United States: PCAOB Considers Changes To Standards For Auditors’ Reports On Audited Financial Statements

Financial Fraud Report (November/December 2011)

As investment community members continue to call for greater transparency in public company financial statements and express dissatisfaction with the scope of auditors' reports on audited financial statements, the Public Company Accounting Oversight Board (PCAOB) is considering actions that could change the dynamics of the relationships between public companies and their independent auditors and expand the scope of auditors' reporting responsibilities. On June 21, 2011, the PCAOB issued a concept release (the Release), which can be found here, that represents the most recent step in a project that could have significant consequences for public companies. The PCAOB may issue additional concept releases on related topics, including mandatory audit firm rotation, in the near future.

The Release discusses possible alternatives for changes in the content and form of auditors' reports on their audit of public company financial statements and other matters. Certain of the alternatives would require that significant information be included in the auditors' reports in addition to the "pass/fail" audit report now issued¹ and would require auditors to discuss various aspects of the financial statements and the audit process. Another alternative would require a form of auditor assurance be given as to information outside the financial statements, such as management's discussion and analysis of financial condition and results of operations (MD&A). At best, the adoption of the most expansive of the alternatives would likely increase management time spent on audits, audit fees and the time needed to complete an audit. At worst, those alternatives would increase the risk and frequency of disputes between auditors and their public company clients, auditor and company exposure to liability and the potential for suits against public companies. The PCAOB has not yet proposed new or amended audit standards on these matters.²

The Release solicits public comment on the potential direction of a proposed standard-setting project respecting the proposed alternatives and announces that the PCAOB will convene a public roundtable to discuss these and other alternatives for enhanced auditors' reports in the third quarter of 2011. Public companies may want to comment on one or more of the alternatives, as well as on whether any changes to the auditor's report are needed or even prudent. Comments must be received by the PCAOB by September 30, 2011.

Possible Alternatives for Changes to Auditors' Reports

If the PCAOB determines to adopt changes to the auditor's report, the revised auditor's report could include one or any combination of the four alternatives discussed in the Release (which the PCAOB views as not mutually exclusive), elements of those alternatives or other alternatives not discussed in the Release.

Auditor's Discussion and Analysis. This alternative would require auditors to provide a supplemental narrative report regarding the audited financial statements, dubbed the "Auditor's Discussion and Analysis" (AD&A). The PCAOB envisions the AD&A as providing financial statement users with context for understanding the financial statements and the related MD&A, as well as information about the significant judgments made by the auditor in forming its audit opinion. The AD&A would be adopted to enable the auditor to discuss significant matters relating to the financial statements, including:

• information about the audit, identified audit risks, audit procedures addressing those risks and those procedures' results;
• auditor independence and the independence-related matters discussed with the audit committee;
• the auditor's views regarding the financial statements, including management's judgments and estimates made in the preparation of the financial statements, critical accounting policies and practices and difficult or contentious issues relating to the financial statements, including "close calls" requiring significant deliberations between the auditor and management;
• material matters that, although in technical compliance with the applicable financial reporting framework, the auditor views as matters for which the company's disclosure could be enhanced; and
• areas where the auditor believes management, in its preparation and presentation of the financial statements, could have applied different accounting or made different disclosures and the ramifications of the different accounting or disclosure.

The AD&A as proposed is not intended to provide separate assurance on individual balances, disclosures, transactions or any other matters, but to facilitate an understanding of the auditor's opinion on the financial statements taken as a whole, and could include discussion of information the auditor has communicated to the company's audit committee. The PCAOB acknowledges that it will need to provide standard, objective criteria for the content and level of detail of the AD&A.

Because an AD&A would provide the auditor's perspectives about the audit and the financial statements, the AD&A might contain views differing from those of management, including views reflected in the related MD&A. In this regard, the PCAOB notes that the auditor and management might attempt to resolve any differences before the AD&A and the MD&A are published. By so noting, the PCAOB acknowledges that the AD&A could increase disagreements between auditors and their public company clients and could result in conflicting positions on financial statement-related matters appearing in a company's public disclosures.

Required and Expanded Use of Emphasis Paragraphs. This alternative would require auditors to include emphasis paragraphs in all auditors' reports to highlight the most significant matters in the financial statements and identify where those matters are disclosed in the financial statements. Auditors currently have the discretion to include emphasis paragraphs in their audit reports to emphasize matters regarding the financial statements, such as significant related party transactions and unusually important subsequent events, as well as accounting matters, other than changes in accounting principles, affecting comparability of the financial statements with those for prior periods. In addition to discussing such matters, these new emphasis paragraphs could also be required to address:

• significant management judgments and estimates;
• areas with significant measurement uncertainty;
• other areas that the auditor concludes are important to a better understanding of the financial statement presentation; and
• key audit procedures performed on the identified matters.

The PCAOB foresees this alternative as a means for communicating primarily those matters the auditor must address as part of an audit under current auditing standards.

