As you may recall, auditors of large accelerated filers will be required to report on CAMs—critical audit matters—in their auditor’s reports for fiscal years ending on or after June 30, 2019 and in auditor’s reports for all other companies (except EGCs) to which the requirements apply for fiscal years ending on or after December 15, 2020. (See this PubCo post.) As SEC Commissioner Kara Stein observed in her statement on approval of the new rule, the new “standard marks the first significant change to the auditor’s report in more than 70 years.” Because the selection of and disclosure regarding CAMs will certainly present a challenge for both auditors and audit committees, auditors have been taking steps to prepare for the coming change, including conducting “dry runs” to get a better handle on how the new CAM disclosures will look and how the process will affect financial reporting. To provide some lessons learned from these early dry runs and enhance the understanding of audit committees, auditors and other participants in the process, the Center for Audit Quality has published Critical Audit Matters: Lessons Learned, Questions to Consider, and an Illustrative Example.
Under new AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, CAMs are defined as “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” Essentially, the concept is intended to capture the matters that kept the auditor up at night, so long as they meet the standard’s criteria.
Once the auditor has identified a CAM, in preparing the CAM disclosure, the auditor must identify the CAM, describe the principal considerations that led the auditor to determine that the matter was a CAM, describe how the matter was addressed in the audit and refer to the relevant financial statement accounts or disclosures.
But how does the auditor identify a CAM? Identification of CAMs is a principles-based inquiry. Once the auditor identifies a matter communicated or required to be communicated to the audit committee that relates to material accounts or disclosures, the auditor must determine whether the matter involved especially challenging, subjective or complex auditor judgment, taking into account a nonexclusive list of factors, including the following:
- “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.”
Depending on the matter, the auditor’s determination might be based on only one factor or a combination of these or other factors.
What does the CAQ tell us about the first lessons learned from these dry runs?
- As you might be able to discern from the list above, the principles-based process of determining which matters are CAMs involves “significant auditor judgment.” The auditor’s exercise of that judgment will be affected by a number of different factors, with the result that the determination of which matters amount to CAMs will be “unique to each audit.”
- To avoid surprises, communication among the auditor, audit committee and management should occur early and often. As discussed in this PubCo post, the prospect of CAM disclosures may drive audit committees and managements to revisit the company’s own disclosures. Why? Because, generally, audit committees and managements much prefer that the company get a jump on the disclosure so that the auditors will not need to resort to the creation of original material and the company can best frame the discussion from its own perspective. The CAQ cautions, however, that any “modifications of a company’s disclosures should be based on management’s reporting requirements and should be independent of the auditor’s identification of CAMs.”
- The process will take substantial time, and auditors and other participants in the process need to build appropriate time into the schedule, taking into account the necessity of discussions of draft CAM communications with management and the audit committee “well in advance of when the auditor’s report is to be issued.”
- A key lesson learned is that drafting “informative, but not overly technical” CAM disclosure is not easy, particularly with regard to achieving “the right balance between the CAM description in the auditor’s report and information in the company’s disclosures, to convey concisely the essence of why a matter is a CAM, and to describe how the CAM was addressed in the audit.”
To facilitate the dialogue between auditors and audit committees regarding CAMs, the CAQ has developed a list of questions and responses for audit committee members to consider in developing their understanding of the requirements, including the following:
- “How will CAMs relate to disclosures made by management in the Form 10-K outside the financial statements?”
Although CAMs, by definition, relate to an account or disclosure that is material to the financial statements, the MD&A may well include information that relates to information in the CAM description, such as a critical accounting estimate (or related assumptions) included in the financial statements.
- “Will there be a CAM for every critical accounting estimate disclosed by management?”
That will depend on whether auditing of each of the critical accounting estimates involves especially challenging, subjective or complex auditor judgment. Some estimates may not, depending on the facts and circumstances, such as some legal contingencies.
- “Will there be a CAM related to every significant risk identified by the auditor?”
