For more than 70 years, the auditor’s report has remained virtually the same, following a simple pass/fail template. Recent changes issued by the PCAOB constitute the most significant revision of the audit report in the profession’s history. Auditors will face increased reporting and disclosure responsibilities. The authors present the details of the new auditor’s report, focusing specifically on the required reporting of critical audit matters.
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On June 1, 2017, the PCAOB adopted a new standard, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, Release 2017-001, which replaces various portions of the former AS 3101, Reports on Audited Financial Statements. As approved by the SEC, the effective dates for the new requirements are: for critical audit matters (CAM) disclosures, annual periods ending on or after June 30, 2019, for large accelerated filers and December 15, 2020, for other filers; for other provisions, annual reporting periods ending on or after December 15, 2017. The updated audit report will provide information that the PCAOB believes will be more informative and relevant to investors and other financial statement users in making capital allocation decisions.
The changes to the auditor’s report, including CAMs, have been controversial ever since they were first proposed in 2013. While the report retains the pass/fail opinion, significant changes include discussing CAMs of 1) significant accounts and disclosures that the auditor deemed as especially challenging, subjective, or complex that the auditor communicated or was required to communicate to the audit committee; 2) audit firm tenure; and 3) clarifying the auditor’s role and responsibilities (e.g., to maintain their independence).
This new reporting standard provides a different narrative for virtually every audit engagement. The PCAOB’s objective was to meaningfully modernize the auditor’s report, to provide more useful and relevant information, and to lessen the perceived imbalance of information, or “information asymmetry,” between investors and auditors, where auditors have more information about audit issues that investors wish to receive. Investors have often requested more information on audit procedures about especially challenging, subjective, or complex judgments, which auditors are now required to discuss in a CAM section that uses a principles-based framework and reflects the audit’s nature and complexity. The PCAOB has called this a significant step forward in auditor reporting, although some may consider it a small step when considering the overall expectations gap related to auditor performance and reporting.
This article provides a review of the changes to the auditor’s report contained in the new standard, with a particular focus on the new CAM section.
Critical Audit Matters
CAM reporting forms the centerpiece of the PCAOB’s revised audit report. All CAMs arising from the current period’s audit of the financial statements must be communicated in the report. AS 3101.11 defines a CAM as:
Any matter arising from the [current period’s] audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.
Investors and other third parties generally focus on significant management estimates and judgments, areas of high financial statement or audit risk, and significant unusual transactions. Concerns arise, however, over more complex financial reporting frameworks and increasing use of fair value measurements that may cause measurement uncertainty. Auditors are therefore now required to consider whether such items cause them to make challenging, subjective, or complex judgments. Auditors are not expected to ascertain and report on the quality of the client’s accounting practices and policies, as long as they comply with GAAP, or analyze the financial statements as a whole.
The standard does not list required CAMs or identify specific items that constitute CAMs. Significant risks that exist may or may not be CAMs; for example, while revenue recognition is presumed to heighten fraud risk, and all fraud risks are significant per PCAOB standards, a matter related to revenue recognition that did not involve especially challenging, subjective, or complex auditor judgment does not constitute a CAM. AS 3101.12 provides guidance on factors an auditor is required to take into account, alone or in combination, in determining what constitutes challenging, subjective, or complex judgments:
- The auditor’s assessment of risks of material misstatement, including significant risks;
- The degree of auditor judgment related to areas in the financial statements that involve 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.
Auditors must determine what constitutes a CAM by first considering applicable technical rules from applicable authoritative pronouncements and then ascertaining the information that financial statement users need to identify; specifically, 1) information on estimates and judgment, 2) areas of high risk, 3) unusual transactions, and 4) significant changes in the preparation process.
In identifying potential CAMs, auditors must address and document all matters considered and conclusions reached on whether to report the matter to the audit committee. The auditors must document whether each potential CAM 1) related to material financial statements accounts or disclosures that entailed especially challenging, subjective, or complex auditor judgment and 2) was communicated or required to be communicated to the audit committee. Auditors must consider the PCAOB’s position that “it is expected that, in most audits, the auditor would determine that at least one matter involved especially challenging, subjective, or complex auditor judgment” (AS 3101.12, Note).
