United States: PCAOB Adopts Changes To The Auditor's Report To Require Disclosure Of Critical Audit Matters

On June 1, 2017, the Public Company Accounting Oversight Board (PCAOB) adopted a new auditor reporting standard, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (AS 3101) that requires the auditor to provide new information about the audit and make the auditor's report more informative and relevant to investors. The new standard retains the pass/fail opinion of the existing auditor's report but makes significant changes to the existing auditor's report, including the following:

  • Communication of critical audit matters (CAMs) – 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
  • Disclosure of auditor tenure – Disclosure of the year in which the auditor began serving consecutively as the company's auditor
  • Clarify auditor's role and responsibilities – Clarifies standard language about the nature and scope of the auditor's existing responsibilities, including:
    • Disclosure of auditor independence – Disclosure that the auditor is required to be independent
    • New error or fraud language – The addition of the phrase "whether caused by error or fraud," to be used in the description of the auditor's responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements; the existing standard does not require the auditor's report to contain the phrase "whether due to error or fraud"
    • Addressed to shareholders and the board – The audit report will be addressed to the company's shareholders and board of directors, with additional addressees permitted
    • Financial statement notes – Identification of the financial statements, including the related notes and, if applicable, schedules, as part of the financial statements that were audited; under the existing standard, the notes to the financial statements and the related schedules are not identified as part of the financial statements
    • Nature of the audit – The description of the nature of the audit reflected the auditor's responsibilities in a risk-based audit and aligned the description with the language in the PCAOB's risk assessment standards, including:
      • Performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks
      • Examining, on a test basis, appropriate evidence regarding the amounts and disclosures in the financial statements
      • Evaluating the accounting principles used and significant estimates made by management
      • Evaluating the overall presentation of the financial statements
  • More helpful and standardized format – The audit opinion will appear in the first section of the auditor's report, and section titles have been added to guide the reader

Critical Audit Matters

Communicated or required to be communicated to the audit committee

Under the new standard,1] a CAM is defined as any matter arising from the audit of the financial statements that was required to be communicated to the audit committee (even if not actually communicated) and matters actually communicated (even if not required) that are related to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective or complex auditor judgment. It will include auditor communication requirements under AS 1301, Communications with Audit Committees, other PCAOB rules and standards, 2and applicable law, 3 as well as communications made to the audit committee that were not required.

Required communications to the audit committee generally include the areas in which investors have expressed particular interest in obtaining information in the auditor's report, 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. The new standard does not limit the source of CAMs to critical accounting policies and estimates, nor does it exclude from the source of CAMs certain required audit committee communications that relate to sensitive areas (e.g., corrected and uncorrected misstatements, qualitative aspects of significant accounting policies and practices, alternative treatments within GAAP, independence considerations, disagreements with management, overall planned audit strategy, delays encountered in the audit, and competency issues of management) and that could result in the auditor communicating information not disclosed by management. To the extent that any such communication qualifies as a CAM (including that it (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective or complex auditor judgment), it will be an appropriate subject for an auditor to communicate.

Relates to Accounts or Disclosures That Are Material to the Financial Statements

The new standard provides that each CAM relates to accounts or disclosures that are material to the financial statements, which means that the CAM could be a component of a material account or disclosure and does not necessarily need to correspond to the entire account or disclosure in the financial statements. For example, the auditor's evaluation of the company's goodwill impairment assessment could be a CAM if goodwill was material to the financial statements, even if there was no impairment. The CAM 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. In addition, a CAM may not necessarily relate to a single account or disclosure but could have a pervasive effect on the financial statements if it relates to many accounts or disclosures. For example, the auditor's evaluation of the company's ability to continue as a going concern could also qualify as a CAM depending on the circumstances of a particular audit.

On the other hand, a matter that does not relate to accounts or disclosures that are material to the financial statements cannot be a CAM. 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 CAM. The same rationale would apply to a potential illegal act if an appropriate determination was made that disclosure was not required in the financial statements.

Similarly, the determination that there is a significant deficiency in internal control over financial reporting does not qualify as a CAM because it does not relate to an account or disclosure that is material to the financial statements. However, a significant deficiency could be among the principal considerations that led the auditor to determine that a matter is a CAM.

Involved Especially Challenging, Subjective or Complex Auditor Judgment

The determination of whether a matter qualifies as a CAM is principles-based. The new standard does not specify any items that would always constitute CAMs. For example, not all matters determined to be "significant risks" under PCAOB standards would qualify as CAMs because not every significant risk would involve especially challenging, subjective or complex auditor judgment. For example, improper revenue recognition is a presumed fraud risk, and all fraud risks are significant risks; however, if a matter related to revenue recognition does not involve especially challenging, subjective or complex auditor judgment, it will not be considered a CAM. In accordance with the new standard, material related-party transactions or matters involving the application of significant judgment or estimation by management do not qualify as CAMs, unless the auditor determines, in the context of the specific audit, that the matter involved especially challenging, subjective or complex auditor judgment. The PCAOB believes that focusing on the auditor's judgment should limit the extent to which expanded auditor reporting could become duplicative of management's reporting. The PCAOB also believes that CAMs reflecting differences in auditors' experience and competence will also be informative.

