The Public Company Accounting Oversight Board (“PCAOB”) recently re-proposed an audit standard to amend the form and content requirements for the independent auditor’s report on financial statements.[1] The new proposal retains the pass/fail model present in the existing audit report but also requires the auditor to include new disclosures in the audit report about “critical audit matters” that are identified during the course of the audit. The re-proposal also requires new disclosures about the length of the auditor’s tenure and the applicable auditor independence requirements.
The re-proposal is the latest chapter in a standard-setting project that dates back to 2011, when the PCAOB issued a concept release[2] on potential changes to the audit report, and that evolved in 2013, when the PCAOB issued its original proposal[3] on this topic. The PCAOB’s re-proposal narrows in some respects the scope of the disclosure requirements for critical audit matters that appear in the audit report, and also drops the component of the original proposal that would have required the auditor to review and report on matters outside the financial statements. But the re-proposal still represents an important development for the financial reporting landscape that issuers and their audit committees should review and consider in detail, including as described below under “Steps to Consider.”
The deadline for commenting on the PCAOB’s proposal is August 15, 2016.
What are CAMs?—Required Disclosures in the Audit Report about Critical Audit Matters
Under the re-proposal, a critical audit matter (“CAM”) is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.”
The proposed definition thus has three component pieces. First, a CAM must be a matter that was voluntarily communicated to the audit committee or that was required to be communicated to the audit committee under Auditing Standard 1301 (formerly AS No. 16), Communications with Audit Committees. As issuers and audit committees are well aware, the scope of these required communications is not narrow, with AS 1301 containing more than fifteen topics and several dozen related paragraphs that specify what must be communicated to the audit committee. Second, a CAM must relate to an account or disclosure that is “material” to the financial statements. Notably, the proposed definition does not require the communication itself to involve a material issue, but rather that the communication must be about an account or disclosure that is material to the financial statements. And third, the proposed definition provides that a CAM must have involved an “especially challenging, subjective, or complex auditor judgment.” The proposal seeks to inject some objective criteria to help guide this test by laying out several factors that an auditor should take into account in determining whether a matter involved such judgments, specifically:
- the auditor’s assessment of the risks of material misstatement, including significant risks;
- the degree of auditor subjectivity in determining or 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;
- 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; and
- the nature of audit evidence obtained regarding the matter.
The new proposal provides that if the auditor determines that a CAM exists, the auditor must include disclosure in the audit report that identifies the CAM, describes the principal considerations that led the auditor to determine that the matter is a CAM, describes how the CAM was addressed in the audit, and identifies the relevant financial statement accounts and/or disclosures that relate to the CAM.
The CAM definition offered in the original proposal was more expansive because it did not specifically relate back to disclosure of matters that were communicated to the audit committee. By incorporating the concept of matters required to be communicated to the audit committee, the re-proposal draws on existing AS 1301 to provide some guideposts for determining which matters may be treated as CAMs. However, given the lengthy list of required communications in AS 1301 and that the re-proposal includes both required communications and those that are voluntarily communicated to the audit committee, the range of matters that could be CAMs remains quite broad and could lead to significant new disclosures in the audit report, as discussed in more detail below under “Steps to Consider.”
The new proposal specifies that CAMs would not have to be disclosed in audit reports issued in connection with audits of brokers and dealers; investment companies other than business development companies; or employee stock purchase, savings, and similar plans.
Additional New Disclosures in the Audit Report
Auditor Tenure. The re-proposal requires the auditor to include in its report “[a] statement containing the year the auditor began serving consecutively as the company’s auditor.” Under the proposed requirement, the auditor tenure would include the years the auditor served as the company’s auditor both before and after the company became subject to SEC reporting obligations. Although the Board unanimously approved the issuance of the proposal, several Board members indicated they were not certain this disclosure is needed. These sentiments were expressed in part because many issuers have voluntarily included enhanced audit committee-related disclosures in their proxy statements and such disclosures often include information about the length of service by the auditor.
Independence. The re-proposal also requires a statement in the audit report that the auditor “is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC and the PCAOB.”
Clarification of Auditor Responsibilities. Under the re-proposal, the auditor also has to include in its audit report the phrase “whether due to error or fraud,” when describing the auditor’s responsibilities under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements. This phrase is not included in the existing auditor’s report and the release accompanying the re-proposal says that the phrase is added to clarify that the auditor is responsible for detecting material misstatements, whether such misstatements are due to error or fraud.
