SEC Approves PCAOB’s New Audit Report Standard to Enhance the Auditor’s Reporting Model
John Marsh, Audit Principal
On October 23, 2017, the Securities and Exchange Commission (“SEC”) approved the Public Company Accounting Oversight Board’s (“PCAOB”) proposal to adopt a new auditing standard, AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and related amendments to other auditing standards (the “standard”).
The PCAOB adopted and the SEC approved the final standard after more than six years of outreach and public comment, including comments from members of the PCAOB’s Standing Advisory Group and Investor Advisory Group. (See SEC order here and PCAOB proposal here.) The PCAOB feels it has taken into consideration all comments and believes its approach responds to investor requests for additional information about the financial statement audit without imposing requirements beyond the auditor’s expertise or mandate. This is the first significant change to auditor reporting in over 70 years. Similar changes have been made in recent years to auditor reporting in other countries.
The PCAOB feels that adoption of the requirements within this new auditing standard responds to the strong interest of investors for expanded communication about the audit and is consistent with its mandate to “protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.”
The standard retains the pass/fail audit opinion, meaning that an opinion will still conclude, based upon obtaining reasonable assurance, the financial statements either are or are not in accordance with the applicable accounting framework in all material respects. However, the standard requires auditors to include in their reports additional information and format changes such as auditor tenure, auditor independence, and other information (excluding a communication of Critical Audit Matters (CAMs), as defined below) effective for all audits relating to fiscal years ending on or after December 15, 2017. CAM requirements will be phased in for large accelerated filers for audits relating to fiscal years ending on or after June 30, 2019 and for all other companies for audits relating to fiscal years ending on or after December 15, 2020. Auditors may voluntarily comply early. The standard generally applies to audits conducted under PCAOB standards, but CAMs do not have to be communicated for audits of brokers and dealers, investment companies other than business development companies, employee stock purchase, savings and similar plans, and emerging growth companies.
Critical Audit Matters
The standard requires an auditor’s report to disclose any CAMs arising from the current period’s audit, or to state that the auditor determined that there were no CAMs for that period. A CAM is defined in the standard as items communicated to the audit committee or required to be communicated to the audit committee that related to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective or complex auditor judgment. In determining whether a matter rises to the level of a CAM due to it involving especially challenging, subjective, or complex auditor judgment, auditors should take into account, alone or in combination, factors including but not limited to:
- the auditor’s assessment of the risks of material misstatement, including significant risks (defined as a risk of material misstatement that requires special audit consideration);
- 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.
The communication of each CAM includes:
- Identifying the CAM;
- Describing the principal considerations that led the auditor to determine that the matter is a CAM;
- Describing how the CAM was addressed in the audit; and
- Referring to the relevant financial statement accounts or disclosures.
Under the standard, the auditor will be required to communicate CAMs in the auditor’s report in order to provide more information about the audit and make the auditor’s report more informative and relevant to investors and other financial statement users.
In discussions of the final standard, the PCAOB clarified that:
- a significant deficiency in internal control over financial reporting, in and of itself, cannot be a CAM (as it does not relate to an account or disclosure that is material to the financial statements, even though it might involve especially challenging, subjective or complex judgement);
- a potential illegal act, if an appropriate determination had been made that no disclosure of it was required in the financial statements, would not meet the definition of a CAM; and
- a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a CAM.
Other Changes to the Audit Report
The standard also includes a number of other changes to the auditor’s report that are primarily intended to clarify the auditor’s role and responsibilities related to the audit of the financial statements, provide additional information about the auditor, and make the auditor’s report easier to read:
- Auditor tenure—the reports must include a statement disclosing the year in which the auditor began serving consecutively as the company’s auditor;
- Independence—the reports must include a statement regarding the requirement for the auditor to be independent;
- Addressee—the report will be addressed to the company’s shareholders and board of directors or equivalents (additional addressees are also permitted);
- Amendments to basic elements—changes to certain standardized language in the report, including adding the phrase whether due to error or fraud, when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and
- Standardized form of the auditor’s report—requiring the opinion to appear in the first section of the auditor’s report, and adding section titles to guide the reader.
BNN Thoughts and Insights for Management and Audit Committees
Overall, the standard is intended to make the auditor’s report more relevant and useful to investors and other market participants in assessing a company’s financial reporting and making capital allocation and voting decisions. The PCAOB feels that CAMs should provide investors with a new perspective on the financial statements and focus their attention on the related financial statement accounts and disclosures, which should facilitate their analysis of the financial statements, and help them assess financial performance, for example by highlighting potentially relevant information or by reducing the costs to process or search for the information. The ability to identify and evaluate the matters identified as CAMs should also help investors and analysts engage management with targeted questions about these issues and support investor decisions on ratification of the auditor.
Management and Audit Committees may want to consider having discussions with their auditors about the standard and the best way to apply it. Audit Committees may wish to design and establish best practices to identify and evaluate probable CAMs and work with their auditors to establish procedures for receiving timely communication of the auditor’s intent to disclose CAMs and each CAM’s content. In regard to auditor tenure, the PCAOB noted that many companies already disclose auditor tenure in audit committee reports generally contained in proxy filings. In many of those instances, the audit committee report provides incremental context regarding the audit committee’s consideration of tenure and other factors they consider relevant to their responsibilities for hiring, dismissing and overseeing auditors. The PCAOB does not believe that disclosure of auditor tenure in the auditor’s report necessarily suggests a specific correlation between auditor tenure and audit quality, or between auditor tenure and auditor independence. BNN believes audit committees are best positioned to consider whether the length of the auditor’s tenure may negatively affect audit quality, based on their direct interaction with auditors. As such, audit committees may wish to consider whether proxy disclosures around audit committee oversight of auditors, including its considerations related to auditor appointment and retention, are sufficiently informative. Additionally, companies with long-tenured auditors may wish to consider expanded disclosure in their proxy statements addressing the benefits of having a long-term relationship with their auditor, such as company and industry specific knowledge, decreased risk, and higher quality audits, as well as how the audit committee monitors auditor independence.
If you would like to discuss these matters further, contact John Marsh or your BNN advisor at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.