Last week, after five years of outreach, the PCAOB once again attempted to make the auditor’s report more relevant and informative to investors by reproposing the auditor reporting standard, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and related amendments. Typically, as you know, auditors just give companies a pass/fail grade and provide no description of any issues or problems that occurred during the audit process; those problems are instead taken up with the audit committee. However, PCAOB Chair Jim Doty commented, “in today’s complex economy, and particularly in light of lessons learned after the financial crisis, investors want a better understanding of the judgments that go into an opinion – not a recitation of the standard procedures that apply to any audit, but the specific judgments that were most critical to the auditor in arriving at the opinion.” While the reproposal would retain the standard pass/fail model, it would also provide for the inclusion in the auditor’s report of “critical audit matters” and new elements related to auditor independence and auditor tenure. According to the proposing release, the communication of critical audit matters “would inform investors and other financial statement users of matters arising from the audit that required especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters.” Here is the press release and a fact sheet.
As you may recall, the PCAOB originally proposed the disclosure of critical audit matters (CAMs) in 2013 (see this Cooley news brief) to substantial controversy. Supporters of the concept at that time contended that the current form of the audit report was just boilerplate that “tells investors little of substance about a company’s true condition.” As former PCAOB member commented in a BusinessWeek article at that time, “[t]he concern coming out of the financial crisis was that auditors had more information into judgment calls and business risks than they conveyed in their opinion… Some insight from the auditor about what the challenging part of the audit was and what the risks are would provide some additional insight. The question is, at what cost.” The PCAOB had tried to address this concern in its 2011 Concept Release by floating various alternatives, principle among them the “auditor’s discussion and analysis.” (See this Cooley news brief.) But the ADA concept was widely criticized because, among other things, it was viewed as “fundamentally changing the auditor’s current role from attesting on information prepared by management to providing an analysis of financial statement information,” thus causing the auditors to step into a role of management. As PCAOB member Steven Harris explained in 2013, the “challenge of this project is to find a way to balance the need for a different, more useful and communicative, model of the auditor’s report with the need not to change what auditors do, but to change how they report on what they do.” Initial reactions by some large audit firms at the time to the PCAOB’s proposal were surprisingly positive. (However, that may well have been because of what the PCAOB didn’t propose as opposed to what it did. The absence from the proposal of the controversial ADA must certainly have allowed audit firms to breathe a sigh of relief. But it wasn’t a full-blown exhale.)
Although there was general support for the objective of the project, the critics – primarily smaller accounting firms, accountant associations, companies and audit committee members – were not silent about the PCAOB’s proposal to achieve it. These critics argued that CAMs “would not provide relevant information to investors, may be duplicative of the company’s disclosure, may result in disclosing information not otherwise required to be disclosed, could increase cost, or could delay completion of the audit.” In addition, critics pointed out that, notwithstanding the PCAOB’s efforts to avoid changing the auditor’s current attestation role, the proposal could still have required the auditors to provide subjective analysis: as one commentator observed in this Law360 article, the proposal put auditors in the position “where they are essentially editorializing on the contents of a company’s reports,” which could well alter the client relationship and “raises key questions about who is responsible for revealing internal company information. ‘The traditional view is – that in a company’s filing, it is the company that speaks. Not the auditor, not the company’s lawyer,’” the commentator added. Similarly, as reported in this AccountingWeb article, another issue was whether the proposal properly allocated “the burden of transparent reporting onto the auditor rather than management. ‘We need to look at how to make the auditor’s report more useful to investors without taking the burden of financial reporting away from management and putting it on auditors….In theory, it sounds like a great idea for investors, but in practicality, we have to make sure the process is managed so that companies retain responsibility for communication about their financial results and that auditors remain objective about that information.’”
Another concern raised was that the proposal could cause tension between auditors and their clients: according to another commentator in Law360, “It creates tension in the relationship between the auditor and the audit client. It puts pressure on the auditor to say more things, some of them subjective.…” Further, the standard was criticized for giving “new ammunition to enterprising plaintiffs’ attorneys.” Allowing a third party to make public “questions arising during the audit process could increase the chance that an enterprising plaintiffs[’] attorney or regulator could take a second look at that information, and potentially file a lawsuit.’ The risk is by having the immediate disclosure, you open yourself up to immediate second-guessing,’ ” according to another commentator cited in Law360. The WSJ reported that the U.S. Chamber of Commerce saw the PCAOB’s proposal as “a fundamental change that can harm both businesses and investors alike, and may drive up liability for management and auditors,” according to a Chamber representative. And, as reported in CFO.com, companies “are concerned about potential increases in cost from having more disclosure under the new proposal.”
