New disclosures now required by auditors don’t produce any direct new requirements for the public companies they audit, but companies can expect plenty of potentially serious consequences from the new auditing standard—at least 10 issues to beware as a starting point.
First, here’s what’s new for auditors. The Public Company Accounting Oversight Board has adopted a new auditing standard that requires auditors to disclose, among other things, the “critical audit matters” they identified and wrestled during the course of the audit. CAMs are defined as issues auditors discussed or should have discussed with the audit committee. They would relate to material accounts or disclosures in financial statements, and they would involve “especially challenging, subjective, or complex auditor judgment,” the standard says.
The PCAOB has given auditors some guidance on the factors they should consider in deciding whether to regard a particular issue as a CAM. They should take into account, for example, the risk of material misstatement, the degree of auditor judgment surrounding a management estimate, especially when there’s big uncertainty involved, the nature and timing around significant unusual transactions, the degree of auditor subjectivity, the nature and extent of audit effort or specialized skill required, and the nature of audit evidence.
Once auditors identify CAMs that should be disclosed under the standard, they’ll be required to provide some narrative text in their audit reports to explain them. What led the auditor to identify this as a CAM? How was it addressed in the audit? Where can a reader find the relevant data or disclosures in the financial statements? Audit firms generally supported the idea of doing CAM disclosures while audit committees and preparers were not as enthusiastic.
“The new standard does not impose new performance requirements on the auditor other than the determination, communication, and documentation of critical audit matters, which will be based on work the auditor has already performed and on matters already communicated to the audit committee," said PCAOB Chief Auditor Marty Baumann. "Additionally, our research has shown that similar auditor reporting introduced in the United Kingdom has not significantly increased audit fees and has not resulted in increased time to issue the auditor’s report.”
What does all that mean for the public companies whose audits will be subject to these new audit disclosures? Plenty, says Nicolas Grabar, partner at law firm Cleary Gottlieb. “Companies should expect to spend quite a lot of time with auditors on the drafting of this new information in the audit report,” he says. “It will be a grueling process.”
1. Audits will take more time. The standard doesn’t change the fundamental requirements of the audit activity itself, says Leonard Combs, PwC’s U.S. chief auditor, but auditors will need more face time with the company. “We do expect there to be more dialogue with management and the audit committee about the nature of items we’re reporting, how we talk about them, how we report,” he says.
“The audit report shouldn’t be the single source of information. We’re required to report what we’re required to report, and we’ll do that, but I could see this creating situations where management may make a decision to disclose or report things they wouldn’t have otherwise.”
Jeff Burgess, National Managing Partner of Audit Services, Grant Thornton
“You can imagine situations where there will be differences of opinion,” says Dan Goelzer, senior counsel at law firm Baker & McKenzie and a former member and acting chair at the PCAOB. “It will take time to discuss and work that out.”
2. Audits will cost more money. Auditors will need to spend additional time producing documentation and work papers showing how they made CAM determinations and drafting those disclosures. “It’s going to happen at the end of the period, and it’s going to involve senior people in the engagement,” says Goelzer. Those folks bill at the highest hourly rates, of course. “I would expect cost increases,” he says.
3. Audit work will happen earlier. Auditors are already making efforts to do more work earlier in the audit cycle to reduce the rush as filing deadlines approach. “This change only magnifies that need,” says Jeff Burgess, national managing partner of audit services at Grant Thornton.
Audit committees will want to know early in the process what will be identified as a CAM, and auditors will want time to work out those determinations and draft those disclosures. “All of that will drive us to communicate more often, and earlier in the process,” says Burgess.
4. Management may rethink its own disclosures. Imagine “close calls” in the financial reporting process where management believes a particular disclosure need not be made, but auditors identify it as a CAM. Auditors and preparers tend to agree that no one wants to see auditors going out with disclosures that management has not made.
DOTY DISCUSSES STANDARD
Below is an excerpt from PCAOB Chair James Doty’s speech at an open board meeting on the new audit standard.
Investors have long called for enhancing the auditor's report, given the effort involved and the value the auditor brings to investor confidence.
With a global economy, companies' operations have become more complex, and financial reporting frameworks have evolved toward an increasing use of estimates. As a result, auditors must frequently make challenging, subjective or complex judgments.
These evolutionary developments are the reason investors want more information about the auditor's work. The new auditing standard before the Board today is the first significant change to the standard form auditor's report in more than 70 years.
