Yesterday, the SEC approved the PCAOB’s proposed rules requiring changes to the auditor’s report, AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, along with related amendments to other auditing standards. The new auditing standard for the auditor’s report, while retaining the usual pass/fail opinion, will require auditors to include a discussion of “critical audit matters,” that is, “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.” The new CAM disclosure requirement will apply (with some exceptions) to audits conducted under PCAOB standards, including audits of smaller reporting companies and non-accelerated filers (although at a later phase-in date). The SEC also determined that the new standard, other than the provisions related to CAMs, will apply to emerging growth companies. As Commissioner Kara Stein observed in her statement, the new “standard marks the first significant change to the auditor’s report in more than 70 years.”
The new auditor’s report will include other disclosures designed to enhance its usefulness, including:
- auditor tenure;
- a statement that the auditor is required to be independent;
- a requirement to address the report to the board and shareholders;
- standardization of the format, including location of the opinion in the first section of the report; and,
- in describing the auditor’s responsibility to obtain reasonable assurance about whether the financial statements are free of material misstatements, inclusion of the phrase “whether due to error or fraud.”
There are also amendments to other PCAOB standards, including requirements that the auditor provide to and discuss with the audit committee a draft of the auditor’s report, and requirements that the engagement quality reviewer evaluate the engagement team’s determination, communication and documentation of CAMs.
All changes other than those related to CAMs, such as format and auditor tenure, will apply to all audits of fiscal years ending on or after December 15, 2017. Changes related to CAMs will apply to audits of large accelerated filers for fiscal years ending on or after June 30, 2019, and to audits of all other companies to which the requirements apply for fiscal years ending on or after December 15, 2020. Note that the requirements relating to CAMs do not apply to EGCs, reflecting uncertainty regarding whether the imposition of CAM disclosure would violate a prohibition in the JOBS Act. (See this Cooley Alert.)
It remains to be seen whether we will see disputes erupt over CAM disclosure. 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. But will auditors’ judgments about which CAMs were the real nightmares be called into question? Will the new disclosure requirement precipitate many auditor-management squabbles over the CAMs selected or the nature or extent of the disclosure? And just how enthusiastic will the CFO be about the prospect of the auditor’s sharing with the investing public the convoluted nature or opacity of the company’s policies or the struggles involved in performing the audit or reaching conclusions about the financials? Although the adopting release suggests that the process will be an iterative one between management and the auditors, how much input will auditors really allow audit committees or managements in reviewing the auditors’ selection or disclosure? Will auditors use the new disclosure requirement as leverage to compel managements to include disclosure in the notes or MD&A that management may not view as necessary? Will the new disclosures provide roadmaps to baseless litigation or will the new standard ultimately end up just producing more boilerplate, as auditors (and companies) find comfort in conformity?
In his statement regarding approval by the SEC of the new standard, SEC Chair Jay Clayton confirmed his strong support for the objective of the rule to provide investors with meaningful insights from the auditor about the audit, as well as his belief “that the independent audit committee has emerged as one of the most significant and efficient drivers of value to Main Street investors.” Acknowledging the risks involved, however, he then puts us to the test, framing the challenge in a way that verges on the parental: “I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships—with Main Street investors ending up in a worse position than they were before. I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”
You certainly couldn’t argue that the PCAOB rushed heedlessly into adoption of this new standard—it has been engaged in discussion and outreach on the concept of an enhanced audit report since 2010. Following the financial crisis of 2008, the fact that clean audit reports were given to a number of failed or failing companies, together with the lack of transparency in the current form of audit report, led to a demand for a new look at whether the pass/fail report model might be improved; the current model has long been disparaged as just boilerplate that doesn’t really convey to investors any of the auditor’s insight into judgment calls and business risks. In 2011, the PCAOB sought to address this concern in a 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.
Then, in 2013, the PCAOB issued a new proposal that required disclosure of CAMs (see this Cooley news brief), but that concept was not without controversy of its own. 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.” While smaller audit firms and companies raised objections, 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, although it may not have been a full-blown exhale.)
