On June 21, 2011, the Public Company Accounting Oversight Board issued a concept release (PCAOB Release No. 2011-003) soliciting public comment on possible changes to the current requirements for the form and content of reports on audited financial statements. The Release responds to concerns expressed by some investors and other users of financial statements to the Board that outside auditors frequently possess useful information regarding a company’s financial statements and business activities that is not reflected in the current version of a standard auditor’s report. The Release outlines four alternative changes to the current reporting model that the PCAOB believes might serve to increase the transparency and relevance of audit reports to financial statement users:
- Supplementing the auditor’s current report with a new “Auditor’s Discussion and Analysis” section;
- Requiring auditors to highlight significant areas of focus during an audit through the use of “emphasis paragraphs”;
- Expanding the scope of current reporting to require that auditors also provide assurance on information outside the financial statements, such as a company’s MD&A disclosures and non-GAAP financial measures; and
- Clarifying the meaning of key terms used in the audit report and explaining significant audit concepts.
The Board stated in the Release that it might ultimately decide that a revised auditor's report should reflect all, some, or none of the four alternatives, or might reflect other changes not considered in the Release. The PCAOB also noted that, while it is soliciting views on ways to improve the relevance of audit reports to investors, it has not yet reached any conclusions as to which approach, if any, it should propose.
The PCAOB has requested public comments on the Release through September 30, 2011, and plans to hold a public roundtable before the public comment deadline. The Board has stated that it expects to issue a specific rulemaking proposal in early 2012, and comments on the Release may inform that proposal, which would be subject to a separate round of public notice and comment. If ultimately adopted, some of the proposals identified in the Release would effect the most significant changes in the standard auditor's report in over 50 years. The Board’s issuance of the Release also provides further evidence of the renewed activism of the PCAOB under its new Chairman, James R. Doty, who also notified the auditing profession last month that the Board plans to issue another concept release in the near future to solicit comments on whether mandatory audit firm rotation would enhance the independence of public accounting firms from their clients.
Background on the Current Reporting Model
The standard audit report currently used in audits of public companies largely dates back to the 1940s, and was part of an effort to standardize report language to make audit reports for different companies easy to compare, with any qualifications in those reports simple to recognize. In a few paragraphs, the standard report identifies the financial statements audited, describes the nature of the audit, and presents the auditor’s opinion as to whether the financial statements “fairly represent” the company’s financial position, results of operations, and cash flows, as required by the applicable financial reporting guidelines. The standard report is often referred to as a “pass/fail” model; that is, the financial statements “pass” if the auditor concludes they are “fairly presented” in accordance with GAAP, and “fail” if not so characterized. While current professional standards permit auditors to issue different types of audit reports, the SEC does not accept qualified, adverse, or disclaimer opinions in a Commission filing.
The Release reflects the Board’s and investors’ concerns that the “pass/fail” model may have become too “binary” to meet the current needs of financial statement users. In order to better understand whether changes to the current model might improve the transparency of audit reports, the PCAOB Staff conducted a series of “outreach” efforts involving investors, auditors, audit committee members, regulators and other groups between October 2010 and March 2011. According to the Release, many investors expressed the view that the Board should revise the current audit report to make the work of auditors more relevant and transparent. In response to Board surveys, investors also stated that, while they generally believed that the PCAOB should retain the current reporting format, audit reports should include additional disclosures regarding both the quality of companies’ financial statements and the audit procedures undertaken by the auditors to gain reasonable assurance on the financials. Investors also stated that, in the early days of the recent financial crisis, expanded auditor reporting might have provided additional insights into the quality of companies’ financial statements or provided early warning signals of emerging problems.
Potential Alternatives for Revisions to the Standard Audit Report
The Release solicits comments on the desirability of four alternative changes to the current reporting model. As discussed below, some of the alternatives, if adopted, would entail major changes to current reporting standards; require separate rulemaking by the SEC to revise the Commission’s own financial reporting rules; and significantly alter the current dynamic between auditors and their public company clients. In comparison, other alternatives would entail only modest revisions to the current reporting model.
“Auditor’s Discussion and Analysis”: Under the first alternative, the Board would require a new “Auditor’s Discussion and Analysis” (“AD&A”) to accompany the standard audit report. The AD&A would be intended to provide auditors with a forum to discuss their views regarding significant matters relating to the audit and give investors a broader context for understanding the auditor’s opinion on a company’s financial statements as a whole. The PCAOB included in the Release an illustration of what the AD&A might look like, with the following topical headings: audit risk, audit procedures and results, auditor independence, management’s judgments and estimates, accounting policies and pratices, and difficult or contentious issues (including “close calls”). Under this approach, the PCAOB might require the auditors to disclose in the AD&A various observations, such as observations relating to audit risks, audit procedures and results, and the quality of the financial statements, made during an audit that currently are only communicated to a company’s audit committee, and not generally to outside investors.
