An article in the Federal Securities Law Reporter reports on some tips gleaned from a discussion of, what else, “critical audit matters” on a PCAOB panel at PLI’s 34th Midyear SEC Reporting and FASB Forum. The new auditing standard for the auditor’s report (AS 3101), which requires CAM disclosure, will be effective for audits of large accelerated filers for fiscal years ending on or after June 30, 2019.
As you may recall, CAMs are defined as “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” Essentially, the concept is intended to capture the matters that kept the auditor up at night, so long as they meet the standard’s criteria. For each CAM, the auditor is required to identify the CAM, describe the principal considerations that led to the determination that the matter was a CAM, describe how the CAM was addressed in the audit, and refer to the relevant financial statement accounts or disclosures that relate to the CAM.
On the PLI panel, the new PCAOB auditing chief focused on the language of the new auditing standard. Among other things, she noted that the PCAOB “deliberately chose the word ‘especially’ in the CAM definition as opposed to the word ‘most’ so it could encompass many matters, and not just one or two. She also emphasized that the CAM factors are not meant to be an exclusive list because the Board did not want the standard to become a checklist.” Also focusing on language, a representative from PwC emphasized that the definition employs alternatives: a CAM doesn’t need to comport with all three terms; only one is necessary to fall within the definition of CAM.
The PwC representative also discussed the firm’s conduct of “dry runs” of CAM disclosures for large accelerated filers, noting that the development of CAM disclosures by the auditing team involved dialogues with audit committees and managements—they “didn’t just draft the CAMs and put them on the table at an audit committee meeting.” He identified the most common CAMs disclosed in these dry runs as “goodwill impairment, business combinations, revenue recognition, allowance for loan and lease losses (ALLL), and the valuation of loss reserves….For example, business combinations can involve intangible assets such as customer relationships, he explained. Revenue recognition issues were identified as CAMs due to the new FASB revenue recognition standard and situations involving long-term contracts where revenue is recognized over time.”
A number of auditors have been working with audit committees at large accelerated filers to conduct CAM “dry runs” to get a better handle on how the new CAM disclosures will look and how the process will affect financial reporting. To perform these dry runs, the auditors identified CAMs using the prior year’s audit, actually crafting the disclosures, engaging in discussions with audit committees about the disclosures and creating the supporting documentation. In addition, the practice session helped to identify the types of controls that needed to be developed. The adopting release suggested that the process would be an iterative one between management and the auditors. Some auditors characterized the engagement with audit committees as critical to the process, observing that audit committees have posed many questions related primarily to identification of CAMs, both of the company and of its competitors.
These practice sessions have also led audit committees to consider the impact of CAM disclosures on companies’ own disclosures. Why? Because, generally, audit committees much prefer that the company get a jump on the disclosure so that the auditors will not need to resort to the creation of original material and the company can best frame the discussion from its own perspective. To best position the company, a former Director of Corp Fin (cited in this article from Compliance Week) advised, audit committee members should be revisiting the company’s own disclosures now, as soon as they have an inkling of which CAMs the auditor plans to identify: the “best CAM disclosure…will be one that cross references a disclosure in the financial statements.” (See this PubCo post.)
When asked about the similarity of CAMs to critical accounting estimates, the PwC representative said that “a CAM comes from the auditor. While it is rooted in management estimates, CAMs are highlighted from the point of view of the auditor.” As the PCAOB has previously observed, critical accounting estimates and CAMs may overlap, but they are not congruent. (See this PubCo post.)
The PCAOB auditing chief emphasized that CAM disclosure should be specific to the particular audit, avoiding boilerplate. (Remember that, in 2017, SEC Chair Jay Clayton, commenting on the new CAM requirement in the auditor’s report, observed that “if it results in boilerplate, I’ll be really bummed out.” See this PubCo post.) The auditor must say more than just that “goodwill impairment was a CAM because it was particularly challenging.” Although there may be “some degree of similarities of CAMs, especially in certain industries,” not all CAMs regarding an issue should read the same; rather they must be described in the context of the particular audit. The disclosure should also avoid excessive use of accounting jargon that readers of the auditor’s report may not understand.
In recent guidance, the PCAOB advised that the description of audit procedures should “be specific to the CAM and to the audit,” not general statements that might apply in any audit or “to most significant areas of the audit, such as ‘testing the operating effectiveness of the company’s controls’ in the case of an integrated audit.” Most useful would be descriptions of procedures that are tied to the considerations that led to the matter being identified as a CAM. For example:
- “If a matter was determined to be a CAM because of the degree of auditor judgment involved in evaluating significant assumptions made by management in developing a particular estimate, the description of how the matter was addressed may focus more directly on the procedures the auditor performed to evaluate those assumptions.
- “For a CAM related to an acquisition that required auditor judgment in relation to the valuation of assets acquired and liabilities assumed, if control testing is described, the description would focus on the testing of controls addressing the risks related to the valuation assertion (e.g., controls over the assumptions used to value acquired intangible assets or controls over the selection of a discount rate for a discounted cash flow analysis).
- “In situations where the use of a specialist was an aspect of how a CAM was addressed, the description could include information about the nature and extent of the specialist’s involvement in performing the audit procedures.” (See this PubCo post.)
With regard to documentation, the auditing chief stressed its importance and advised that “the amount of documentation should be driven by the amount of judgment involved in arriving at a particular CAM. For matters determined not to be a CAM, relatively simple documentation should be fine. However, with close calls that require more judgment, the Board will expect to see more documentation about how a matter was determined to be a CAM.”