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Expanded auditor report: take two

Robert Herz | June 1, 2016

The Public Company Accounting Oversight Board recently issued for public comment a re-proposal that would significantly change and expand the content of the auditor’s report. While retaining the overall pass/fail audit opinion, the audit report would be expanded to cover a number of additional subjects including the independence of the auditor from the company, how long the firm has been serving as the company’s auditor, and perhaps of greatest significance, discussion of the “Critical Audit Matters” (CAM) encountered and addressed by the auditor in the course of the examination. The discussion of CAM is intended to cover those matters that were communicated to the audit committee and that relate to accounts or disclosures that are material to the financial statements and that involved especially challenging, subjective, or complex judgments by the auditor.

While the proposed requirements in the re-proposal are similar in many respects to those that the PCAOB previously proposed in August 2013, they reflect a number of changes intended to respond to comments and suggestions the board received on the first proposal, to its analysis of economic considerations, and to relevant academic research. For example, in response to concerns about the potentially broad scope of CAM that would be required to be covered in the auditor’s report, the re-proposed standard limits the source of potential CAM to matters communicated or required to be communicated to the audit committee, adds a materiality component to the definition of CAM, and narrows the definition to only those matters that involved particularly challenging, subjective, or complex auditor judgment. It also revises the related documentation requirements and expands the required discussion of each CAM to include how the critical audit matter was addressed in the audit.

In developing the re-proposal, the PCAOB has also been mindful of recent international developments regarding the auditor’s reporting model, in particular those in the United Kingdom, the European Union, and by the International Auditing and Assurance Standards Board (IAASB) which sets the International Standards on Auditing (ISAs) that are used in many countries around the world. The U.K. Financial Reporting Council (FRC), which regulates and oversees corporate governance and reporting in the United Kingdom, led the way on this topic, adopting a principles-based standard, which took effect starting with audit reports on the 2013 financial statements of U.K.-listed companies. That standard requires that, in addition to an overall opinion on the financial statements, the audit report describe the materiality level(s) the auditor used in conducting the audit, the scope of the audit, the most significant risks of material misstatement, and how these risks were addressed in the audit.

We have now seen three rounds of expanded auditor reporting in the United Kingdom. Overall, I believe the change has been well received in the United Kingdom, both by auditors and perhaps more importantly by investors and audit committee members. For example, in 2014 in the KPMG discussion series Value of Audit: Shaping the future of corporate reporting, Tony Cates, head of audit at KPMG in the United Kingdom, stated “Auditors have broader access to a company than almost any other entity or profession … We are in a unique position to deliver more than a pass/fail audit report; to deliver insights to help shareholders better understand and engage with the companies that they own. That is why I am so passionate about the value we can add in our new, expanded audit reports in the U.K.”

Clearly, we are beginning to witness a fundamental change in auditor reporting across much of the world that will take it from the short, pass/fail audit opinion that we have been used to for many years to a much more expansive model of reporting by the independent auditor on significant areas addressed and findings in the audit.

From my own discussions with U.K. audit partners, with several audit committee members of the boards of major U.K. companies, and with representatives of major U.K. institutional investors, there seems to be general enthusiasm, a spirit of innovation, and a genuine sense of pride in the U.K. financial reporting system over the changes in auditor reporting brought about by the new FRC requirements. Indeed, an FRC survey published in March 2015 on Extended auditor’s reports: A review of experience in the first year found that U.K. auditors appear not only to have met the new requirements but in many cases to have gone further and reported more widely than required in describing audit materiality benchmarks, the audit planning process, key audit risk areas, how these were addressed , the resulting findings by the auditors, the magnitude of unadjusted errors, and improved presentation of audit reports through the use, for example, of diagrams and graphs. The FRC survey contains extracts from numerous actual audit reports showing how various new requirements were addressed in practice.

For those interested in reviewing a good example of an entire audit report on a major U.K. company under the FRC requirements, I suggest you read the Independent Auditor’s Report of KPMG dated 12 February 2014 on its audit of the financial statements of Rolls-Royce Holdings, for the year ended 31 December 2013, which can be found on pages 130-135 of the Rolls-Royce Holdings 2013 annual report. In reading the KPMG audit report on Rolls Royce I was struck by the refreshing color and candor of the commentary, for example, in regard to the audit findings with respect to the company’s estimate of the financial liability relating to the Valuation of Daimler AG’s put option on page 132 in which the KPMG report states “We found the resulting estimate was acceptable but mildly optimistic resulting in a somewhat lower liability being recorded than might have otherwise have been the case=” (emphasis added). It made me wonder whether in the United States, with our different legal and litigation environment than in the United Kingdom, an auditor would be willing to use words such as “mildly optimistic” without such a term having been strictly defined in law, rules, or regulations.

Readers of the KPMG audit report on Rolls Royce will also note that it was rendered by Jimmy Daboo (the KPMG senior statutory auditor of Rolls Royce) for and on behalf of KPMG. As is common practice in many parts of the world, the lead audit partner signs or is named in the audit report. In the United Statesm the expanded audit report will not name the engagement partner. Rather, under a rule adopted by the PCAOB in December 2015 and expected to be approved by the SEC, the name of the engagement partner, as well as extensive information on other accounting firms that participated in the audit of the registrant, will be included in a publicly available Form AP that audit firms will be required to file with the PCAOB starting in 2017.

Audit regulators and standard setters in other parts of the world, including the PCAOB, have watched developments in the United Kingdom with great interest. In April 2014, as part of broad audit reform legislation, the European Union adopted new requirements relating to the independent auditor’s report on listed companies and certain other public interest entities. These new requirements become effective in 2017 and require that, in addition to the overall opinion on the financial statements, the audit report describes the most significant assessed risks of material misstatement (including those relating to fraud), a summary of the auditor’s response to those risks, where relevant key observations with respect to those risks, and any material uncertainties to the audited entity’s ability to continue as a going concern. Similarly, in January 2015, the IAASB issued revised auditor reporting standards that, starting with 2016 calendar year-end, audits of listed entities conducted in accordance with ISAs describe “Key Audit Matters”–those matters that the auditor views as most significant to the audit and how these were addressed in the audit, any material uncertainties with respect to going concern, and to name the engagement partner.

Clearly, we are beginning to witness a fundamental change in auditor reporting across much of the world that will take it from the short, pass/fail audit opinion that we have been used to for many years to a much more expansive model of reporting by the independent auditor on significant areas addressed and findings in the audit. I welcome this change because I have long felt that the current pass/fail audit report does not do justice to either investors or auditors in reflecting and communicating the key areas addressed in the audit and findings thereon and the richness and value of a well-performed independent audit. However, from having discussed this subject with many knowledgeable people in the United States, I recognize that others feel differently and are understandably concerned, for example, about the potential added costs and exposures that could arise from a change in auditor reporting in this country.

Comments on the PCAOB’s May 2016 re-proposed standard are due by Aug. 15, 2016. I encourage interested parties to read it, discuss it with colleagues and your auditors, and to consider sending the PCAOB a comment letter with your views and suggestions on this important subject.