The PCAOB noted that, in the AD&A, auditors might be required to identify areas where they believed that management could have followed different (and, presumably, preferable or less aggressive) accounting treatments or made different disclosures. The Board acknowledged that such a requirement could alter the current dynamic between auditors and their clients, noting that “[a]n AD&A could give the auditor greater leverage to effect change and enhance management disclosure in the financial statements, thus increasing transparency to investors.” Conversely, the Board raised a concern that over time, the language used in AD&A could become boilerplate and less useful to investors. It also noted that, if this option were pursued, the PCAOB and the SEC would likely need to work together to develop new standards specifying the types of information and level of detail to be included in an AD&A. The PCAOB also recognized that the AD&A alternative was likely to prove the most expensive of the alternatives identified in the Release, since auditors would be required to draft new, client-specific disclosures, and companies and their auditors frequently might end up devoting considerable amounts of time attempting to reconcile differences between a company’s disclosures and the AD&A.
Expanded Use of “Emphasis Paragraphs”: The second alternative identified in the Release is a more modest revision than the AD&A alternative, and would call for the expanded use of “emphasis paragraphs” in audit reports. Under current auditing standards, emphasis paragraphs are optional, and are included, at the auditor’s discretion, to highlight the most significant matters in the financial statements and their location within the financial statements. They are rarely used in public company filings to provide material unknown information. For example, emphasis paragraphs currently can be used to highlight that an entity is part of a larger business enterprise, has engaged in signficant related-party transactions, or had important subsequent events, as well as note accounting matters that may significantly affect a financial statement user’s ability to compare current and past financial statements. As described in the Release, the PCAOB might decide to require auditors to include emphasis paragraphs in all audit reports that addressed critical areas, such as significant management judgments and estimates, areas of measurement uncertainty, and other topics that the auditor determined were necessary for investors to gain a better understanding of the financial statements. The Board also noted that, under this approach, it might require auditors to describe the key audit procedures that were performed with respect to each issue that was emphasized. As with the AD&A alternative, the PCAOB acknowledged that there was a risk that the language in required “emphasis” paragraphs might become boilerplate over time, and that the Board would likely need to issue detailed standards to clarify exactly which types of matters an auditor would have an obligation to emphasize in its reports.
Reporting on Corporate Disclosures and Non-GAAP Financial Measures: A third alternative identified in the Release to potentially improve the robustness of the auditor’s report is to expand the current auditor’s report to require assurance on information outside a company’s financial statements, such as its MD&A disclosures, non-GAAP financial measures, and/or information contained in earnings releases. The PCAOB stated that an auditor’s report that provided assurance on information outside a company’s financial statements could provide investors with greater confidence in the quality of information provided by management. Currently, companies may retain their auditors to provide some level of assurance on their MD&A disclosures, but there is no requirement that they do so, nor is such work mentioned in the standard audit report. In addition, companies seem to rarely retain auditors for this work. The Release provided an illustration of possible expanded reporting to cover such additional matters, using the current attest standard and report as its model.
This alternative might require companies to furnish their periodic filings at an earlier stage of the process, in order to provide the auditors with a chance to complete their procedures before the filing deadlines. The PCAOB acknowledged that, as with the AD&A alternative, this approach would also substantially increase the scope of auditors’ current responsibilities. In addition, the Board noted that, before adopting any such requirement, it would need to collaborate closely with the SEC on new auditing standards for PCAOB-registered firms and new reporting requirements for issuers.
Clarification of Auditing Concepts and Terms Used in Audit Reports: Under the final alternative identified in the Release, auditors would be required to provide additional disclosures in the standard audit report to clarify key terms used in the report, such as the concept of “reasonable assurance” and the “responsibility of the Company’s management” for the financial statements. In addition, the Board suggested that it might require auditors to make additional disclosures about significant auditing concepts, such as an auditor’s responsibilities with respect to the detection of fraud, the extent of an auditor’s obligations with respect to information outside a company’s financial statements, and relevant auditor independence requirements. This alternative is considerably more modest than the other three alternatives, and if adopted, would not impose significant costs on auditors or on companies.
The Board’s Request for Comments
In requesting public comment on the alternatives described in the Release, the PCAOB posed a series of specific questions with respect to each option to facilitate future discussion. The Board also candidly acknowledged that there may be “practical challenges and unintended consequences” if it decides to revise the current model and adopt new requirements. With those risks in mind, the Board requested comments addressing the effect the potential alternatives might have on the required scope of audit work (including the pressure any changes might have on the current public reporting deadlines), auditors’ relationships with their clients, current audit committee governance and oversight of the audit relationship, potential auditor and issuer liability, and the confidentiality of client information provided to auditors (and future willingness of clients to readily share proprietary information with their auditors).
While the PCAOB’s formal authority under the Sarbanes-Oxley Act extends only to registered public accounting firms and their associated persons, the Board’s standard-setting activities can also significantly impact issuers, registered broker-dealers, and other SEC-regulated entities. By issuing the Release, the PCAOB has encouraged a dialogue among many constituencies as to the advantages and disadvantages of the current audit report, and potential ways to improve the relevance of those reports to financial statement users. Comments received by the PCAOB in response to the Release can be expected to play a significant role in shaping the Board’s future rulemaking initiatives on this important topic.