In determining whether a matter involved especially challenging, subjective or complex auditor judgment, the auditor should take into account, alone or in combination, certain nonexclusive factors, including:

  1. The auditor's assessment of the risks of material misstatement, including significant risks
  2. 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
  3. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions
  4. The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures
  5. 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
  6. The nature of audit evidence obtained regarding the matter

The new standard requires the auditor to communicate in the auditor's report any CAMs arising from the current period's audit of the financial statements or state that the auditor determined that there are no CAMs. Once an auditor decides that a CAM needs to be included in the report, the auditor would (1) identify the CAM, (2) describe the principal considerations that led the auditor to determine that the matter is a CAM, (3) describe how the CAM is addressed in the audit and (4) refer to the relevant financial statement accounts or disclosures.

Some investors believe that CAMs will highlight areas that they may wish to emphasize in their engagement with the company and provide important information that they can use in making proxy voting decisions, including ratification of the appointment of auditors.

Excluded Companies from CAM Disclosures

The new standard will generally apply to audits conducted under PCAOB standards. Communication of CAMs is not required for audits of brokers and dealers, investment companies other than business development companies, benefit plans, and emerging growth companies; however, auditors of these entities may choose to include CAMs in the auditor's report voluntarily. The other requirements of the new standard will apply to these audits.

Effective Dates

Subject to approval by the Securities and Exchange Commission (SEC), the new standard will take effect as follows:

  • All provisions other than those related to CAMs will take effect for audits of fiscal years ending on or after December 15, 2017.
  • Large accelerated filers – Provisions related to CAMs will take effect for audits of fiscal years ending on or after June 30, 2019
  • All other companies not excluded – Provisions related to CAMs will take effect for audits of fiscal years ending on or after December 15, 2020

This proposed timeline should provide accounting firms, companies and audit committees time to prepare for implementation of the CAM requirements, which are expected to require more effort to implement than are the additional improvements to the auditor's report. Auditors may elect to comply before the effective date, at any point after SEC approval of the new standard.

Expectations of the New Standard

We expect the new standard to present meaningful challenges for public companies and their audit committees with respect to their disclosures and the dynamics of their interactions with the auditors. The new standard recognizes that the audit report may disclose a company's nonpublic information as part of the CAM communications if that information is needed to describe the principal considerations that led to the CAM determination or how the CAM was addressed in the audit. In addition, the auditor's insistence that certain CAM-related disclosures be included in the auditor's report may impact a public company's disclosure in other areas. For example, public companies already provide substantial disclosures regarding their accounting practices, policies and processes, particularly in the risk factors and MD&A section, and often have to contend with the auditor's desire or suggestion to include additional (viewed as either clarifying or unnecessary, depending on your perspective) disclosures.

There is also likely to be additional pressure between management and the auditors to understand how the auditor intends to approach CAM disclosure with respect to the company, which existing accounting policies and practices would be likely to receive a CAM designation, and extensive discussions about what CAM disclosure would look like for those matters. As these discussions evolve, it will be interesting to see whether companies provide additional details of the communications with their auditors in the proxy statement in areas such as the audit committee report (which is furnished rather than filed), ratification of the independent auditor proposal (which is not required but is a matter of good corporate practice), a summary of the audit committee's responsibilities or discussion related to the board of directors' role in risk oversight. In that regard, we are mindful that only a handful of companies have volunteered additional disclosures, whether in the audit committee report or elsewhere in the proxy statement, in light of the SEC's encouragement to do so in its 2015 concept release regarding possible revisions to its audit committee disclosures. We certainly encourage companies to engage in these discussions sooner rather than later to minimize these issues and to allow senior management and the board of directors time to consider these issues well in advance of finalizing their financial statements and substantive disclosures. This is not a discussion a public company wants to wrap up the week its public filing is due.

There is also likely to be additional pressure between management and the auditors to understand how the auditor intends to approach CAM disclosure with respect to the company, which existing accounting policies and practices would be likely to receive a CAM designation, and extensive discussions about what CAM disclosure would look like for those matters. As these discussions evolve, it will be interesting to see whether companies provide additional details of the communications with their auditors in the proxy statement in areas such as the audit committee report (which is furnished rather than filed), ratification of the independent auditor proposal (which is not required, but is a matter of good corporate practice), a summary of the audit committee's responsibilities or as part of the discussion related to the board of directors' role in risk oversight. In that regard, we are mindful that only a handful of companies have volunteered additional disclosures, whether in the audit committee report or elsewhere in the proxy statement, in light of the SEC's encouragement to do so in its 2015 concept release regarding possible revisions to its audit committee disclosures. We certainly encourage companies to engage in these discussions sooner rather than later to minimize these issues and to allow senior management and the board of directors time to consider these issues well in advance of finalizing their financial statements and substantive disclosures. 4 This is not a discussion a public company wants to wrap up the week their public filing is due.

Footnotes

[1] The PCAOB release contains a helpful chart that summarizes the critical audit matter analysis.
[2] See Appendix B of AS 1301, which identifies other PCAOB rules and standards that require audit committee communication.
[3] See, e.g., Section 10A(k) of the Exchange Act;, Rule 2-07 of Regulation S-X;, and Exchange Act Rule 10A-3.
[4] See Possible Revisions to Audit Committee Disclosures, SEC Rel. No. 33-9862 (July 1, 2015) (e.g., Section VI.A.1.).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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