A significant part of the reporting of CAMs is how to describe a matter in the audit report. AS 3101.14 suggests some combination of the following:
- The auditor’s response or approach that was most relevant to the matter;
- A brief overview of the audit procedures performed;
- An indication of the outcome of the audit procedures; and
- Key observations with respect to the matter.
In describing CAMs, auditors should avoid providing nonpublic information about the client. An exception would be a situation where “such information is necessary to describe the principal considerations that led the auditors to determine that a matter is a CAM or how the matter was addressed in the audit” (AS 3101.14, Note 2).
Global standards setters have already made similar changes to the auditor’s report. In 2012, the United Kingdom’s Financial Reporting Council (FRC) required public interest entities (similar to U.S. publicly traded companies) to present a fair, balanced, and understandable assessment of the company’s position and prospects, and for audit committees to formally report on their activities in annual reports—including having the auditors’ report disclose key audit matters (KAM). More recently, International Standards on Auditing (ISA) require discussing KAMs in auditors’ reports on financial statements for periods ending on or after December 15, 2016, and the European Union requires an expanded auditor’s report for periods ending on or after June 30, 2017. Exhibit 1 is an example of a report intended to comply with the ISA standards. Exhibit 2 is a suggestion of an appropriate form for complying with the CAM requirement.
Example of an ISA Key Audit Matter Taken from the 2016 Audited Financial Report of Unilever PLC
Sample Presentation of a Critical Audit Matter
Source: Megan Zietsman, Jennifer Burns, Lisa Smith, and Sasha Pechenik, “PCAOB Adopts Changes to the Auditor’s Report,” Heads Up, June 20, 2017, http://bit.ly/2rCfRMn.
Caution should be exercised in developing approaches to the new reporting requirement. In developing internal policies on how to comply, auditors should avoid a boilerplate mentality on how to address CAMs. Audit firms should also avoid disclosing audit planning decisions or language that could seek to minimize their responsibilities for the CAM or imply that they provide a separate opinion on either the CAM or any related accounts or disclosures. Auditors should also recognize that reporting a matter to the audit committee makes the matter a potential CAM, which some believe could impair the open line of communication between the auditor and the audit committee.
To clarify the auditor’s role and responsibilities and make the audit report easier to interpret, the opinion paragraph on fair presentation must be moved to the lead section, and section titles used to improve readability. It now 1) states that the auditor must be independent; 2) includes as addressees the shareholders, directors, and other equivalents; 3) changes the language about the auditor’s roles and responsibilities; and 4) discloses the number of consecutive years that the auditor has served in that capacity.
While some investors have stated that disclosing audit tenure is useful when determining auditor ratification voting, others have cited studies finding no correlation between audit tenure, audit quality, or auditor independence. Still others suggest disclosures could add more context, such as changes among key financial management members during the audit firm’s tenure, and mandatory rotation of the lead audit partner, other key partners, and audit team members. The PCAOB has separately mandated the filing of the engagement partner’s full name and the name of other accounting firms participating in the audit in Form AP, but allows firms to include such information in the audit report under an appropriate title.
While IAASB standards do not address adhering to SEC laws and regulations, the new PCAOB standards parallel much of the new international requirements. For example, PCAOB-registered audit firms must be independent with respect to the audit client per SEC securities laws and regulations, as well as PCAOB rules and standards. The board has concluded that the independence statement will enhance financial statement users’ understanding of existing obligations of the auditor to be independent, and also help remind auditors of these obligations. Exhibit 3 provides a sample of the new unqualified report.
Sample New Unqualified Audit Report
Source: AS 3101, Appendix B.
Besides issuing CAMs for their unqualified opinions, auditors must also do so when issuing qualified opinions, but they need not do so when issuing adverse or disclaimers of opinions. Audit firms should develop adequate approaches to CAM reporting before the standard becomes effective so that they and their clients are ready to comply.