The Full Report
Changes to Existing Reporting Standards
Auditor's reports will now have to state that the auditor is required to be independent, disclose the year the auditor began serving consecutively as the company's auditor, specify the addressees of the report, and contain the phrase "whether due to error or fraud" when describing the auditor's responsibility to obtain reasonable assurances about whether the financial statements are free of material misstatements.5
In addition to those more technical changes, beginning in 2019 for the largest public companies, the new standard will require auditors to identify and disclose "critical audit matters." Currently, the auditor's report provides assurance that the financial records and statements of a company fairly present the company's financial position in all material respects. The new standard retains the binary pass/fail designation of the report, but requires the auditor to communicate any CAMs identified during the course of the audit. If no CAMs are uncovered, the auditor must so state.
To qualify as a CAM, a matter must meet the following three requirements:
- It must be voluntarily communicated to the audit committee or required to be communicated to the audit committee pursuant to AS 1301, Communications with Audit Committees6
- It must relate to accounts or disclosures that are material to the financial statements (though the matter itself need not be material)7
- It must involve "especially challenging, subjective, or complex auditor judgment."8
The PCAOB highlighted the following non-exhaustive list of factors auditors should consider when evaluating whether a matter constitutes a CAM under prong (3) above:
- The auditor's assessment of the risks of material misstatement, including significant risks
- The degree of auditor subjectivity in determining or applying audit procedures to address the matter or in evaluating the results of those procedures
- The nature and extent of audit effort required to address the matter
- The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty
- The nature and timing of significant unusual transactions and the extent of auditor effort and judgment related to these transactions
- The nature of audit evidence obtained regarding the matter.9
If the auditor determines the existence of a CAM, the auditor must disclose both the principal considerations that prompted the auditor to determine that the matter was a CAM and how the auditor addressed the CAM in the audit report (with references to the relevant financial statements or disclosures).10 The release provides a useful flow chart summarizing the process for determining and communicating CAMs.11
The new standard would bring U.S. practices closer to the standards already implemented abroad.12 If greenlit by the SEC, it would be the first major change to the standard form auditor's report in more than 70 years.13
Full implementation of the new standard will take time. First, as mentioned, the standard is subject to review by the SEC, and swift approval may not be forthcoming given that the Trump administration remains vocal in its opposition to many new regulations.14 Even if the SEC approves the standard as is, the PCAOB adopted a phased approach for the new requirements as noted above.
Potential Negative Implications for Transparency, Liability and Efficiency
The PCAOB's chairman lauded the new standard as "giv[ing] investors the information they've been asking for from auditors,"15 but commenters have suggested the CAM disclosure requirements could have the opposite effect. In their view, the new standard may inadvertently impair full and frank discussion between management and audit committees, particularly when applied to voluntary communications, because disclosure of such communications could increase the potential liability for issuers and auditors or subject sensitive company information to public scrutiny. As the PCAOB acknowledged, statements about CAMs could provide the basis for legal claims,16 leading to increased litigation costs and audit fees.
Several commenters questioned the efficacy of the CAM disclosure requirements on other grounds as well. If CAM disclosures in auditor's reports devolve into redundant or boilerplate disclosures, a concern which the PCAOB itself has raised,17 their usefulness to investors will be minimal, and in fact they may result in obfuscation rather than increased clarity. Additionally, despite the PCAOB's claim that the heightened requirements will "give investors the information they've been asking for," investors already have access to much of what will be covered by CAM disclosures through existing regulations requiring the disclosure of companies' critical accounting policies.
The PCAOB also acknowledged other potential drawbacks - for example, that the new standard could bring additional one-time and recurring costs relating to additional audit procedures, time to prepare and review auditor's reports and legal review. Reviewing for CAMs could also delay completion of audits, especially given the uncertainty surrounding exactly what types of matters rise to the level of a CAM.18
Although the PCAOB determined that, after revising the proposal in response to commenters' suggestions, the benefits of the new standard outweigh the costs, it remains to be seen whether issuers, auditors and investors (or the SEC, for that matter) will feel the same way.
1) See PCAOB, Release No. 2017-001, The Auditor's Report on an Audit of Financial Statements when the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. A fact sheet summarizing the Release can be found here. See also Press Release, PCAOB, PCAOB Adopts New Standard to Enhance the Relevance and Usefulness of the Auditor's Report with Additional Information for Investors (June 1, 2017).
2) The new standard will replace portions of AS 3101, Reports on Audited Financial Statements. The remaining portions of AS 3101 will be redesignated as AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances.
3) Press Release, PCAOB, PCAOB Adopts New Standard to Enhance the Relevance and Usefulness of the Auditor's Report with Additional Information for Investors (June 1, 2017).
4) For the definition of "large accelerated filer", see 17 CFR 240.12b-2.
5) Id. at 12–13.
6) PCAOB Release No. 2017-001, at 11, 17. A copy of AS 1301 can be found here.
7) PCAOB Release No. 2017-001, at 11, 19.
8) Id. at 11, 22.
9) Id. at 11–12.
10) Id. at 29.
11) Id. at 14.
12) See id. at 10–11, 26–27 (discussing the similarities between the PCAOB standard and the requirements already implemented by the International Auditing and Assurance Standards Board, the European Union, and the Financial Reporting Council). A white paper looking into the first year of expanded auditor reporting in the UK prepared by PCAOB staff to inform its seven-year quest for change in the U.S. can be found here.
13) James R. Doty, Chairman, PCAOB, Statement on Adoption of Auditing Standard on the Auditor's Report (June 1, 2017).
14) See Michael Rapoport, Coming Soon: What Auditors Really Think About Company Numbers, Wall Street Journal (June 1, 2017).
15) Press Release, PCAOB, PCAOB Adopts New Standard to Enhance the Relevance and Usefulness of the Auditor's Report with Additional Information for Investors (June 1, 2017) (quoting PCAOB Chairman James R. Doty).
16) PCAOB Release No. 2017-001, at 40.
17) See Lewis H. Ferguson, Board Member, PCAOB, Statement on Adoption of an Auditing Standard on the Auditor's Report (June 1, 2017) ("One of the concerns we have had in adopting the CAM approach is whether the CAMs will quickly deteriorate into boilerplate disclosures that are repeated year after year and shortly provide no additional useful information to financial statement users. There will be an inevitable attempt, particularly on the part of large audit firms with many public company clients, to achieve some, and perhaps a very high degree of uniformity in the disclosure of the CAMs.").
18) For example, see the PCAOB's commentary on the finer points of the CAM determination: "The determination of critical audit matters is principles-based and the final standard does not specify any items that would always constitute critical audit matters. For example, the standard does not provide that all matters determined to be 'significant risks' under PCAOB standards would be critical audit matters. Some significant risks may be determined to be critical audit matters, but not every significant risk would involve especially challenging, subjective, or complex auditor judgment. To illustrate, improper revenue recognition is a presumed fraud risk and all fraud risks are significant risks; however, if a matter related to revenue recognition does not involve especially challenging, subjective, or complex auditor judgment, it will not be a critical audit matter. Similarly, the final standard does not provide, as some commenters suggested, that material related party transactions or matters involving the application of significant judgment or estimation by management always constitute critical audit matters. The auditor must determine, in the context of the specific audit, that a matter involved especially challenging, subjective, or complex auditor judgment." PCAOB Release No. 2017-001, at 22 (internal citations omitted).