Recently, the Public Company Accounting Oversight Board (“Board”) adopted Auditing Standard No. 3101, which will require the auditor to provide significant additional information about the audit to make the auditor's report more informative and relevant to financial statement users. The final standard retains the original pass/fail opinion of the auditor's report, but mandates the addition of the communication of critical audit matters ("CAMs"), and other improvements to clarify the auditor's role and responsibilities to make the auditor's report easier to read.
The Board is adopting these final standards after more than six years of outreach and public comment from members of the Board's Standing Advisory Group and Investor Advisory Group. The Board hopes that adopting these new standards will enhance the communication between auditors and investors, and investors and management, without imposing requirements beyond the auditor's expertise or mandate. The new requirements are intended to aid in protecting investors' interests, and will further the public interest in the preparation of informative audit reports.
Auditing standards have undergone change internationally, as well. The International Auditing and Assurance Standards Board, the European Union, and the Financial Reporting Council in the United Kingdom have adopted requirements for expanded auditor reporting that mandate more than the pass/fail model. These organizations are also concerned with ensuring that auditors effectively communicate information about audit-specific matters.
Originally, many investors were not satisfied with the content of the auditor's report because the report provided little information specific to the audit of the company's financial statements. In turn, auditors argued that the complaining investors should acquire this information through the company's own management or audit committee.
Several commissions and committees have discussed changes to the auditor's report. They have noted that because of the increasing complexity of global business operations, auditors engage in an increasing use of judgments or estimates related to fair value measurements, which makes for intricate financial statements that are not easily accessible to parties other than auditors. With the new standards, the Board hopes to bridge the gap in knowledge between the auditors and investors.
Critical Audit Matters
The new standard requires the auditor to communicate, in the auditor's report, any critical audit matters arising from the current period's audit of the financial statements, or state that there are no critical audit matters:
A critical audit matter is a matter that was communicated or required to be communicated to the audit committee that:
- Relates to accounts or disclosures that are material to the financial statements, and,
- Involved especially challenging, subjective, or complex auditor judgment.
To determine whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor takes into account various factors, including but not limited to:
- The auditor's assessment of the risks of material misstatement, including significant risks;
- The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to requisite transactions; and,
- The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures.
Matters that are material to the financial statements but that don't relate to accounts or disclosures are not critical audit matters. For example, if a potential loss contingency was communicated to the audit committee, but was determined to be remote and was not recorded in the financial statements or disclosed under the applicable financial reporting framework, it does not count as a critical audit matter, even if the contingency involved especially challenging auditor judgment. Similarly, if an auditor determined that a potential illegal act required no disclosure on the financial statements, the matter would not relate to an account or disclosure that is material to the financial statements. Finally, a determination that there is a significant deficiency in internal control over financial reporting is not a critical audit matter because it does not, in itself, relate to an account or disclosure that is material to the financial statements.
To communicate each critical audit matter, the report must:
- Identify the critical audit matter;
- Describe the principal considerations that led the auditor to determine that the matter is a critical audit matter; and,
- Describe how the critical audit matter was addressed in the audit, and refer to the relevant financial statement accounts or disclosures.
Auditors must document each matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and relates to accounts or disclosures that are material to the financial statements. The auditor must document whether the matter was determined to be a critical audit matter, and the basis for the determination.
In addition to the critical audit matters, the auditor's report must contain:
1. A discussion of auditor tenure – a statement disclosing the year in which the auditor began serving consecutively as the company's auditor.
2. A discussion of auditor Independence – a statement that the auditor is required to be independent.
3. Addressee – the auditor's report will be addressed to the company's shareholders and board of directors or equivalents.
4. Enhancements to basic elements – certain language in the auditor's report has been changed. For example, reports may include the phrase "whether due to error or fraud" when describing the auditor's responsibility to obtain reasonable assurance about whether the financial statements are free of material misstatements.
The Board is adopting a phase based approach to the effective dates, so as to provide accounting firms, companies, and audit committees more time to prepare for implementation of the critical audit requirements.
Subject to approval by the Securities and Exchange Commission ("SEC"), all provisions other than those related to critical audit matters will take effect for audits of fiscal years ending on or after December 15, 2017. Provisions related to critical audit matters will take effect for audits of fiscal years ending on or after June 30, 2019 for large accelerated filers; and for fiscal years ending on or after December 15, 2020 for all other companies to which the requirements apply.
The final standard will generally apply to audits conducted under PCAOB standards, but communication of critical audit matters is not required for audits of brokers and dealers reporting under the Securities Exchange Act of 1934 Rule 17a-5; investment companies other than business development companies; or employee stock purchase, savings, and other benefit plans and emerging growth companies. These entities must comply with the final standards’ other requirements, but may voluntarily choose to include critical audit matters in the auditor's report.
Many companies did not support the new requirements, alleging that critical audit matters would not provide important information to investors, would be duplicative of the company's disclosure, may result in disclosing superfluous information, could increase cost, or could delay the audit's completion.
Commenters have suggested that because it is solely the management’s responsibility to determine what disclosure is appropriate, requiring the auditor to disclose information about the company's financial statements would undermine the role of the audit committee or management. Commenters were concerned that communication of critical audit matters would give auditors leverage to encourage disclosure of information by management, and that management would modify its disclosure in response to the communication of critical audit matters in the auditor's report so that the auditor would no longer be a source of original information. This may either expand the auditor's role or add significant costs. Additionally, investors may be confused or misled if auditor reporting conflicted with management disclosures.
Although the Board acknowledges these concerns, the Board has stated that they sought to strike a balance between investor demands for expanded auditor reporting and the costs and potential unintended consequences associated with providing it. Therefore, auditor reporting is intended to be limited to areas uniquely within the perspective of the auditor, such as describing the principal considerations that led the auditor to determine that the matter is a critical audit matter.