It will make the auditor's report more relevant, useful and informative to investors and other financial statement users in light of the progress of history. The new standard will breathe new life into a formulaic reporting model.
The standard before the Board today is grounded in considerable outreach to investors, auditors, capital-seeking securities issuers, academics and others, plus three extended public comment periods over a period of more than six years. It is backed up by a robust economic analysis of the impact of making audit reports more informative to our capital markets.
In today's complex economy, and particularly in light of lessons learned after the financial crisis, investors in our public capital markets want a better understanding of the judgments that go into an auditor's opinion – not a recitation of the standard procedures that apply to any audit, but the specific judgments that were most critical to the auditor in arriving at the opinion.
The new standard provides a clear, well-vetted description of what should be included as "critical audit matters" – or "CAMs" – as well as a list of six factors the auditor should take into account in determining the CAMs to include.
The standard envisions that auditors describe their critical audit judgments. It does not put them in the position of speaking for management.
By focusing on auditor judgments, the new standard delivers on the Congress's intention, expressed in Section 101(a) of the Sarbanes-Oxley Act, to further the public interest in the preparation of more informative audit reports for public investors.
“The audit report shouldn’t be the single source of information,” says Burgess. “We’re required to report what we’re required to report, and we’ll do that, but I could see this creating situations where management may make a decision to disclose or report things they wouldn’t have otherwise.”
5. That might even include immaterial disclosures. The standard does not direct auditors to identify CAMs from among matters that are material themselves, but matters related to material accounts or disclosures, says Michael Scanlon, a partner at law firm Gibson, Dunn & Crutcher. “So it doesn’t focus auditors only to material information,” he says. “It could be immaterial information related to material accounts.”
6. Management may feel compelled to make more concessions to auditors. If management finds itself in a contentious debate with auditors, that increases the likelihood it will end up on the audit committee agenda and eventually in a CAM disclosure. The easier management makes the audit for auditors, the less auditors will have to disclose.
“Everyone will agree that management and auditors should work things out first and then take it to the audit committee,” says Grabar. “I would assume we’ll see more concessions between auditors and management.
7. Audit committees may get more guarded in what they say to auditors. Anything discussed between the audit committee and the auditor is a candidate for CAM disclosure. Discussing an issue doesn’t mean it’s automatically a CAM, but it’s automatically added to the pool of potential CAMs.
That may give audit committees some pause about initiating dialogue with auditors. Goelzer is even cautioning audit committees to be “thoughtful” about issues they raise with auditors, both in nature and in scope.
8. Audit committees will want to initiate dialogue with auditors early. Discussing matters early reduces the likelihood for surprises, contentious discussions, and rushed analysis late in the financial reporting process. Audit committees could even ask auditors to go through a dry run of the CAM disclosure process using historical financial statements. “Get an understanding of what the auditor sees as CAMs and how we may change our cadence with respect to the timing and number of meetings and conversations that take place between the audit committee and auditors,” says Burgess.
9. Audit committees may choose to rethink auditor selection. In addition to the CAM disclosures, the new standard also requires auditors to say in their audit reports how long they’ve served continuously as the company’s auditor. Views and research are mixed on whether that has any bearing whatsoever on the fitness of the auditor to continue to serve, but the number will now be out there and easily visible to investors.
Goelzer is advising audit committees to be prepared to answer questions from shareholders about their decision to stick with the same audit firm year after year. “It does put some pressure on audit committees about whether to retain the auditor and how to evaluate auditor performance,” he says.
10. The rules could still change yet again. All PCAOB standards are subject to approval of the Securities and Exchange Commission. While not common for the SEC to pick apart PCAOB standards before approving them, it’s not unprecedented, says Scanlon. “It’s widely acknowledged even in the adopting release that this standard will inject significant complexity into the disclosure regime,” he says.
The PCAOB has been developing the standard for several years under the watchful eye of SEC staff, but SEC leadership is still in significant transition under a new chair appointed by a deregulation-minded administration. Scanlon is hopeful the standard will get a fresh look from a full commission to determine “whether this is a sound policy decision.”
According to its normal due process, the SEC will issue the PCAOB’s final standard for another round of public comment. Scanlon is urging companies with concerns to speak up. “Consider commenting to the SEC even if you already commented to the PCAOB,” he says. “This could be the last bite at the apple.”