In 2016, the PCAOB issued a reproposal (see this PubCo post) that attempted to tackle these issues. For example, among other things, the reproposal:
- Limited 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”)
- Added 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
- Narrowed the definition to only those matters that involved “especially challenging, subjective or complex auditor judgment”
The final standard adopted without change the reproposed narrower definition of CAM, as described above. The PCAOB has indicated that it will monitor the implementation of the new standard for any unintended consequences.
The New Standard
CAMs: As noted above, under the new standard, CAMs will be 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.” The new standard indicates that CAMs “will likely be identified in areas that investors have indicated would be of particular interest to them, such as significant management estimates and judgments made in preparing the financial statements; areas of high financial statement and audit risk; significant unusual transactions; and other significant changes in the financial statements.”
For example, the PCAOB’s adopting release indicates that
“the auditor’s evaluation of the company’s goodwill impairment assessment could be a critical audit matter if goodwill was material to the financial statements, even if there was no impairment; it would relate to goodwill recorded on the balance sheet and the disclosure in the notes to the financial statements about the company’s impairment policy and goodwill….On the other hand, a matter that does not relate to accounts or disclosures that are material to the financial statements cannot be a critical audit matter. For example, a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a critical audit matter; it does not relate to an account or disclosure in the financial statements, even if it involved especially challenging auditor judgment. The same rationale would apply to a potential illegal act if an appropriate determination had been made that no disclosure of it was required in the financial statements; the matter would not relate to an account or disclosure that is material to the financial statements.
“For the same reason, the determination that there is a significant deficiency in internal control over financial reporting, in and of itself, cannot be a critical audit matter; such determination, in and of itself, does not relate to an account or disclosure that is material to the financial statements as no disclosure of the determination is required. A significant deficiency could, however, be among the principal considerations that led the auditor to determine that a matter is a critical audit matter.”
While the SEC order indicates that most commenters supported the PCAOB’s objective, particularly investors and larger accounting firms, other commenters raised doubts regarding, among other things, the usefulness of the information in CAMs. In particular, commenters expressed some concern that auditors would be driven to overkill on disclosure of CAMs to protect themselves and/or that they would fall into overly standardized prose. The SEC acknowledged that, as with “Risk Factors,” standardization was a possibility, but contended that the narrower definition of CAMs and related disclosure requirements should mitigate that risk.
Notably, an earlier PCAOB staff study of expanded auditor reporting in the UK did not find overkill or standardization, at least for the first year of implementation: “On average, the auditor’s reports in the first year of implementation included descriptions of four risk topics, with total risk topics ranging from one to eight. Additionally, the descriptions of the risks of material misstatement in the auditor’s reports in the first year of implementation were not presented in standardized language, but included variations in content length, description, and presentation. The most frequently described risk topics related to revenue recognition, tax, and goodwill and intangible assets.”
Factors in determining CAMs: Identification of CAMs will be a principles-based inquiry. 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, in determining whether a matter involved especially challenging, subjective or complex auditor judgment, will need to take into account a nonexclusive list of factors, including the following:
- “The auditor’s assessment of the risks of material misstatement, including significant risks;
- 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;
- The degree of auditor subjectivity in 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; 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.
Because the trigger for CAM consideration is whether a matter has been or is required to be communicated to the audit committee, will the new requirement have the effect of chilling communications among auditors, audit committees and managements? Commenters had mixed views on this issue, some contending that CAM disclosures would improve communications and some contending that they would chill communications. The PCAOB argued that, in light of the broad requirements in AS 1301, Communications with Audit Committees, any potential chilling effect would relate only to matters not required to be communicated to audit committees, and the PCAOB expected those to be few and far between. The SEC acknowledged the risk, but agreed with the PCAOB’s conclusion, particularly in view of the broad correlation between the list of mandated communications to the audit committee and the list of factors to be considered in determining CAMs identified above.
Communication in the auditor’s report: The required introductory language will expressly state that the communication of CAMs does not alter the auditor’s opinion on the financials as a whole, nor is the auditor, by communicating CAMs, providing separate opinions on the CAMs or on the related accounts or disclosures. In addition, the auditor will 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.
