ABSTRACT We provide evidence that regulatory guidance aimed at improving audit efficiency and effectiveness—allowing auditor reliance on a multi‐location client's competent and objective internal audit function (IAF)—can unintentionally increase auditors' litigation risk. Our research is important in demonstrating how client characteristics and juror cognitive processing, such as the number of client locations and jurors' susceptibility to the numerosity heuristic, factors beyond auditors' control, can exacerbate their litigation exposure. Consistent with theoretical predictions, we find that susceptibility to the numerosity heuristic contributes to jurors assessing an increased likelihood of misstatement on multi‐location compared to single‐location audits. Furthermore, these assessments of higher misstatement risk on multi‐location audits lead jurors to perceive that auditor reliance on the client's IAF in multi‐location audits is less appropriate (i.e., not normal). Accordingly, jurors judge that auditors are more negligent when they rely on the IAF during multi‐location audits than when they do not, but IAF reliance does not impact auditor negligence on single‐location audits. Our results suggest auditor reluctance to use a qualified IAF, despite client pressure and regulatory allowance, can provide potential benefits to firms in terms of reduced litigation exposure. Thus, we demonstrate the legal regime can undermine the objectives of regulators' guidance to enhance audit efficiency and corporate governance.

ABSTRACT We investigate the joint effects of auditors' reporting choice and audit committee effectiveness on management disclosures about complex estimates. A new PCAOB standard requires auditors to report on Critical Audit Matters (CAMs): issues “communicated or required to be communicated to the audit committee” about accounts or disclosures that (1) “are material to the financial statements,” and (2) “involved especially challenging, subjective, or complex auditor judgment” (PCAOB 2017a, 11). Consistent with investor arguments, we find that audit committee effectiveness and more detailed CAM reporting encourage managers' disclosures of the risk underlying complex estimates. When the auditor's report is more informative about a complex estimate and the audit committee is more effective, management's related financial disclosures are more forthcoming. However, less informative auditor disclosures or more effective audit committees alone do not prompt greater management disclosure. Thus, expanded auditor reporting and more effective audit committees, together, can enhance the disclosures investors value.