Auditors will start listing, describing critical audit matters in 2019

Corporate hopes for curtailment of a new auditor reporting model have been dashed, dispatching auditors to begin expanding their audit reports to describe where they had the most difficulty in each public company audit.

Despite appeals to reconsider an auditing standard developed and approved by the Public Company Accounting Oversight Board, the Securities and Exchange Commission endorsed the standard, putting it into effect with the end of the 2017 reporting year. The standard requires auditors to change some of the standard boilerplate language of the traditional audit report, but it also requires them to begin making some potentially lengthy new disclosures about where they had the most difficulty with each audit.

Beginning with 2017 year-end audits, the new audit report will contain some additional language that tells investors the tenure of the audit firm on the company’s engagement and clarifies the auditor’s role with respect to misstatements, whether due to error or fraud. It also contains an affirmative statement that the auditor has a duty is to assure its independence from the audited company.

The tenure disclosure, while not a difficult data point to gather and report, has been a topic of debate for years. PCAOB Chairman James Doty initially championed term limits on audit firms as a way to break up long-standing, collegial ties between companies and audit firms, which some believe impairs the auditor’s ability to be an independent watchdog of the companies they audit.

Stymied by a lack of evidence to support the connection between tenure and independence, Doty’s drive for term limits failed. As a compromise, the PCAOB sought the disclosure of tenure as a way of at least giving it to investors in case they cared to question it or act on it.

The most significant element in the new audit report, however, is the requirement of the auditor to list and describe “critical audit matters” (CAMs) that arose during the course of the audit. The idea is to give investors some insight into what auditors found as they worked through a company’s financial statements and internal controls.

“Investors really wanted this. They want the benefit of the good conversation. They want to hear from both the audit committee and the auditor about the things they discussed.”
Sandy Peters, Head of Financial Reporting Policy, CFA Institute

CAMs are defined in the new standard as those issues that were discussed or required to be discussed with the audit committee relating to material accounts or disclosures in the financial statements that involved “especially challenging, subjective, or complex auditor judgment.” The standard tells auditors, in deciding whether a particular issue involved challenging, subjective, or complex judgement, they should consider factors like their assessment of the risk of material misstatement, the degree of judgment involved, significant unusual transactions, the nature and extent of audit effort, and the nature of audit evidence.

In calling out each CAM, auditors are required to describe how the issue was addressed in the audit and what reasons led the auditor to identify it as a CAM. Auditors also are required to tie each CAM to the relevant accounts or disclosures in financial statements.

The PCAOB left far more lead time in the standard for auditors to develop their policies and processes internally for producing the new disclosures. For large accelerated filers, the CAM disclosures will begin with fiscal years ending on or after June 30, 2019. For other companies, the CAM disclosure takes effect for fiscal years ending on or after Dec. 15, 2020, a full 18 months later.

That creates an opportunity for audit committees to begin to educate themselves on what auditors will be disclosing and work with auditors to understand how they plan to comply, says Mike Scudder, a partner at law firm Skadden, Arps, Slate, Meagher & Flom. “The audit committee doesn’t want to be a passive recipient of this,” he says. “They want to understand what’s required to be communicated and then proactively position themselves to ask questions of the auditor.”

Audit committee should plan to talk with auditors about where they regard their judgments to be particularly difficult, especially with respect to the more judgment-oriented areas of the company’s financial statements, such as various accounting estimates. That will not only facilitate their understanding of CAM disclosures, but it will improve governance overall, says Scudder.

Audit committees can even consider asking their auditors to engage in a “dry run” of what CAMs would be disclosed and what auditors would say about them for a recent historic reporting period, says Greg Wilson, a retired inspections director at the PCAOB who now consults on accounting and auditing issues. “Invest some time with the auditor to go through a couple of CAMs and look at a mock-up disclosure of what the auditor would be including in the report,” he says.