Auditor Assurance on Information Outside of the Financial Statements. This alternative would require auditors to provide assurance as to information outside of the financial statements, such as the MD&A, non-GAAP information and earnings releases, to improve the "quality, completeness, and reliability" of that information and to give users a higher level of confidence regarding that information. This assurance requirement might be similar to the current attest standard for engagements that auditors may perform with respect to an MD&A. As described in the Release, this assurance requirement for an MD&A could take the form of an auditor's opinion addressing whether:

• the MD&A includes, in all material respects, the elements required by the SEC's rules and regulations to be in an MD&A;³
• the historical financial amounts in the MD&A have been accurately derived, in all material respects, from the related financial statements; and
• underlying information, determinations, estimates and assumptions of the company provide a reasonable basis for the MD&A disclosures.

The PCAOB acknowledges that requiring that auditor assurance be given on information outside the financial statements would increase the scope of an auditor's responsibilities, require the development of new auditing standards specifically relating to such assurance and require the development of a reporting framework for management's presentation of the information.

Clarification of the Auditor's Report. This alternative could require the auditor's report to include clarifying language explaining the nature and meaning of the auditor's report, including the meaning of the "reasonable assurance" standard and the related auditor responsibilities, such as for fraud, financial statement disclosure and information outside of the financial statements, as well as management's responsibilities for preparing the financial statements and auditor independence. These clarifications would do no more than explain principles, responsibilities and requirements currently in effect.

Implications of the Release

The Release poses for public comment the obligatory questions as to the necessity for changes to auditors' reports. However, the Release's general tenor and the comments of the members of the PCAOB about the Release suggest that the PCAOB is disposed to and motivated to change the standards for auditors' reports to institute a shift in auditing from "a culture that emphasizes client service to a culture that emphasizes public service"⁴ and to expand auditors' responsibilities. As the Release reflects, public companies may, in the future, see the auditor cast in the role of an agent of change expected to push its audit clients to change their financial statement disclosure as the auditor deems appropriate and to inform the public when a client fails to measure up to the auditor's standards for appropriate disclosure.

That such a change in the auditor's role is contemplated is reflected in the PCAOB's view of the AD&A as not only a medium for facilitating the understanding of the auditor's opinion on the financial statements taken as a whole, but also as a tool giving the auditor "greater leverage to effect change and enhance management disclosure in the financial statements"⁵ to improve transparency to investors. The expansion of the auditor's role would be even more pronounced if auditor assurances were required to be given as to the presence in an MD&A of all of the required elements, which is more a legal determination than a matter of compliance with accounting principles. Although in practice auditors have frequently been able to influence an audit client's financial statement disclosures, the PCAOB's direction appears to be leading to a place in which auditors will not only audit the audit client's financial statements, but will be expected to influence the quality and content of, and comment on, the audit client's financial statements and related disclosures.

Mandatory AD&A and auditor assurances as to information outside the financial statements are likely to be a source of dispute between a public company and its auditor, making the efficient production of audited financial statements and the annual reports in which they appear all the more difficult. Such increased responsibilities for auditors will, no doubt, adversely affect the relationships of auditors and companies, making them even more prone to conflicting viewpoints and goals, especially where auditors are required to provide their assessments, analysis or opinions regarding the quality of the audited financial statements and financial statement disclosure. These changes to the auditor's report and responsibilities could also harm the quality of the audit by chilling communication between an auditor and an audit client concerned that the substance of that communication may be publicly disclosed. Moreover, with the additional disclosure that would be required by certain alternatives, both the auditor's and the company's exposure to liability will increase, and any public disclosure reflecting that the auditor and the company hold conflicting views respecting the company's financial statements and other matters could create investor confusion and adversely affect the market in the company's stock.

Although the PCAOB may not adopt all or any of the alternatives described in the Release, public companies and the various trade associations and other organizations of which they and their senior officers are members may wish to take advantage of the opportunity to comment on the Release. Doing so may give public companies the best opportunity to influence the PCAOB's direction in this initiative and to shape any changes that may ultimately be made to the standards for auditors' reports and auditor assurances.

Footnotes

1. The "pass" aspect of the "pass/fail" form of auditor's report is the familiar formulation that the financial statements fairly present, in all material respects, the company's financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

2. As the Release notes in several respects, most of the changes described in the alternatives would involve the Securities and Exchange Commission (SEC) and could require SEC rulemaking.

3. The Release does not indicate whether this assurance would be limited to assurance that the MD&A complies with the line item disclosure requirements in Item 303 of the SEC's Regulation S-K or would go beyond those specific requirements to address compliance with the guidance provided by the SEC in its numerous interpretative releases regarding the contents and preparation of MD&A.

4.  James R. Doty, Remarks at PCAOB Open Board Meeting (Jun. 21, 2011), at http://pcaobus.org/News/Speech/Pages/06212011_DotyStatement.aspx.

5. Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards/Notice of Roundtable, PCAOB Release No. 2011-003 (Jun. 21, 2011) at 13.

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