In May, the PCAOB issued a proposed standard, “The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion,” which, if adopted, would make significant changes to the standard auditor’s report intended to make it more relevant and informative for investors and other financial statement users. The 2016 proposal represents a modified reproposal of a similar standard issued in September 2013. Although other changes have been proposed, the most significant change would require the auditor’s report to include a discussion of critical audit matters (CAM) and to provide audit-specific information about particularly challenging, subjective, or complex aspects of the audit.
Critical Audit Matters
Under the 2016 proposal, a CAM is defined as a matter that was communicated, or required to be communicated, to the audit committee relating to accounts or disclosures considered material to the financial statements that involved especially challenging, subjective, or complex auditor judgment. This represents a narrowing of the proposed scope of the standard; under the 2013 proposal, matters that 1) posed the most difficulty to the auditor in obtaining sufficient appropriate evidence or 2) caused the most difficulty to the auditor in forming the opinion on the financial statements also qualified as CAMs.
Although it narrowed the definition of a CAM, the 2016 proposal added a requirement for the auditor to describe how each CAM was addressed in the audit. The auditor’s report would thus be required to 1) identify all CAMs, 2) describe the principal considerations that led the auditor to determine that each matter rose to the level of a CAM, 3) describe how each CAM was addressed in the audit, and 4) refer to the relevant financial statement accounts or disclosures. If no CAMs arose, the auditor’s report would have to include an affirmative statement to that effect.
Following the International Lead
Over the past few years, several international regulators and standards setters, including the International Auditing and Assurance Standards Board (IAASB) and the European Union (EU), have adopted requirements to expand the auditor reporting model. While those requirements differ in detail and terminology from those in the PCAOB’s 2016 proposal, their main themes are similar, including the requirement that the auditor’s report contain a discussion of CAMs. In September 2014, the IAASB adopted changes to the auditor’s report that included a new requirement to include a discussion of “key audit matters” (KAM) for audits of listed companies [International Standards on Auditing (ISA) 701, Communicating Key Audit Matters in the Independent Auditor’s Report]. KAMs are defined as matters communicated to those charged with governance that, in the auditor’s professional judgment, were of most significance in the audit. In April 2014, the EU adopted legislation creating a number of new requirements, including an expanded auditor reporting model, for audits of so-called public interest entities (PIE), which include listed companies, credit institutions, and insurance companies, among other entities. Under the EU reforms, the auditor’s report on a PIE is required to include a description of the most significant assessed risks of material misstatement, including those due to fraud, as well as a summary of the auditor’s response to those risks and key observations arising with respect to those risks.
As with the PCAOB’s 2016 proposal, the IAASB’s standard requires that the description of each KAM include 1) an explanation of why the matter was considered to be a KAM, 2) a discussion of how the matter was addressed in the audit, and 3) a reference to the related disclosures in the financial statements. Therefore, for all intents and purposes, the IAASB’s new auditor reporting requirements are substantially the same as those currently being proposed by the PCAOB. ISA 701 becomes effective for reports covering 2016 calendar-year financial statements, with early application permitted. The new EU auditor reporting model is effective (based on member state implementation) for fiscal years ending on or after June 30, 2017. The PCAOB has not proposed a specific effective date for its standard, although the comment period runs through August 15, 2016.
Form and Content of the CAM Narrative
Because CAMs and the details surrounding them are, by their very nature, expected to be fact-specific, the PCAOB’s proposal provides only limited guidance on the form and content of that section of the auditor’s report. While the IAASB and EU reforms are not yet effective, under Dutch law, the new form and content of the auditor’s report became mandatory for periods ending on or after December 15, 2014, for audits of PIEs. The following observations are thus based on information, including KPMG’s report on the financial statements, contained in the 2015 Annual Reporting Form 20-F of Koninklijke Philips N.V. (Royal Philips), a Dutch PIE that is also registered with the SEC (http://bit.ly/1UtRcuX). Note that while the company’s financial statements have been prepared on the basis of International Financial Reporting Standards (IFRS), the main points would apply to similar U.S. GAAP situations as well.
- Identified key audit matters. KPMG identified six separate KAMs in its report, all of which, as would be expected, are the same ones identified by the company as “critical accounting policies” (albeit with slightly different descriptive titles and wording).
- The sheer volume of words. In KPMG’s report, the section covering key audit matters, on its own, comprises a staggering 2,100 words.
- An audit program. The discussion of how the identified KAMs were addressed during the course of the audit reads as if it were taken directly from a standard audit program. To illustrate, consider the following excerpt from KPMG’s report regarding the KAM “Accounting for Income Tax Positions”:
We have tested the completeness and accuracy of the amounts reported for current and deferred tax, including the assessment of disputes with tax authorities, based on the developments in 2015 and the impact of the scheduled separation of the Company. In this area our audit procedures included, amongst others, assessment of correspondence with the relevant tax authorities, testing the effectiveness of the Company’s internal controls around the recording and continuous re-assessment of the other tax liabilities, and the involvement of our local component auditors including tax specialists in those components determined to be the regions with significant tax risk. In respect of deferred tax assets, we analyzed and tested management’s assumptions used to determine the probability that deferred tax assets recognized in the balance sheet will be recovered through taxable income in the countries where the deferred tax assets originated and during the periods when the deferred tax assets become deductible. During our procedures, we use amongst others budgets, forecasts and tax laws and in addition we assessed the historical accuracy of management’s assumptions. We believe the assumptions used are within the acceptable range. We also assessed the adequacy of the Company’s disclosure included in Section 12.9, Note 8, Income taxes in respect of income tax positions and uncertain tax positions.
Would merely repeating the required discussion of critical accounting policies in the auditor’s report, but labeling them as critical audit matters, actually help investors or other financial statement users? Would repeating information otherwise required to be disclosed elsewhere in an SEC filing really make the auditor’s report more relevant and informative? Not in this author’s opinion. As for the new proposed requirement that the auditor describe how each CAM was addressed in the audit, would a listing of auditing procedures performed actually benefit investors? Would investors really be interested in reading about how the sausage is made? Not in this author’s opinion. Investors implicitly trust—and will continue to trust—that the auditor has performed enough relevant procedures to be able to issue an opinion and that knowing precisely what those procedures entailed would be of little, if any, benefit. Could investors—or anyone else, for that matter—even assess whether the work performed was sufficient or proper? Not in this author’s opinion.
A large number of CAMs that take thousands of words to describe might cast a shadow on the expression of an auditor’s unqualified opinion. More ominously, it would not be much of a stretch to visualize plaintiffs’ lawyers using the listing of procedures performed as the basis for making a case that the auditor failed to do enough work because an auditor’s report on the financial statements of another company having some of the same identified CAMs listed more or different procedures. In this author’s opinion, the requirement to explain how CAMs were addressed could open auditors up to heightened scrutiny and increased susceptibility of being second-guessed.
Nevertheless, unless comments by constituents on the 2016 proposal are overwhelmingly unsupportive, it would appear inevitable that the auditor’s report of the not-so-distant future will look a lot like what the PCAOB is currently proposing. After all, much of the rest of the world is already there.