by Cydney Posner
As discussed in this PubCo post, in May of this year, after five years of outreach, the PCAOB once again attempted to make the auditor’s report more relevant and informative to investors by reproposing the auditor reporting standard, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion. While the reproposal would retain the standard pass/fail model, it would also provide for the inclusion of critical audit matters (CAMs) in the auditor’s report, as well as new elements related to auditor independence and auditor tenure. Comment letters to the PCAOB regarding its reproposal of the standard have reflected a predictable split. As discussed in this Bloomberg BNA article, investors generally have approved of the proposed changes, while auditors have continued to express concern that, even under the reproposal, they — not management — remain a primary source for the new disclosures regarding CAMs.
Typically, as you know, auditors just give companies a pass/fail grade and provide no description of any issues or problems that occurred during the audit process; those problems are instead taken up with the audit committee. As you may recall, in originally proposing the disclosure of CAMs in 2013 (see this Cooley news brief), the PCAOB encountered substantial controversy. As proposed, the communication of CAMs was intended to “inform investors and other financial statement users of matters arising from the audit that required especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters.” Supporters of the concept at that time contended that the current form of the audit report was just boilerplate that “tells investors little of substance about a company’s true condition.” As a former PCAOB member commented in a BusinessWeek article at that time, “[t]he concern coming out of the financial crisis was that auditors had more information into judgment calls and business risks than they conveyed in their opinion… Some insight from the auditor about what the challenging part of the audit was and what the risks are would provide some additional insight. The question is, at what cost.” The PCAOB had tried to address this concern in its 2011 Concept Release by floating various alternatives, principle among them the “auditor’s discussion and analysis.” (See this Cooley news brief.) But the ADA concept was widely criticized because, among other things, it was viewed as “fundamentally changing the auditor’s current role from attesting on information prepared by management to providing an analysis of financial statement information,” thus causing the auditors to step into a role of management.
Although there was general support for the objective of the project to enhance the audit report, the critics were not silent about the PCAOB’s proposal to achieve it. These critics argued that CAMs “would not provide relevant information to investors, may be duplicative of the company’s disclosure, may result in disclosing information not otherwise required to be disclosed, could increase cost, or could delay completion of the audit.” In addition, critics pointed out that, notwithstanding the PCAOB’s efforts to avoid changing the auditor’s current attestation role, the proposal could still have required the auditors to provide subjective analysis: as one commentator observed in this Law360 article, the proposal put auditors in the position “where they are essentially editorializing on the contents of a company’s reports,” which could well alter the client relationship and “raises key questions about who is responsible for revealing internal company information. ‘The traditional view is – that in a company’s filing, it is the company that speaks. Not the auditor, not the company’s lawyer,’” the commentator added.
The PCAOB 2016 reproposal narrowed the definition of “CAM” to any matter that was “communicated or required to be communicated to the audit committee,” that relates to accounts or disclosures that are “material to the financial statements,” and that involved “especially challenging, subjective, or complex auditor judgment.” This revised definition limited the source of potential CAMs to communications with the audit committee (as opposed to those “addressed during the audit” as originally proposed), added a materiality component and narrowed the definition to only those matters that involved “especially challenging, subjective or complex auditor judgment.” According to PCAOB Chair Jim Doty, the reproposal “envisions that auditors describe their critical audit judgments. It does not put them in the position of speaking for management.” The Bloomberg BNA article indicates that some remain unconvinced.
According to Bloomberg BNA, investors generally approved of the reproposal. The Council of Institutional Investors contended that investors would benefit “from the insight of auditors, and, as the ‘key customer of audited financial reports,’ their needs should be at the forefront in deciding what and where disclosures should go in the audit report.” However, among other things, auditors contended that the disclosures would be expensive to prepare, but ultimately just result in more boilerplate and repetition that would “not necessarily add anything of value to investors or analysts.” In addition, auditors argued that the reproposal would “chill communication” between the auditor and the audit committee and and undermine the role of audit committee with management.
In particular, preparers expressed the concern that the PCAOB did not “follow through on its promise that auditors wouldn’t be responsible for disclosing original information in the Critical Audit Matters (CAMs) section of the audit report.” The Executive Director of the Center for Audit Quality told Bloomberg BNA that, while the CAQ did agree “that the PCAOB made changes in the reproposed standard to help prevent the auditor from being the original source of information about the company in the identification of a CAM,” a few changes were still advisable. In particular, the reproposal had added a note indicating that, when describing CAMs in the auditor’s report, the auditor “is not expected to provide information about the company that has not been made publicly available by the company unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit.” [Emphasis added.] As recounted in the article, both the CAQ and the Institute of Management Accountants suggested that the PCAOB eliminate the “unless” exception because it “could lead to auditors having to report company information initially” and “blurs the line between whether management or auditors have primary responsibility for disclosures.” Both IMA and a former FASB chair also suggested that, in lieu of the exception, the auditor could simply threaten to issue a “qualified” opinion if management’s disclosures were inadequate. The former FASB chair also suggested as an alternative that part of the auditor’s report should link to the significant accounting policies and estimates made by management in its Form 10-K, thereby avoiding burdening “readers with five or six pages of new writings.” Similarly, corporate commenters suggested that, to eliminate the problems of auditors potentially being an initial source of disclosure and to avoid duplication and conflict, “CAMs should be selected from the critical accounting estimates already disclosed by management, rather than from matters that the auditor communicates to the audit committee.”
Bloomberg BNA reports that a representative of CII indicated that requiring auditors to provide “original information” was not much of a concern “because, in part, the auditor’s insights would come from communications that the auditor already is required to provide to the audit committee.” The CII representative also rejected the cross-referencing suggestion because, without any separate insights by the auditor about management’s significant estimates and judgments, the report would not provide the type of information that investors want. Instead, he suggested that “the importance and relevance to the investor of the auditor’s report would be enhanced if the report included the ‘auditor’s findings as to whether management’s significant accounting estimates and judgments were balanced, mildly optimistic, or mildly pessimistic, or equivalent language.’”
Bloomberg BNA also reported that various international accounting organizations were encouraged that the PCAOB approach was relatively consistent with international standards. The U.K.’s Institute of Chartered Accountants in England and Wales suggested that PCAOB align more closely with the definitions of the International Auditing and Assurance Standards Board (IAASB). However, other commenters objected that, because the “regulatory environment is different in the U.K. than in the U.S.,” the style of audit report advocated as a model in the U.K. “would increase auditors’ liability.” (See this PubCo post for a discussion of an academic study examining whether an expanded audit report improves communication value.)