Audit committees may soon face pressure to increase certain areas of corporate disclosure to get ahead of “critical audit matter” disclosures that will begin appearing in audit reports in 2019.
Auditors at the largest firms are preparing to comply with a new standard that requires them to list and describe CAMs in their audit reports beginning as early as July 2019 for large accelerated filers. Firms are engaging some audit committees in pilot tests or dry runs using historic financial statements to help auditors, audit committees, and management understand how the new CAM disclosures will develop and how they may affect the financial reporting process.
EY, for example, is taking all of its large accelerated filers through a full dry run using prior-year audit results to identify critical audit matters, discuss them with audit committees, draft and review disclosures, and develop all the necessary documentation to support CAM conclusions. The exercise is helping auditors not only determine what to disclose and how to describe it, but also what system of internal quality control needs to be built around the process, said David Kane, EY Americas vice chair in professional practice, at a recent presentation to the Standing Advisory Group of the Public Company Accounting Oversight Board.
“We expect questions over the summer,” said Kane. “That’s what we get from the dry run. It’s been informative to us.”
The PCAOB, which finalized a new standard in 2017 that requires auditors to include a great deal of new information in audit reports, is pleased to see audit firms taking such a proactive approach, said Jennifer Rand, deputy chief auditor at the PCAOB. “The board intends to monitor the results of implementation, including consideration of unintended consequences,” she said.
“Early discussion has a ripple effect not just about the audit report but what the company’s own disclosures need to say.”
Mike Santay, Partner, Grant Thornton
The most significant change to the audit report under the new standard is the requirement for auditors to identify and explain the critical audit matters that arose during the audit. CAMs are defined as those issues pertaining to material accounts or disclosures that proved most difficult for auditors because they involved complex, subjective, or challenging auditor judgments.
Other aspects of the new audit report are taking effect with 2017 year-end audit reports, including a disclosure regarding the auditor’s tenure on the engagement. As straightforward as it may seem to simply state the number of years the auditor has served continuously on each engagement, that has proven tricky due to various types of consolidation or break-up events, both among audit clients and the firms themselves.
CAMs, however, are not required until mid-2019 for large accelerated filers and 2020 for all other companies. That gives both audit firms and their clients more time to prepare for what many have characterized as the most significant change to the standard auditor’s report in generations.
Mike Santay, a partner at Grant Thornton, said his firm also is pilot testing CAM disclosures with about 10 audit clients. “We’re going to do a deep dive,” he said. “How would you use filters or factors to determine CAMs?” The firm is “at the beginning” of exploring a lot of questions, he said.
Audit committees are asking plenty of questions, said Kane, focusing primarily on what auditors envision to be CAMs and what kinds of CAMs will be reported for competitors. “Engagement with audit committees is a critical part of the dry run to make this successful,” he said.
Kane indicated many of the CAMs that are being identified through the pilot testing and dry run processes tend to focus on accounting and auditing areas that are known to be difficult—valuations of indefinite-lived assets, goodwill impairments, uncertain tax positions, and revenue recognition, especially using the percentage-of-completion method under the historic approach to revenue recognition.
The CAM dialogue is inspiring audit committees to think hard even about their own disclosures, said Santay. Audit committees do not want to see auditors disclosing information about the company that the company itself has not already disclosed. That concern emerged among auditors during the public dialogue and debate as the PCAOB developed the new auditor’s reporting model.
“Early discussion has a ripple effect not just about the audit report but what the company’s own disclosures need to say,” said Santay.
John White, chair of the corporate governance and board advisory practice at law firm Cravath, Swaine & Moore and a member of the PCAOB’s SAG, said he’s advising audit committees to take a good look at their own disclosures as they learn what CAMs auditors plan to identify. “Most disclosure lawyers involved with this process are advising companies to front run or get ahead of CAM disclosures that will be coming,” he said.
The best CAM disclosure, said White, will be on that cross references a disclosure in the financial statements. “That’s the advice lawyers are dispensing in this space,” he said. “You don’t want original information coming from the auditor. The company should be trying to lay the ground work to get their version or their description of what’s going on in their disclosures and they should be doing that this year, not waiting or dropping it in at the same time as the auditor for the first time.”
Apart from the SAG discussion, Dave Sullivan, national managing partner at Deloitte & Touche, said his firm is also doing plenty of pilot testing and dry run exercises to prepare for CAM disclosures. “We’re engaged with both management and audit committees in the identification of CAMs and disclosures of CAMs, and we’re using that information to help refine our methodology and our guidance prepared for our engagement teams,” he said.
So far, the firm is not finding situations where auditors are identifying no CAMs whatsoever, said Sullivan. Although the standard contains language to make it clear auditors are not obligated to identify CAMs on every engagement, Sullivan said so far no dry run has resulted in the identification of zero CAMs.
Audit leaders say they are starting to see or expect to see audit committees continuing to consider their own disclosures as auditors continue to prepare to disclose CAMs. “I think that was the objective of the entire standard,” said Jim Burton, partner in charge of audit methodologies and standards at Grant Thornton. “It not only gets the view of the auditor’s unique perspective on corporate reporting, but it could help the overall disclosure package in total.”
Adam Hallemeyer, a partner at audit firm RSM, said corporate disclosure is becoming part of the CAM disclosure discussion. “Auditors and management are sensitive to this and aware of it,” he said. “It gives management an opportunity to take a fresh look at what their own disclosures look like.”
That makes it imperative for audit committees and management to assure they are having some early discussions with auditors, says Jan Herringer, a partner at BDO USA. “The most important suggestion I could make is the earlier public accounting firms and audit committees have conversations about matters that are potential CAMs, that will make the process go a whole lot better,” she said.