The evolution of the standard audit report has been slow and cautious over the past century. Most recently, in 2011, the AICPA’s Auditing Standards Board (ASB) issued Statement on Auditing Standards (SAS) 122, Statements on Auditing Standards: Clarification and Recodification, referred to as its clarity standards, which revised the form of the standard audit report by introducing captioned sections and additional language intended to clarify auditors’ responsibilities and distinguish them from management’s responsibilities. Prior to that, the last substantive changes made to the standard audit report were introduced in 1988 (SAS 58, Reports on Audited Financial Statements) as part of a group of standards collectively called the “expectations gap” standards. SAS 58 represented an earlier attempt to inform users of auditors’ responsibilities.
With the likely adoption of a group of new audit reporting standards proposed by the ASB in November 2017, the form and content of the “standard” audit report will expand substantially. Particularly with the introduction of “critical audit matters” (CAM), as they are termed by the PCAOB, these reports will come full circle to something like the nonstandardized, “long-form” format that dominated reporting in the first half of the 20th century.
Historically, the typical long-form audit report effectively summarized the audit procedures applied in most areas of the audit. With 1957’s Statement on Auditing Procedure (SAP) 27, Long-Form Reports, the importance of eliminating or reducing opportunities for auditors to include vague and inconsistent language in their reports was recognized. SAP 27 provided little or no specific guidance as to form and content of long-form reports; such nonstandardized reporting was not prohibited, but was effectively discouraged by cautioning auditors against certain risks associated with it, emphasizing—
- the need to maintain a “clear-cut distinction” between representations of management and auditors,
- the observation that “comments or other data contained in the long-form report lend themselves to a contention that they constitute exceptions or reservations, as distinguished from mere explanations,” and
- that any client financial information contained in such a report may “support a contention that the auditor has made factualrepresentations rather than express[ed] an opinion … [on] management representations.”
Consequently, the use of long-form audit reports began to diminish, particularly as an alternative for what became known as a “short-form” report. In 1974, the short-form report was formally redesignated the “standard” audit report in SAS 2, Reports on Audited Financial Statements, and use of the long-form audit report as a stand-alone alternative effectively became unacceptable. Its use was permitted only as a supplement to a standard report, but such supplements were rarely issued except for distribution to a select group of users. Use of the long-form audit report has virtually vanished from modern practice, most likely largely in recognition of the risks set forth in SAP 27 and for other reasons, not the least of which was a growing concern for liability risk (discussed below).
The Proposed Reporting Requirements for Private Companies
In addition to including CAMs in the audit report, which is optional based on the terms of the engagement and the known or perceived needs of influential users, significant reporting changes would result if the ASB were to adopt the proposed AUC section 700, Forming an Opinion and Reporting on Financial Statements. These changes are summarized as follows:
- The “opinion” section of the report would necessarily be presented first (a practice that has been used by one of the largest audit firms for many decades and, in this author’s opinion, is likely to discourage users from reading the balance of the report).
- The “basis for opinion” section would follow the “opinion” section (unless law or regulation prescribe otherwise) and include affirmative statements about the auditor’s independence and compliance with other relevant ethical responsibilities.
- The description of management’s responsibilities for preparation and fair presentation of the financial statements would be expanded in considerable detail, and both the caption and the text would make separate reference to those responsible for oversight of the financial reporting process if different from those responsible for the preparation of the financial statements.
- The description of the auditor’s responsibilities would likewise be expanded in considerable detail, and it would include key features of a typical audit.
- If applicable, information about the auditor’s responsibilities relating to other information included in annual reports would be required.
- If, after considering relevant conditions or events identified and related management plans, the auditor concludes that substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time remains, a separate section would be included in the auditors’ report in lieu of an emphasis-of-matter paragraph (as is used today). Substantial doubt about going concern would not be included in a CAM disclosure, but, if satisfactorily mitigated, it might be. (The sections of the report on management’s and auditors’ responsibilities would be required to include mention of their respective responsibilities relative to evaluating going concern matters without regard to the presence or absence of substantial doubt.)
Disclosure of CAMs is not likely to enhance transparency in any meaningful way, but rather would dilute the pass/fail message retained in the new reporting format, thereby diminishing the value of an audit report.
