, namely the FRC in the U.K., the IAASB and the PCAOB. The Chapter shows the similarities in the approaches taken by the three standard setters, and also shows the differences in the implementation of the relevant standards. The thesis also provides a critical review of the relevant literature in Chapter Three to highlight the rationales behind the mixed results, particularly when investigating the reactions of equity investors, and to underscore the strands of literature the empirical studies will be expanding upon.

The thesis contributes to the debate on the usefulness of CAMs by investigating the reaction of (i) corporate managers in Chapter Five, (ii) short-sellers in Chapter Six, and (iii) Twitter users in Chapter Seven. Drawing from the accounting theory of disclosure, as well as recent relevant literature, the first empirical study investigates how CAM disclosures impact the textual properties, such as length, complexity and tone of item 7 of the 10-K report, the Management Discussion & Analysis (MD&A). The overall results show that while there are significant changes to the textual properties of the MD&A sections of the first group of CAM adopters after implementing the new auditing regulations, these changes cannot be attributable to CAMs. The results are persistent for alternative measures of the textual properties. The results of additional tests provide evidence that the type, topic and number of CAMs are associated with changes in the MD&A textual properties, which is consistent with prior literature that suggests that auditors influence the textual properties of the MD&A text (De Franco et al., 2020).

The second empirical Chapter uses a sample of 3,698 firm-year observations and employs a difference-in-differences research design to investigate if short-sellers, arguably the most sophisticated group of investors in terms of obtaining, processing and reacting to information, react to CAM disclosures. The theoretical rationale of this study is based on the line of literature arguing that investors with different levels of experience, knowledge and education react differently if provided with the same information. Consistent with prior literature, the results show no significant relationship between short-seller interest and CAMs. These results are robust for alternative measures of short-interest. Additional tests do not find evidence that suggests that short-sellers react to the type of CAMs, or the number of CAMs disclosed. There is, however, evidence to suggest that short-sellers may be interested in firms that receive specific CAM topics.

Finally, and following the rationale that users with different levels of sophistication interpret information differently, the third empirical Chapter investigates the discourse on CAMs within the online investing community by using Twitter as a novel research setting due to its popularity within the investing community. Through the Twitter API, 824,916 Tweets discussing 1,870 public U.S. firms within a one-month window before and after the release of their 10-K filings are mined and scraped. Textual analysis methods are used to identify tweets that discuss the same topics as the CAMs received by the firms they mention. The results show that only 1,905 tweets, representing 442 firms, are relevant to the CAM topic of the firms they mention. Overall, the results find little evidence to support the notion that CAMs are new information, implying that what auditors consider “critical” may not always be of interest to Twitter users. Overall, the results of the empirical studies should be informative for auditors and auditing standard setters.