Steps to Consider
With this re-proposal, the PCAOB appears to be moving closer to requiring changes to the pass/fail model that has served as the basis for an unqualified audit report for many decades. As a result, issuers and their audit committees would be well served to review in depth the new disclosures contemplated by the proposal—particularly as they are disclosures for which the auditor will have the final say; consider the potential implications and costs associated with the new disclosures, including the questions and potential issues discussed below; and evaluate whether to comment on the proposal. In considering this topic, issuers and audit committees also may wish to engage with their auditors to understand what types of issues in prior audits may be considered CAMs under the proposal and what corresponding disclosures would have looked like if they had been disclosed in connection with those prior audit reports.
- Scope of the New CAM Definition. In its re-proposal, the PCAOB made efforts to reign in the breadth of its original concept for critical audit matters, but aspects of the proposed CAM definition still may present concern. The audit standard governing communications that the auditor is required to make to the audit committee is itself expansive, as noted above. The definition also includes any communication made to the audit committee outside of the required communications. It also appears that CAMs may not be limited to communication about material issues, but rather could include disclosure of an issue that may not itself be material but that may involve a material account or disclosure. And, the question of whether an issue was “especially challenging, subjective, or complex auditor judgment” by its terms still leaves the auditor with broad discretion to determine whether a matter is a CAM that should be disclosed in the audit report. Auditor discretion in making this determination of course could cut either way, but issuers and their audit committees may wish to consider whether the degree of uncertainty in how the proposed CAM definition will be applied in practice, given its potential breadth and subjectivity, merits comment.
- Auditor Disclosure of Original Information. In reviewing the original proposal, a number of commenters expressed concern that the proposal would place the auditor in the position of being the source of disclosure of original information about a company—in other words, having to make disclosures before a company itself has made the disclosure or, in effect, forcing a company’s hand to make disclosures. The PCAOB’s re-proposal responded to this concern by noting that “[s]ince the auditor would be communicating information regarding the audit rather than information directly about the company and its financial statements, the communication of critical audit matters should not diminish the governance role of the audit committee and management’s responsibility for the company’s disclosure of financial information.” Companies and audit committees may wish to consider if this response is sufficient to allay the noted concerns, particularly given the nature of the proposed disclosure topics that have to be addressed once a CAM has been identified—as reflected by the three pages of sample disclosures for a CAM that appear in the proposing release. The PCAOB’s proposed standard also includes a note intended to address concerns about the auditor becoming the source of original (and potentially confidential) information about the company. This note says that the auditor will not be 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.” Companies and audit committees may wish to consider whether this exception in effect nearly swallows the rule, and if so, what disclosure considerations may be implicated, including whether it would put the auditor in a position of having to make disclosures in the first instance about any number of matters, such as loss contingency considerations or investigations.
- Uncertainty in Application. A number of concerns expressed in relation to the original proposal also appear not to have been fully addressed by the re-proposal. Companies and their audit committees may wish to comment on these issues as well. For example, because the re-proposal may require disclosure of matters that have been voluntarily reported to the audit committee, some have expressed the view that the approach outlined could lead auditors to hesitate in raising matters to audit committees as it would then trigger potential CAM reporting. Conversely, some have expressed concern that there will be a tendency to over-disclose the existence of CAMs given the subjectivity in the proposed standard and the potential adverse consequences for the auditor associated with being second-guessed in whether a CAM should have been disclosed. Still others have expressed concern that the range of CAM disclosure practice amongst firms and engagement teams will lead to unhelpful variability across audit reports. Concerns expressed about the original proposal with respect to the increased strain on audit committee resources and timing issues associated with completing the audit—for example, when financial reporting or audit-related issues that have CAM implications arise at the last moment—also seem relevant in relation to the re-proposal. Although varied in nature, the common theme underlying these concerns appears to be that uncertainty in application will result from requiring CAM disclosures in the audit report, particularly in light of the subjectivity inherent in the definition and the significance of the changes to the audit reporting model.
ENDNOTES
[1] Proposed Auditing Standard—The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, PCAOB Release No. 2016-003 (May 11, 2016), available at http://pcaobus.org/Rules/Rulemaking/Docket034/Release-2016-003-ARM.pdf.
[2] Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards, PCAOB Release No. 2011-003 (June 21, 2011), available at http://pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf.
[3] Proposed Auditing Standards—The Auditor’s Report on an Audit of the Financial Statements When the Auditor Expresses an Unqualified Opinion; The Auditor’s Responsibilities Regarding Other Information In Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report; and Related Amendments to PCAOB Standards, PCAOB Release No. 2013-005 (Aug. 13, 2013), available at http://pcaobus.org/Rules/Rulemaking/Docket034/Release_2013-005_ARM.pdf.
The preceding post comes to us from Gibson, Dunn & Crutcher LLP, and is based on their memorandum published on May 18, 2016 and available here.