A number of communication responsibilities and reporting considerations necessarily arise whenever a successor auditor concludes that a client’s prior year’s financial statements require restatement, either because they are materially misstated or because an accounting change must be retrospectively applied.
Successor auditors are required [for privately held entities, AU-C section 510.12 or for publicly held entities, Auditing Standard (AS) 2610.21] to request that client management 1) inform a predecessor auditor whenever they become aware of information that leads to the belief that financial statements reported on by the predecessor auditor may require revision and 2) arrange for the parties to discuss this information to arrive at a consensus as to the need for restatement and to determine a course of action (including selecting from available reporting options). In addition, a successor auditor is obligated to provide any information available that the predecessor may need to make the judgments required pursuant to AU-C section 560, “Subsequent Events and Subsequently Discovered Facts” (or, for SEC issuers, AS 2905.04-.09 and 3101.72).
Although these communication responsibilities are essentially the same for all audits, the reporting issues relative to non-SEC issuers are simpler because predecessor auditors are typically not asked to reissue their reports to accompany comparative financial statements. For SEC issuers, however, a reissued auditor’s report must accompany a prior year’s audited financial statements, whether restated or not, except in rare circumstances where the predecessor audit firm has ceased operations. If the predecessor is no longer registered with the PCAOB or is no longer independent, the reporting choices relative to restated financial statements are reduced.
The operative authoritative guidance for these reporting issues may be difficult to navigate for the purposes of determining the proper reporting language, especially for SEC issuer audit clients.
In the relatively rare case when a predecessor auditor agrees to issue a new report on the restated financial statements of a non-SEC issuer, including a not-for-profit or governmental entity, the successor’s report should make no reference to the predecessor’s audit of the restatement adjustment/s (AU-C section 700.56). Additional authoritative guidance applicable to successor reporting when prior year financial statements of a non-SEC issuer are restated, and the predecessor’s report is not reis-sued or presented, is found in a single place—but unfortunately, not in the main body of the standard. Rather, it resides in the “Application and Other Explanatory Material” that supplements the main body of the standard (AU-C section 700.A57). This guidance enables the more popular reporting alternative of the successor auditor reporting on the restatement adjustments. This reporting option entails including an “other matter” paragraph in the successor auditor’s report, such as the following:
As part of our audit of the 20X2 financial statements, we also audited the adjustments described in Note X that were applied to restate the 20X1 financial statements. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the 20X1 financial statements of the Company other than with respect to the adjustment(s), and accordingly, we do not express an opinion or any other form of assurance on the 20X1 financial statements as a whole.
Unlike the PCAOB requirements for SEC issuers (discussed below), use of this reporting option bears no qualifying conditions except that the successor auditor 1) be engaged to audit the restatement adjustments and 2) obtain sufficient appropriate audit evidence to be satisfied about their appropriateness.
Because the SEC requires that a reissued auditor’s report accompany a restated prior year’s audited financial statements included in filings, and because of the fragmented and difficult-to-find structure and somewhat conflicting content, of the relevant PCAOB and related SEC staff literature, these reporting issues are more complicated.
The principal source of reporting guidance for SEC issuer clients is AS 3101.70-.74; however, these sections are incomplete in that they do not address reporting by successors or predecessors when the predecessors’ reports are presented (as required by the SEC), and predecessors do not accept responsibility for auditing any restatement adjustment/s. For additional guidance, the standard refers auditors to less authoritative interpretive PCAOB literature, which references are so subtly placed at the top of the standard as to be easily unnoticed. In particular, auditors are referred to a Staff Questions and Answers (Q&A), “Adjustments to Prior-Period Financial Statements Audited by a Predecessor Auditor,” dated June 6, 2006. Old references contained in the Q&A to interim auditing standards AU sections 508 and 9508 have been superseded, without modification, by AS 3101 and Auditing Interpretation (AI) 23.60-.75, respectively, but nevertheless continue to be effective. AS 3101 also refers successor auditors for guidance to AI 23.60-.75 (question 15), which is limited in its applicability to circumstances when the predecessor has ceased operations (beyond the scope of this discussion).
Answer 5 of the Q&A illustrates two optional reporting models for use by successor auditors who audit restatement adjustments that are similar to the non-SEC model, while Answer 9 illustrates two optional reporting models that are similar to the non-SEC model above for use by predecessor auditors reissuing reports for when the successor has been engaged (with audit committee approval) to audit the restatement adjustments.
The language in AS 3101.72 implies, without qualification, that a predecessor who agrees to reissue a report invariably has an obligation to perform certain procedures when becoming aware of information that may affect a previously issued report on financial statements of a prior period and then has to decide whether to revise the report. Nevertheless, the supplemental guidance referred to above clearly affords two reporting options. Either the predecessor or the successor may audit and report on restatement adjustments for an SEC issuer, but not without certain circumstantial constraints.
The views of the staff of the SEC’s Division of Corporation Finance for a successor auditor’s report when the prior-period financial statements have been restated, consistent with the foregoing PCAOB materials, are briefly set forth in sections 4820 and 4830 its Financial Reporting Manual (last updated November 2016, as of the time of this writing).
Qualifying Conditions for Successor Reporting
Most importantly for SEC issuers, when the predecessor has not ceased operations, the PCAOB staff believes that successor reporting on restatement adjustments (without a full re-audit) is not a freely unrestricted option. Rather, its use is subject to auditor judgments about certain qualifying conditions deemed necessary to enable the successor auditor to form an opinion that the adjustments are appropriate and have been properly applied. These conditions, which must be evaluated and documented by the reporting successor, are set forth and explained in Answer 4 of the Q&A. Relevant considerations are—
- the extent and pervasiveness of the adjustments,
- the reason for the adjustments, and
- the extent of cooperation expected from the predecessor.
In addition, a successor auditor is cautioned to consider whether any evidence was observed in the process of auditing restatement adjustments which indicates a risk that the prior-period financial statements are materially misstated in other respects, and whether a full reaudit of the prior year financial statements may therefore be necessary.
Answer 6 of the Q&A provides that a predecessor auditor who has been engaged to and is considering reissuing a report on prior year financial statements that have been (or need to be) restated for an error correction has an obligation to determine that the report is still appropriate (other than with respect to the error correction) when a successor has been engaged to audit the restatement adjustments. Relevant predecessor considerations include but are not limited to the following:
- The nature and extent of the adjustments pertaining to the error correction
- Whether management has withdrawn the prior-period financial statements
- Whether the errors were intentional.
Although not listed in Answer 6 or other cited guidance, predecessor auditors also should consider whether the errors being corrected might indicate previously unidentified or inadequately addressed internal control deficiencies that might have permitted undetected material misstatements in other areas.