Companies whose audit reports are about to get a lot longer would be wise to give financial statement users some advance communication and education to head off any knee-jerk reactions.
That’s the advice from experts in the trenches who are preparing for critical audit matters, or CAMs, to begin appearing in audit reports this summer. Large accelerated filers with a June 30 fiscal year end will be the first to see their audit reports expanded with new auditor disclosures regarding what proved most difficult during the audit.
The Public Company Accounting Oversight Board approved a new auditing standard in June 2017 that revises and expands the standard audit report. “This is the most significant change to auditor reporting in 70 years,” said David Kane, Americas vice chair at EY, during a recent Webcast hosted by the Center for Audit Quality. “It’s a huge undertaking for the profession, and it also has significant impacts for everyone else along the supply chain.”
The new standard required auditors beginning in 2018 to make some changes to the format and standard language of the auditors report, most notably to disclose their tenure on each engagement, or how long the firm had served continuously as the company’s auditor. For the most significant change, however, which is the disclosure of CAMs, the PCAOB gave auditors more time to prepare. CAM disclosures begin for large accelerated filers this summer and for all other filers in 2020.
CAMs are defined by the PCAOB as any matter the auditor communicated or should have communicated to the audit committee relating to any material account or disclosure in financial statements that involved any challenging, subjective, or complex auditor judgment. Auditors are required in each audit report to identify the CAMs that arose on the engagement, to describe them, and to explain what they did to address them.
“Certainly there are possibilities of material disagreements. We have a system designed to resolve those situations, but it’s better to know what those areas are so they can be resolved over the course of preparing the information, so the end product reflects the trio of voices—management, audit committee, and auditors—with as much consistency and clarity as the three can work out.”
Wes Bricker, Chief Accountant, Securities and Exchange Commission
Big Four firms have been performing dry runs of the process of identifying CAMs and drafting the disclosures to prepare for live reporting and to help audit committees get a sense for the process. The PCAOB recently issued its observations on the dry runs and advised audit firms to be careful not to narrow their determination of CAMs.
Kane said the dry runs have allowed auditors to learn how to identify CAMs, to practice drafting the disclosures, to engage in deeper discussions with audit committees, and to develop the materials internally that auditors will need to assure compliance. It also allowed auditors to help senior management and audit committees come to grips with how CAM reporting might affect their own reporting. “I don’t think the benefits of the dry runs can be overstated,” he said.
Audit committees are going to be looking for plenty of understanding early in the reporting process what auditors plan to identify as CAMs and how they plan to describe them, said Leslie Seidman, an independent director who also participated in the CAQ Webcast. That will help audit committees to determine whether they might want to revisit any of their own disclosures, either in financial statements or in management discussion and analysis.
Certain areas of Generally Accepted Accounting Principles, for example, do not require companies to make extensive disclosures, said Seidman. To the extent an auditor identifies a CAM where the company is not making extensive disclosures of its own, preparers might like to get in a word of their own on the subject.
“We’d like an opportunity to have some time to take a fresh look at our own disclosures to make sure the whole package of information goes together nicely, so an investor could connect the dots, if you will,” said Seidman.
While the new disclosure is a requirement for auditors, companies will want to take a proactive approach to prepare for it, said Seidman. The education process begins with auditors and audit committees working through what might be identified as CAMs, but “to me, that is just the beginning,” she said.
Companies should consider treating this “like any other change in accounting,” Seidman said, forming cross functional teams to explore the potential effects and consider how to respond. The new auditor disclosure could have implications for financial planning and analysis, she said, along with tax, investor relations, the general counsel’s office, and the company’s disclosure committee.
Todd Castagno, executive director at Morgan Stanley, said one of his big concerns leading up to CAM disclosures is that some investors will over-react. “There will be constituencies that will conflate this to aggressive accounting, rightly or wrongly,” he said. Companies need to get ahead of that with heavy communication, he says. “The day will come when a large company has a material misstatement, and the microscope will be on these CAMs.”
Wes Bricker, chief accountant at the Securities and Exchange Commission, agreed communication will be critical at the outset. “It’s appropriate for all of us to be very vigilant with the information that is communicated out,” he said. The dry run process has been helpful in assuring the information that will be communicated to investors reflects “the best calibration of the requirements,” he said.
Plenty of preparation and education on the front end might also help mitigate the likelihood of disagreements between companies and auditors over what constitutes a CAM, said Bricker. “Certainly there are possibilities of material disagreements,” he said. “We have a system designed to resolve those situations, but it’s better to know what those areas are so they can be resolved over the course of preparing the information, so the end product reflects the trio of voices—management, audit committee, and auditors—with as much consistency and clarity as the three can work out.”
Kane is urging companies not to regard the CAMs process strictly as a compliance exercise for auditors. “Use this as an opportunity to deepen the conversation about audit quality,” he said.