On June 21, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release seeking input on possible changes to auditors' reports. These changes, if adopted, have the potential to increase both the cost of required audit services and the legal liability faced by both companies and their auditors.
The auditor's report is the primary means by which an auditor communicates information regarding the audit of the financial statements to investors and other financial statement users. The concept release presents several alternatives for changing the auditor's report and the PCAOB is seeking specific comment on those or other alternatives that could provide investors with increased audit process transparency and insight into the company's financial statements and other information outside the financial statements. Alternatives discussed in the concept release are:
- An auditor's discussion and analysis
- Required and expanded use of emphasis paragraphs
- Auditor assurance on other information outside the financial statements
- Clarification of language in the standard auditor's report
As a result of the performance of required audit procedures, auditors often have significant information regarding how a company's financial statements were prepared that might be useful to investors and other financial statement users. It is believed that discussion in the auditor's report of this information could lead to more efficient markets and improved allocations of capital. According to PCAOB Chair James R. Doty, the concept release “represents a significant step for investor protection in response to the financial crisis, and a first step toward a holistic consideration of reforms designed to foster the relevance, transparency and reliability of the audit process.” Mr. Doty also stated that the alternatives discussed in the concept release “are intended to spur debate over how to change auditing, from a culture that emphasizes client service to a culture that emphasizes public service.”
The current standard auditor's report, largely unchanged since its adoption almost six decades ago, identifies the financial statements that were audited, describes the nature of the audit, and presents the auditor's opinion as to whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in conformity with the applicable financial reporting framework. The current auditor's report is commonly described as being pass/fail because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).
In 2010, the PCAOB began evaluating its auditing standards for reporting on audited financial statements in response to investors' and other financial statement users' historical concerns, including recent concerns highlighted by the financial crisis related to preparing and auditing financial statements for complex global businesses, as well as the active international debate in this area.
The staff found that the pass/fail model and the standardized language of the auditor's report provides investors with consistency, comparability, and clarity. However, investors also told the PCAOB staff that the standard auditor's report is too “boilerplate” and does not convey the significant judgments made by the auditor in forming the audit opinion. Accordingly, there was support for retaining the pass/fail form but supplementing the auditor's report with discussion by the auditor about the audit and the company's financial statements. This would allow the auditor to issue an unqualified opinion while also adding commentary on significant matters. Investors also suggested that clarification of some of the language in the standard auditor's report could be helpful. Investors indicated that they are looking to the auditor for more information, rather than management or the audit committee, because the auditor is a third party.
All of the alternatives presented in the concept release would retain the pass/fail opinion of the standard auditor's report. The PCAOB emphasized that the alternatives are not intended to in any way alter the auditor's ultimate responsibility to obtain sufficient appropriate audit evidence to support the audit opinion. Nor are the alternatives intended to qualify or piecemeal the auditor's opinion or to shift the requirement to assess the risk of material misstatement of the financial statements from the auditor to investors or other users of financial statements.
The alternatives presented below are not mutually exclusive. A revised auditor's report could include one or a combination of the alternatives, elements within the alternatives, or alternatives not currently presented in the concept release.
Auditor's Discussion and Analysis
This alternative would require that an auditor provide an Auditor's Discussion and Analysis (AD&A) along with the auditor's report. The AD&A would be a supplemental narrative report that would provide the auditor with the ability to discuss his or her views regarding significant matters. The AD&A could include information about the audit, such as audit risks identified in the audit, audit procedures and results, and auditor independence. It also could include a discussion of the auditor's views regarding the company's financial statements, such as management's judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close calls.”
The AD&A would not be intended to provide separate assurance on individual balances, disclosures, transactions, or any other matters discussed. Rather, the AD&A would be intended to facilitate an understanding of the auditor's opinion on the financial statements taken as a whole.
The AD&A would likely be among the most expansive form of reporting of the alternatives presented in the concept release and could require the auditor to communicate some of the same information that the auditor currently communicates to the audit committee. However, the AD&A may give the auditor greater leverage to effect change and enhance management disclosure in the financial statements, thus increasing transparency to investors. On the other hand, auditor communication with management and the audit committee may suffer if the auditor is required to disclose additional information about the company.
Required and Expanded Use of Emphasis Paragraphs
This alternative would require an auditor to include an expanded emphasis paragraph in all audit reports, highlighting the most significant matters in the financial statements and identifying where such matters are disclosed in the financial statements. Currently, emphasis paragraphs are not required, but may be added at the auditor's discretion to emphasize a financial statement matter.
Emphasis paragraphs could be required in areas of critical importance to the financial statements, including significant management judgments and estimates, areas with significant measurement uncertainty and other areas that the auditor determines are important for a better understanding of the financial statement presentation. The auditor could also be required to comment on key audit procedures performed pertaining to the identified matters.
Auditor Assurance on Other Information Outside the Financial Statements
This alternative would require an auditor to provide assurance on information outside the financial statements, such as the management's discussion and analysis (MD&A), earnings releases, or non-GAAP information. This assurance could improve the quality, completeness, and reliability of such information and provide investors and other users of financial statements with a higher level of confidence in such information. Currently, auditors are not required to provide assurance on the MD&A, earnings releases, or non-GAAP information.
Clarification of the Standard Auditor's Report
This alternative would involve adding language to the auditor's report clarifying what an audit represents and the related auditor responsibilities. Possible language and concepts that could be clarified in the auditor's report include:
- Reasonable assurance
- Auditor's responsibility for fraud
- Auditor's responsibility for financial statement disclosures
- Management's responsibility for the preparation of the financial statements
- Auditor's responsibility for information outside of the financial statements
- Auditor independence
The changes being considered by the PCAOB raise a number of concerns for companies, management, audit committees, and auditors, including:
- The changes would require additional effort by auditors, management, and audit committees, increasing the costs of and time spent on audits. Some companies might find it more challenging to meet their release and filing dates.
- Because the changes would include the disclosure by the auditors of additional, and in some cases more subjective, information, the changes would raise liability risks for companies and auditors.
- Companies may be concerned about auditors discussing proprietary or highly sensitive company information in the new disclosures.
- The additional disclosures could create further questions as to whether the financial statements are truly the responsibility of management and not the auditor and call into question the oversight role of the audit committee. This issue may be further exacerbated by the movement to a more principles-based approach to accounting standards, including the proposed conversion to International Financial Reporting Standards, which may lead to more opportunities for differences of opinion and conflicts between auditors and management.
Request for Comment
The PCAOB has requested comment on a number of issues in connection with the concept release. Beyond the specific alternatives presented in the concept release, the PCAOB also is interested in receiving comments on the effect changes to the auditor's report would have on:
- Auditor time and effort, including additional costs
- The auditor's relationships with management and the audit committee
- The governance role of the audit committee
- Liability for companies and auditors
- Maintaining the confidentiality of proprietary and sensitive company information
Comments must be submitted by September 30, 2011.