According to Doty, “the new proposal envisions that auditors describe their critical audit judgments. It does not put them in the position of speaking for management.” As described in the release, the reproposed standard “is intended to respond to investor requests for additional information about the financial statement audit by increasing the relevance and usefulness of the auditor’s report, without imposing requirements beyond the auditor’s expertise or mandate.” The reproposal attempts to address the comments received, providing “a refined description” of CAMs, which “would be determined using a principles-based framework leveraging the work already performed by the auditor under existing PCAOB standards.”
What modifications to the concept of “CAMs” does the reproposal offer? Notably, the reproposal would:
- Limit the source of potential CAMs to matters communicated to the audit committee – even if not required – or required to be communicated – even if not actually communicated (as opposed to just “addressed during the audit”)
- Add a materiality component to the definition of CAM – they must relate to accounts or disclosures that are material to the financial statements, such as the auditor’s evaluation of the company’s goodwill impairment assessment – an element of “goodwill” account – or the auditor’ s evaluation of the company’ s ability to continue as a going concern, which has a pervasive effect
- Narrow the definition to only those matters that involved “especially challenging, subjective or complex auditor judgment”
- Reduce the related documentation requirement consistent with the definition
- Expand the communication requirement so that the auditor describes how the CAM was addressed in the audit
Significantly, the reproposal also excludes the provision that was in the prior proposal for a new auditing standard regarding the auditor’ s responsibilities for other information outside the financial statements.
CAMs. More specifically, the reproposal would require communication in the auditor’s report of any CAMs arising from the audit of the current period’s financial statements (or state that there were no CAMs):
- Definition: “CAM” would be defined as “any matter that was communicated or required to be communicated to the audit committee and that:
- Relates to accounts or disclosures that are material to the financial statements, and
- Involved especially challenging, subjective, or complex auditor judgment.”
- Factors in determining CAMs: Not all significant risks are necessarily CAMs because they may not involve especially challenging, subjective or complex auditor judgment. Once the auditor identifies a matter communicated or required to be communicated to the audit committee that relates to material accounts or disclosures, the auditor would take into account a nonexclusive list of factors in determining whether a matter involved especially challenging, subjective, or complex auditor judgment, including the following:
- “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, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding 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 audit effort and judgment related to these transactions; and
- The nature of audit evidence obtained regarding the matter.”
Depending on the matter, the auditor’s determination might be based on only one factor or a combination of these or other factors. Two factors from the 2013 proposal that received substantial criticism were not included in the reproposal: the severity of relevant control deficiencies and the nature and significance of corrected and uncorrected misstatements.
- Communication in the auditor’s report: Under the caption “Critical Audit Matters,” and following specific explanatory language (which expressly states that the auditor is not providing a separate opinion on the CAMs or on the related accounts or disclosures), the auditor would identify the CAM, describe the principal considerations that led the auditor to determine that the matter is a CAM, describe how it was addressed in the audit, and refer to the relevant financial statement accounts and disclosures.
In describing how the CAM was addressed, the auditor could describe: “(1) the auditor’s response or approach that was most relevant to the matter; (2) a brief overview of procedures performed; (3) an indication of the outcome of the auditor’s procedures; and (4) key observations with respect to the matter, or some combination of these elements.” If there are no CAMs (considered to be a rather unlikely event), the auditor would state that in the auditor’s report. Language that could be viewed as disclaiming or qualifying the auditor’s responsibility for CAMs or the auditor’s opinion on the financial statements is not permitted. To help readers, the release suggests limiting the use of highly technical accounting and auditing terms.
To the concern that communication of CAMs would “undermine the role of the audit committee or management by requiring the auditor to disclose information about the company’s financial statements that would typically be management’s responsibility to disclose,” the release contends that the communication “should not diminish the governance role of the audit committee and management’s responsibility for the company’s disclosure of financial information,” since “the auditor would be communicating information regarding the audit rather than information directly about the company and its financial statements.” To address concerns regarding potential disclosure of confidential information, the reproposal adds a note indicating that, when describing CAMs in the auditor’s report, the auditor “is not expected to provide information about the company that has not been made publicly available by the company unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit.”