CHANGES TO PCAOB STANDARDS

Below the SEC discusses the changes to Critical Audit Matters.
The Proposed Rules retain the pass/fail opinion of the existing auditor’s report but make significant changes to the existing auditor’s report, including the following:
Critical audit matters (“CAMs”). The Proposed Rules require the auditor to communicate in the auditor’s report any CAMs arising from the current period’s audit or state that the auditor determined that there are no CAMs.
o A 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.
o In determining whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor should take into account, alone or in combination, the following factors, as well as other factors specific to the audit:
The auditor’s assessment of the risks of material misstatement, including significant risks; 
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;
The degree of auditor subjectivity in 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; and 
The nature of audit evidence obtained regarding the matter. 
o The communication of each CAM within the auditor’s report includes:
Identifying the CAM; 
Describing the principal considerations that led the auditor to determine that the matter is a CAM; 
Describing how the CAM was addressed in the audit; and 
Referring to the relevant financial statement accounts or disclosures. 
o For each matter arising from the audit of the financial statements that (a) was communicated or required to be communicated to the audit committee, and (b) relates to accounts or disclosures that are material to the financial statements, the auditor must document whether or not the matter was determined to be a CAM (i.e., involved especially challenging, subjective, or complex auditor judgment) and the basis for such determination.
Source: SEC

To get a better understanding of the standard, Wilson advises audit committees to begin by parsing through it with the company’s internal financial management team and internal auditors. “The supplement that with the external auditor’s input as well,” he says. “The key is going to be staying in step with external auditors as they go through their process, understanding what auditors are being advised by their firm to do.”

Jay Knight, a partner at law firm Bass, Berry & Sims, says audit committees can be expected to approach this cautiously at first, especially in light of how closely the PCAOB has been monitoring audit firms through their inspection process the past several years. Some experts have surmised audit committees may even hesitate to initiate discussions with auditors on certain subjects, fearing it may automatically cause the issue to fall within consideration as a CAM.

That kind of wariness would tend to contradict the audit committee’s fiduciary duty of oversight of the external audit, says Knight. “I’d want audit committees to feel free to ask whatever questions they feel are appropriate for the auditor without hesitation of what might be a CAM,” he says. “If they need to ask the auditor question about a particular item, just as the auditor.”

Fred Lipman, a partner at law firm Blank Rome and president of the Association of Audit Committee Members, says the likely universe of CAMs shouldn’t be that mysterious to audit committees. “Any audit committee that is surprised by the information contained in CAMs should seriously re-evaluate their relationship with their current independent auditor,” he says. “This information should have been routinely furnished to the audit committee well before the new rule became effective.”

Lipman is like some observers of the new rule who believe the audit firms may develop boilerplate language to address CAM disclosures, which are not likely to cause audit committees a great deal of concern.

Ron Steger, a retired audit partner who now chairs two public company audit committees, says his discussions with Big 4 firms so far suggests they expect CAM disclosures to align closely with matters auditors are already required to discuss with audit committees under auditing standards. With respect to the results of the audit, auditors are required to have dialogue with audit committees on topics such as accounting policies and practices, estimates, significant unusual transactions, the quality of the company’s financial reporting, difficult or contentious matters that involved outside consultations, disagreements with management, and more.

“I don’t think any of the firms have come to a conclusion as to what the report will look like,” says Steger.

SEC Chairman Jay Clayton said when the standard was issued he’s hopeful the standard won’t produce a contentious environment. “I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships—with Main Street investors ending up in a worse position than they were before,” he said.

At a public meeting of a PCAOB advisory group, Clayton hailed the standard as “one of the single best developments for investors in markets in the last 20 years.”

Sandy Peters, head of financial reporting policy at the CFA Institute, says analysts and investor advocates have been stumping for more insight into the audit since at least the 1970s. “Investors really wanted this,” she says. “They want the benefit of the good conversation. They want to hear from both the audit committee and the auditor about the things they discussed.”