New PCAOB audit report raises the question: What exactly is a ‘critical audit matter’?

In its latest attempt to make over the standard, boilerplate audit report, the Public Company Accounting Oversight Board has taken to heart widespread criticisms of its earlier proposal and reigned in what new information it might require auditors to provide.

Nearly three years after its first proposal to revise the audit report by requiring auditors to provide some insight into their audit findings, the PCAOB has revised its plans based on feedback and issued a new proposal for a new round of public comment. The new proposal still requires auditors to list and describe “critical audit matters” that arose during the course of each public company audit, but it provides a revised definition of CAMs intended to narrow the scope of what auditors might need to explain.

The new definition provides three tests for what constitutes a CAM. Was it communicated or required to be communicated to the audit committee? Is it related to accounts or disclosures that are material to the financial statements? Did it involve especially challenging, subjective, or complex audit judgment? The standard would list six factors auditors would discern to help them arrive at the answer to that final question.

If the answer to all three questions is yes, then it’s a CAM that must be identified in the audit report, with description of what led auditors to conclude it was a CAM and reference to the relevant financial statement accounts and disclosures. And if there were no CAMs on a given audit, auditors must provide that assertion as well.

The new definition is more targeted than that contained in the original proposal, which drew plenty of criticism from all corners of capital markets that it would lead to lengthy disclosures of information that shouldn’t come from the auditor or don’t belong in the audit report. The PCAOB says the new definition narrows the scope of possible CAMs by limiting them to issues taken before the audit committee and deemed material to financial statements.

“A key takeaway from the CAQ's effort to field test the auditor's reporting model was that focusing the source for CAMs to only those matters communicated to the audit committee may be more effective and efficient to the benefit of all stakeholders.”

Cindy Fornelli, Executive Director, Center for Audit Quality

In addition to some documentation requirements around CAMs, the new standard also would require auditors to provide new language in every audit report to clarify their existing responsibilities. That would include, for example, an explanation of the requirement for auditors to maintain their independence from audit clients. It also would require auditors to clarify that their opinion provides reasonable assurance regarding material misstatements, whether those misstatements might arise due to error or fraud.

Finally, the new proposal still would require audit reports to tell investors how long the audit firm has served continuously as the company’s external auditor. That’s a controversial hold-over from the days when some members of the PCAOB, concerned that long tenures lead to relationships that compromise independence, were trying to push for term limits for audit firms.

While it will take time for auditors and other audit stakeholders to review the 238-page proposal, the Center for Audit Quality is encouraged by what it has heard so far. A CAQ field test of the original standard determined it would lead to voluminous disclosures, some of which are not required by companies or would more appropriately come from the companies themselves. That prompted the CAQ and others to advocate that CAMs should be limited to issues discussed with or required to be discussed with the audit committee.

“A key takeaway from the CAQ's effort to field test the auditor's reporting model was that focusing the source for CAMs to only those matters communicated to the audit committee may be more effective and efficient to the benefit of all stakeholders,” said Cindy Fornelli, executive director of the CAQ. “As other jurisdictions have adopted expanded auditor reporting, we believe this is a move in the right direction.”

Adam Hallemeyer, a senior manager at audit firm RMS, says he’s pleased to see the new proposal does not appear to put auditors in the position of disclosing information that management is not otherwise providing or required to provide to investors. “That was a concern in the auditor community as well as the preparer community,” he says. “It appears they’ve made a number of changes focused on that concern.”

AUDITOR CONSIDERATIONS

The auditor would take into account the following nonexclusive list of factors when determining whether a matter involved especially challenging, subjective, or complex auditor judgment:
1. The auditor's assessment of the risks of material misstatement, including significant risks;
2. The degree of auditor subjectivity in determining or applying audit procedures to address the matter or in evaluating the results of those procedures;
3. 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;
4. 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;
5. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions; and
6. The nature of audit evidence obtained regarding the matter. The determination should be made in the context of the particular audit, with the aim of providing audit-specific information rather than a discussion of generic risks.
Source: PCAOB

Still, there will be plenty to debate under the new proposal. At least one board member still worries that the CAM definition contains too much subjectivity. “Allowing auditors to decide what matters involved especially challenging, subjective or complex auditor judgment still grants them too much discretion,” said PCAOB member Steve Harris. “And the factors listed in the standard that guide the auditor in determining whether a matter meets these criteria do not help as they are subjective themselves.” He worries that auditors will pursue “artful means” to avoid disclosures, and that it will make the inspection process more difficult.

Some board members also are still not convinced that audit tenure is relevant and therefore should be the subject to a required disclosure. Evidence about any connection between auditor tenure and audit quality is “mixed, at best” said PCAOB member Jay Hanson, so he wonders if requiring disclosure would lead to investor perception that long tenure correlates to poor audit quality. “I am not yet convinced that a regulatory requirement is appropriate,” he said in his statement accompanying the proposal.

Hallemeyer says he expected continued debate on that disclosure requirement as well. “Just hearing that was a concept that lived on was interesting,” he says. “I expect it will continue to be a subject of debate, and I expect the comments will be similar to what they were the last time on that issue.”

Dave Sullivan, deputy managing partner of professional practice at Deloitte & Touche, says he’s encouraged by the discussion he’s heard so far and the summary highlights he’s seen of the new proposal in moving toward a standard that will be workable in practice and informative to investors. “The current auditor’s reporting model has been essentially the same pass-fail boilerplate report for many, many decades,” he says. “This discussion about auditors providing more meaningful communication to the users of financial statements has been going on since the 60s.”

The new, more narrow definition of CAMs targeting matters addressed with the audit committee should go a long way to giving investors that insight, Sullivan says. “Focusing on the most challenging, subjective, or complex matters that auditors are addressing and focusing on matters that are already discussed with the audit committee—that will open the essence of those conversations to all users of financial statements.”