On June 1, the U.S. Public Company Accounting Oversight Board adopted a new auditing standard that will require auditor’s reports filed with the Securities and Exchange Commission to include a discussion of critical audit matters (CAMs) that arose during the audit. Auditor reports will also be required to include the year in which the auditor began serving as the company’s auditor. While the traditional pass-fail auditor’s opinion will also be retained, the addition of CAM reporting will fundamentally change the auditor’s report from a standardized document, with little variation across clients, to an individually-tailored report highlighting the most challenging aspects of each specific audit.

Under the new standard, a CAM is defined as matter that the auditor communicated, or was required to communicate, to the company’s audit committee; that relates to accounts or disclosures that are material to the financial statements; and that involved an especially challenging, subjective, or complex auditor judgment. The auditor’s opinion must identify each CAM, describe why it is a CAM and how it was addressed in the audit, and refer to the relevant financial statement accounts or disclosures. CAMs will often correspond to the most judgmental aspects of the company’s financial reporting.

This change in the auditor’s role will be revolutionary for public companies that file reports with the SEC in the United States. However, regulators outside the U.S. have already expanded auditor reporting beyond the traditional boilerplate. The International Standards on Auditing require the auditor to communicate “key audit matters”, defined as matters that, in the auditor’s professional judgment, were of the most significance in the audit of the financial statements. The European Union has adopted legislation requiring listed company auditors to include in their reports a description of the most significant risks of material misstatement and a summary of the auditor’s response to those risks. CAM reporting will bring the U.S. more into line with these requirements.

The requirement that the auditor’s report include the year in which the auditor began serving as the company’s auditor is an off-shoot of the PCAOB’s consideration of mandatory limits on auditor tenure. While the Board has apparently dropped the idea of requiring auditor rotation, disclosure of the number of consecutive years that the auditor has served will highlight instances of lengthy tenure (some U.S. companies have used the same audit firm for upwards of a century). Disclosure may encourage companies to consider periodically changing auditors.

If the SEC approves the new PCAOB standards, auditor tenure disclosure will take effect for audits of fiscal years ending on or after December 15, 2017. For the largest public companies – large accelerated filers – CAM reporting will begin for audits of fiscal years ending on or after June 30, 2019. For other public companies, CAM reporting will start with audits for fiscal years ending on or after December 15, 2020.

Public companies that file audited financial statements with the SEC may want to consider several issues as a result of the PCAOB new auditor reporting model:

  • Communicate carefully. Since audit committee discussion of a matter with the auditor could trigger CAM analysis, auditors and audit committees should be thoughtful as to new issues raised and the nature and scope of discussion.
  • Avoid surprises. Audit committees and managements will need to develop a protocol with their audit engagement partner so that they learn, as far in advance of the issuance of the audit opinion as possible, the issues that the auditor intends to disclose as CAMs. It will also be important to know what the auditor intends to say regarding the CAMs and how the auditor’s statements will compare to management’s disclosures.
  • Review disclosure. There is a potential for the auditor’s CAM disclosure to be the source of new information. If the auditor is going to discuss a matter in the audit report, the company should make sure that it has made its own disclosures regarding the issue. Insofar as possible, management, not the auditor, should control disclosure about the company and its financial reporting.
  • Monitor comparability. Investors are likely to expect companies in the same industry to have generally similar auditing challenges. Management should monitor the audit opinions of its competitors. If those reports present different, or fewer, CAMs than those identified by the company’s auditor, management and the audit committee may wish to explore the reasons for the differences and whether those differences suggest the need to strengthen the company’s financial reporting.
  • Justify tenure. Because of the auditor tenure disclosure requirement, audit committees with long-serving auditors should be prepared to explain to shareholders what their philosophy is with respect to auditor rotation and the nature of their evaluation and decision-making process concerning whether to seek proposals from other audit firms.