The Case against Reporting KAMs Voluntarily
According to the ASB’s exposure draft, “the call for changes to the auditor reporting model in the United States and other jurisdictions around the world resulted from a desire by users of financial statements and the auditor’s report for more information about significant aspects of the audit.” The ASB believes the optional (and nonstandardized) CAM feature, among other proposed changes, “will increase the informational value and relevance of the auditor’s report for users and, therefore, are in the public interest.” Many have questioned the strength, significance, and credibility of such claims; these observers see the ASB’s proposal and the PCAOB’s new requirements as merely the result of a compelling desire to conform (or converge) U.S. standards with those of the International Auditing and Assurance Standards Board (IAASB). The IAASB recently adopted a requirement to include key audit matters (KAM), rather than CAMs, in reports for “listed” (i.e., publicly held) companies.
When originally proposed by the IAASB, the PCAOB, and the ASB, many auditors objected to the provisions for reporting KAM/CAMs for a variety of reasons; accordingly, they remain unlikely to opt to report KAM/CAMs for privately held businesses except when pressed to do so by their clients due to the demands of material users. Because auditing is such a complex professional discipline that requires years of education, training, and experience, there are countless historical examples of experts who disagree on matters of risk assessment and audit scope adequacy. Disclosures of such details in CAMs would inherently be limited by space. Making meaningful assessments and useful judgments about risks and audit scope without opportunities for a two-way dialogue with auditors (which is not practicable), and without all the factual and technical knowledge available to the auditor, would be beyond the capabilities of typical users and probably confusing to most. Accordingly, it is unlikely that such disclosures would serve any useful purpose and be worth the necessary costs and exposure to liability.
In America’s highly litigious culture, long form-reporting can expose auditors to considerable liability risk, particularly in troubled economic or political environments.
Moreover, assessing audit quality is not the job of financial statement users; it is the job of engagement reviewers, regulators (such as the PCAOB and licensing authorities), peer reviewers, and those charged with governance. Financial statement users should be able to place sufficient reliance on the functionality of such institutions and processes without reading audit reports cluttered with wordy CAMs.
The risks identified over 60 years ago in SAS 27 will reappear and remain significant, more or less, when reporting KAM/CAMs. Another obvious risk to auditors is that those who find little or nothing to explain or comment upon might be viewed adversely by users as having failed to meet their reporting responsibilities. These factors will likely to serve to pressure auditors to report more rather than less, resulting in excessive, costly, self-serving, and unwieldy language in audit reports. This increased pressure could also have the undesirable effect of causing auditors’ objectivity to be impaired. These consequences will likely include delays in issuing audit reports, increased audit fees due to the additional time necessary to consider reporting alternatives, the documentation burdens relative to those considerations and judgments, and additional layers of review by audit firms and, at times, their attorneys. These additional costs would be better spent in operations, thus adding real value to the interests of principal owners and managers, as well as other investors and lenders.
Disclosure of CAMs is not likely to help users make credit or other decisions, enhance transparency in any meaningful way, or serve any other useful purpose, but rather would negate or dilute the pass/fail message retained in the new reporting format, thereby diminishing the value of an audit report. In addition, human nature is such that if audit reports were to become too long, the probability of them being read and achieving any meaningful communication objective will be reduced, further diminishing the report’s value. Note that in an outreach survey conducted by the PCAOB staff when developing AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, it was determined that a large proportion of the investors who responded do not currently read audit reports.
So who will be reading the reports? In all likelihood, litigants’ counsel. In America’s highly litigious culture, long-form reporting can expose auditors to considerable liability risk, particularly in troubled economic or political environments. Such risk relates not just to what an audit firm might include in its audit report, but perhaps even more so to what might be excluded from it.
Opportunity to Comment on the ASB Proposal
None of the many reporting changes proposed by the ASB are nearly as controversial as the KAM, which, unlike its PCAOB counterpart (the CAM), is not destined to be a required, or likely even common, component of an audit report. Nonetheless, professionals have the opportunity, and are encouraged, to participate in the standard-setting process by commenting to the ASB. A copy of the exposure draft can be obtained at http://bit.ly/2rCfRMn. Comments are requested by May 15, 2018, and should be addressed to Sherry Hazel at Sherry.Hazel@aicpa-cima.com.