PCAOB Releases Reproposal of Amendments to Its Audit Report Standard
The Public Company Accounting Oversight Board has reproposed for public comment amendments to its standard on the auditor’s report on financial statements. Most notably, the reproposed standard carries forward, in revised form, a requirement for the auditor to identify and discuss, in the audit report, “critical audit matters” that were addressed in the audit. The comment period will run until August 15, 2016, raising the possibility that the proposed amendments could be in effect for calendar year companies’ next audited financial statements. In addition to deciding whether to comment, companies and their audit committees should consider informing themselves now as to how their auditors may respond to this new requirement, and whether additional company disclosure may be necessary or desirable in light of the anticipated new audit report disclosures.
THE REPROPOSED STANDARD
The reproposed standard is set forth in the PCAOB’s May 11, 2016 release, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion1 , and according to the release, is intended to make the auditor’s report a more informative and useful tool for evaluating the fairness of financial statements in an age of complex, globalized corporate operations.
The reproposed standard would retain the “pass/fail” opinion of the existing auditor’s report and, in addition to disclosure of any “critical audit matters” arising from the current period’s audit – discussed in detail below – the reproposal would require that the audit report include a statement as to auditor independence and a description of the auditor’s tenure. The reproposal would also impose format requirements, directing that the opinion be the first section of the report, and that section titles be included.
The reproposal is the latest development in a process that has extended over more than five years. The PCAOB issued a concept release in 2011, and a proposed rule in 2013 that incorporated a critical audit matters disclosure requirement. In response to comments on the 2013 proposal, the Board has refined the critical audit matters disclosure requirement, and also dropped a proposed new standard governing the responsibilities of auditors with respect to information outside the audited financial statements in a company’s annual report. The PCAOB considers its reproposed standard as broadly consistent with initiatives being undertaken by other standard-setting bodies, including the IAASB, the EU, and UK FRC, all of which have expanded the auditor’s report beyond a traditional “pass/fail” model.
CRITICAL AUDIT MATTERS
A requirement to disclose critical audit matters remains the most prominent feature of the reproposed standard, and appears to be core to the PCAOB’s stated goal of reducing information asymmetries between management and investors. As revised in light of comments to the 2013 proposal, this requirement now states that an auditor must: identify a critical audit matter; describe the principal considerations that led the auditor to determine that the matter is a critical audit matter; describe how the critical audit matter was addressed in the audit; and refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter.
Under the reproposal, a critical audit matter is defined as any matter 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 especially challenging, subjective or complex auditor judgment.
The PCAOB recognizes that what constitutes a critical audit matter is inevitably an audit-specific question. The reproposed standard therefore does not prescribe a list of critical audit matters, but simply provides factors to be taken into account, individually or in concert, to determine whether a matter constitutes a critical audit matter. These include:
- the auditor’s assessment of the risks of a material misstatement about the matter;
- the degree of auditor subjectivity involved in determining or applying audit procedures to the matter (and in evaluating their results);
- the nature and extent of the 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);
- the degree of auditor judgment related to areas in the financial statements that reflect 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 those transactions; and
- the nature of the evidence obtained regarding the matter.
The reproposed standard does not mandate a particular way of describing how each critical audit matter was addressed in the audit. However, the PCAOB has suggested that an auditor may describe:
- the auditor’s response or approach that was most relevant to the matter;
- a brief overview of procedures performed;
- an indication of the outcome of the auditor’s procedures; and
- key observations with respect to the matter, or some combination of these elements.
The reproposed standard states that the audit report discussion of critical audit matters is not expected to include non-public company information, “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.”
The PCAOB has cautioned that, if the auditor provides an indication of the outcome of the auditor’s procedures in its description of a critical audit matter, the language used to communicate a critical audit matter should not imply that the auditor is providing a separate opinion on it, or on the accounts or disclosures to which the critical audit matter relates. Nor is it appropriate for the auditor to use language that would call into question the auditor’s opinion on the financial statements taken as a whole.
The PCAOB expects that most audit reports will include at least one critical audit matter. However, like the 2013 proposal, the reproposed standard accepts the possibility that an auditor could determine that there are no critical audit matters. In that event, the auditor’s report would contain a statement to that effect in its “Critical Audit Matters” section.
The critical audit matter reporting requirement would not apply to audits of brokers and dealers reporting under Exchange Act Rule 17a-5, investment companies other than business development companies, and benefit plans.
It is likely that the new standard will go into effect in substantially the form contemplated by the reproposal, and it is possible that it could be effective as early as for audited financial statements issued in respect of the 2016 calendar year. Companies should be thoughtfully preparing for potential consequences of the new critical audit matters disclosure in their auditors’ reports.
The standard would confer substantial discretion upon the auditor in identifying critical audit matters and then in describing these matters in the audit report. Some portion of these matters are likely to arise in contexts where the company is already addressing sensitive or complex disclosure issues. The new audit report discussion will reflect the auditor’s perspective, which is inherently different from management’s perspective. It is quite foreseeable that in some cases, management may wish to revise or supplement its own disclosures, in light of the auditor’s discussion, in order to ensure that the totality of the disclosure reflects an accurate and complete picture. It would therefore seem useful and appropriate for companies’ managements to start a dialogue with their auditors now, to gain an understanding of how the auditors expect to approach the critical audit matter requirements in the context of their particular company; what matters may, in the auditors’ view, merit this designation; and what sort of disclosure the auditors would anticipate making in their audit reports. The auditors can only make actual determinations on these matters as they perform the audit, but it might be informative to review them on a hypothetical basis, relative to a prior year’s audit, discussing what might have been identified as critical audit matters and how they might have been addressed.