- Documentation — the auditor would document the basis for its determination of whether each matter that both: (1) was communicated or required to be communicated to the audit committee; and (2) relates to accounts or disclosures that are material to the financial statements, involved especially challenging, subjective, or complex auditor judgment.
The PCAOB believes that CAMs are likely to be identified in areas that investors have indicated would be of particular interest to them. These include:
- significant management estimates and judgments made in preparing the financial statements;
- areas of high financial statement and audit risk;
- unusual transactions, restatements, and other significant changes in the financial statements; and
- the quality, not just the acceptability, of the company’s accounting practices and policies; however, the release notes, “communication of auditor’s assessments of the quality of a company’s accounting practices and policies, while not precluded, is not required under the reproposal because there is no framework for such assessments and the determinations are inherently subjective.”
With regard to concerns expressed related to liability considerations, such as the possibility that plaintiffs may attempt to use CAMs as de facto admissions of uncertainty or even error, or that plaintiffs may attempt to use CAMs as a “road map” for litigation against the company, the release notes various suggestions made to reduce the potential liability exposure and indicates that reproposal takes many of these suggestions into account.
SideBar: The proposing release provides the following illustration of CAM reporting:
“Critical Audit Matter
“The critical audit matter communicated below is a matter arising from the current period audit that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. Critical audit matters do not alter in any way our opinion on the financial statements, taken as a whole, and we do not provide separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
“Accounting for Acquisitions
Refer to Notes 2 and 13 to the financial statements
“The Company’s strategy includes growth by acquisition. Acquisitions represent a significant component of the Company’s sales growth through the addition of new customers and new products. During 2015 the Company completed eight acquisitions for net consideration of $2.1 billion. The most significant of these were (1) the acquisition of all outstanding equity of ABC Inc. for net consideration of $1.1 billion and (2) the acquisition of all outstanding equity of XYZ Corp. for net consideration of $0.5 billion.
“Auditing the accounting for the Company’s 2015 acquisitions involved a high degree of subjectivity in evaluating management’s estimates, such as the recognition of the fair value of assets acquired and liabilities assumed. We planned and performed the following procedures in connection with forming our overall opinion on the financial statements. We tested controls over the accounting for acquisitions, such as controls over the recognition and measurement of assets acquired, liabilities assumed, and consideration paid and payable, including contingent consideration. For each of the acquisitions, we read the purchase agreements, evaluated the significant assumptions and methods used in developing the fair value estimates, and tested the recognition of (1) the assets acquired and liabilities assumed at fair value; (2) the identifiable acquired intangible assets at fair value; and (3) goodwill measured as a residual.
“More specifically, for the acquisitions of ABC and XYZ, we assessed whether (1) intangible assets, such as acquired technology, customer lists, and noncompetition agreements, were properly identified, and (2) the significant assumptions, including discount rates, estimated useful lives, revenue growth rates, projected profit margins, and the expected rate of return, used in valuing these intangibles were reasonable. Specifically, when assessing the assumptions related to the revenue growth rate and projected profit margins, we evaluated whether the assumptions used were reasonable considering the past performance of ABC and XYZ and the Company’s history related to similar acquisitions and considered whether they were consistent with evidence obtained in other areas of the audit, such as assumptions used by the Company in its budget.
“The purchase consideration for the acquisitions of ABC and XYZ also reflected, in part, the estimated fair value of significant contingent consideration arrangements based on attainment of product development milestones and patent approvals. In testing the valuation of contingent consideration, we assessed the terms of the arrangements and the conditions that must be met for the arrangements to become payable. Finally, we evaluated management’s classification of contingent payments to continuing employees as either contingent consideration in the business combination or employee compensation.”
Other changes. In addition, the reproposal would, among other things, make the following other changes to the auditor’s report:
- Clarifications of existing auditor responsibilities: the auditor would add standardized language in the auditor’s report, including a statement about the requirement for the auditor to be independent, as well as the phrase “whether due to error or fraud,” when describing the auditor’s responsibilities to obtain reasonable assurance about whether the financial statements are free of material misstatements. The report would also be addressed to the company’s shareholders and board of directors.
- Tenure: the auditor would add a statement regarding the duration of its engagement by the company as its auditor.
- Standardized form of the auditor’s report: the opinion would be required to be the first section of the auditor’s report and include section titles to guide the reader.