ICYMI | The PCAOB’s Proposed New Auditor’s Report

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.

The Downside

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.