The PCAOB release made clear that the description of CAMS must be tailored to each company: the “auditor’s description of the principal considerations should be specific to the circumstances and provide a clear, concise, and understandable discussion of why the matter involved especially challenging, subjective, or complex auditor judgment. It is expected that the communication will be tailored to the audit to avoid standardized language and to reflect the specific circumstances of the matter.”
A note to the new standard includes four examples of potential approaches to the description of 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.” To help readers, the use of highly technical accounting and auditing terms is discouraged. If there are no CAMs (considered to be a rather unlikely event), the auditor will state that in the auditor’s report. In addition, 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 address concerns regarding potential disclosure of confidential information, the new standard explains that 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.” Auditor reporting of “original information” is not prohibited, but it is limited to “areas uniquely within the perspective of the auditor: describing the principal considerations that led the auditor to determine that the matter is a critical audit matter and how the matter was addressed in the audit.” In addition, “as the auditor determines how best to comply with the communication requirements, the auditor could discuss with management and the audit committee the treatment of any sensitive information.”
Some commenters argued that the revised CAM definition continues to intrude on the responsibility of management and the board for the financial statements by making the auditor’s report a primary source of a company’s financial information. On the other hand, one commenter cited in the PCAOB release observed that “concerns regarding ‘original information’ were misplaced because the iterative process [between management and the auditor] would reduce the likelihood that the auditor would be a source of original information since critical audit matters would likely overlap with increased management disclosure.” Ultimately, the PCAOB determined that the provision was necessary to ensure that “the fact that management did not provide a disclosure would not prevent the auditor from communicating a critical audit matter.”
The SEC agreed “with commenters that, in general, the preparation and disclosure of information about an issuer should be the primary responsibility of the issuer, and that the auditor’s role, by contrast, is to audit the issuer’s financial statements and to provide a report thereon. That said, we disagree with those commenters who expressed an absolute view of the relative roles and responsibilities of the issuer and the auditor. Nothing prohibits exceptions to this general principle, and indeed, existing requirements contemplate a role for the auditor in disclosing original information…. Nor do we believe that CAMs, particularly as currently proposed, will displace the financial reporting responsibilities of management. Instead, we believe the communication of CAMs should add to the total mix of information available to investors by eliciting more information about the audit itself, which is uniquely within the perspective of the auditor, irrespective of the financial reporting responsibilities of management….In our view, the importance of this information to investors justifies the possibility that the auditor would provide information about a company that is not otherwise required to be disclosed by the company.” In general, the SEC expected that “communication of original information should be limited to rare circumstances…and relate only to the discussion of the principal considerations as to why a matter was a CAM or how the auditor addressed the CAM.”
Documentation: The auditor will be required to 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.
Liability considerations: Commenters expressed concern that disclosure of CAMs would lead to an increase in litigation risks, while others argued that the disclosure of risks and challenges could actually deter litigation. In its release, the PCAOB acknowledged that including CAMs in the auditor’s report could affect potential liability. The SEC also acknowledged the potential increase in risk of liability, but concluded that the benefits justify potential incremental liability risk. In this regard, the PCAOB expects to monitor the effects of implementation of the new standard.
Other comments. The SEC also disagreed with commenters’ assertions that the PCAOB’s analysis was defective for failing to adequately quantify the costs and benefits of the new standard, contending that a high-quality qualitative analysis of potential economic impact can support well-reasoned regulatory changes, particularly in those cases where quantification is not feasible. The SEC cited in support a D.C. Circuit opinion in the conflict minerals case (see this PubCo post). The SEC also acknowledged that the subjective requirements related to CAMs could lead to diversity in communications, but again agreed with the PCAOB that the principles-based nature of the requirement was necessary to achieve the objective of “having CAM communications provide tailored, audit-specific information by the auditor within the auditor’s report.” Commenters also complained about the absence of illustrative examples of CAM disclosure that were previously included (see this PubCo post). However, the PCAOB had excluded them because it “believe[d] auditors should provide tailored, audit-specific information when communicating critical audit matters in the auditor’s report,” and the SEC agreed that the inclusion of examples could lead to “more boilerplate.”