A significant risk is “a risk of material misstatement that requires special audit consideration…because of the nature of the risk or the likelihood and potential magnitude of the misstatement related to the risk.” A significant risk is required to be communicated to the audit committee, but, according to the PCAOB adopting release, not all “significant risks” are considered CAMs. To be a CAM, auditing of the significant risk must involve especially challenging, subjective, or complex auditor judgment.
- “Can a significant deficiency in internal control over financial reporting (ICFR) be a CAM?”
According to the PCAOB adopting release, a significant deficiency would not, by itself, be a CAM because it “does not relate to an account or disclosure that is material to the financial statements as no disclosure of the determination is required.” Nevertheless, the CAQ advises, a significant deficiency could still be a principal consideration in determining whether a matter is a CAM:
“If a significant deficiency was among the principal considerations in determining that a matter was a CAM, the auditor would describe the relevant control-related deficiencies in the CAM without using the term ‘significant deficiency.’ The other auditor judgment to consider when a control deficiency exists is whether and how the auditor might need to adjust the original audit response in the area where the control deficiency has been identified. However, the audit response to a control deficiency that is not a material weakness is typically less extensive because the auditor has concluded that a reasonable possibility of material misstatement due to the control deficiency does not exist. For example, the audit response may be to perform more of the same testing procedures performed prior to identification of the significant control deficiency. In those situations, judgments about the audit response would likely not be a principal consideration of why something is a CAM, and therefore would not be reported. Likewise, it should not be assumed that if a CAM discusses control-related issues there was a significant deficiency related to the CAM.”
- “What matters will likely be the more common CAMs?”
Most likely, those involving “high degrees of estimation uncertainty and that require significant management judgment.” Good candidates for CAM status are auditing “goodwill impairment, intangible asset impairment, business combinations, aspects of revenue recognition, income taxes, legal contingencies, and hard to fair value financial instruments.”
- “How comparable will CAMs be across companies in the same industry?”
Although CAMs must be determined in the context of the particular audit, it would not be surprising for auditors of companies in the same industry to identify similar CAMs. However, the CAQ advises, “the communication of the CAMs will be specific to that audit, because the auditor’s assessment of the risks of material misstatement and related audit response often will vary based on a company’s unique processes and controls. As a result, while the matters that are CAMs may be relatively similar among companies in the same industry, the principal considerations that led the auditor to determine a matter was a CAM and the way the matter was addressed in the audit may differ,” with the result that the CAM communication may be different.
- “Are CAMs similar to key audit matters?”
Key audit matters (KAMs) is the equivalent term used under IFRS. While the processes for identifying KAMs differs from that for CAMs, some of the criteria and communication requirements are similar, so that some of the same matters could be reported under both approaches. The CAQ provides relevant examples to distinguish the two methodologies.
- “Is it expected that auditors will always communicate at least one CAM in the auditor’s report?”
Although it’s certainly possible that no CAMs will be identified (in which event, the auditor’s report will disclose the absence of CAMs), the PCAOB expects at least one CAM to be identified in most audits.
- “What is the auditor’s process for drafting the CAM section of the auditor’s report, and at what point in that process should management and the audit committee expect to be involved?”
The processes involved in identifying CAMs and preparing CAM disclosure will obviously vary among auditors and companies. However, the CAQ cautions that auditors, audit committees and managements should develop a process and a timetable that sets forth the participants involved and their responsibilities, when the process will begin, when drafts of the CAM disclosures will be provided and when time will be dedicated during audit committee meetings to discuss the CAMs identified and the related CAM disclosure.
- “How can companies prepare for questions about CAMs from investors?”
The best approach is for companies to understand the auditor’s responsibilities associated with CAMs and why the auditor determined particular matters to be CAMs, which should be the subject of prior discussion between the auditors and the audit committee and (probably) management. Management may also want to identify a spokesperson within the company to address questions regarding CAMs from investors or other stakeholders.
In conclusion, the CAQ provides an illustration of a CAM disclosure.