Brown began the panel by talking about the PCAOB’s current status and objectives following the installment of an entirely new board by the SEC at the beginning of the year. “Let me tell you this is extremely unusual, and I don’t mean just at the PCAOB, it’s unusual in our system of government,” Brown noted. “What happens in our system of government is one commissioner comes in at a time and leaves at a time, two come in at a time and leave at a time, but there’s always a group of them that are still there. By bringing in five of us all at once, there’s a little bit of uncertainty that’s attached.”

Brown said he hoped that the new voices and perspectives would ultimately be a benefit to the board. “The PCAOB is moving out of the startup phase,” he said. “What regulator has the opportunity at some point in its career to bring five new people in and rethink everything? That’s the luxury that the SEC gave the PCAOB. And all of us on that board are aware of that and hope to make the most of it.” Brown encouraged stakeholders to weigh in on the new PCAOB’s strategy, saying, “You have a chance to help us change, structurally, organizationally, in any way. Everything is on the table.”

The New Auditor’s Report

Strauss turned the topic toward the new auditor’s report. “The changes were significant in the sense this is really the first time the auditor’s report has changed in 60 years,” noted Jones. He detailed the changes that have already gone into effect, such as the placement of the auditor’s pass/fail opinion at the very beginning of the report, the clarification of auditors’ responsibilities to identify material misstatements, and the continuing requirement that auditors remain independent.

Particularly significant, Jones said, was the new requirement for auditors to disclose how long they have served a particular company. He reiterated SEC Chief Auditor Wesley Bricker’s earlier point that investors have been requesting this feature of the report for several years. “It’s not intended to provide any commentary per se on the quality of the audit or the level of skepticism applied by the auditor,” he said. “But I think through the due process and the feedback provided, having a consistent place in the auditor’s report, as opposed to somewhere else, was thought to be the most useful element for investors.” He described the process of actually determining length of tenure as less simple than accounting firms had expected: “In some cases figuring out how long you’ve been the auditor is kind of hard. How do you think about things like pooling of interests? What about pictures of audit reports from 1920; is this something we can use?” Ernst and Young (EY) eventually sent a team to the Library of Congress to pull old audit reports, he said, and had a particularly hard time untangling the knots of predecessors to both itself and clients.

Pictured, left to right: Jay Brown, Leonard Combs, Josh Jones, Mark LaMonte, and Sarah Ovuka

Photos by E. Lee White

Strauss asked LaMonte what use Moody’s would find for the audit tenure disclosure. “I really don’t know what our analysts would do with that particular data point,” LaMonte said, noting that a change in auditor does create certain interests, but that tenure is not something Moody’s really looks at. Ovuka suggested that concerns about audit quality might be behind the new disclosure, while Jones reiterated his point that determining tenure becomes more complex when things like mergers and acquisitions come into play. “It was certainly manageable,” he said, “but there are questions that we hadn’t really focused on and gave us something to think about for future rulemakings.” Combs added that PricewaterhouseCoopers (PwC) had experienced the same issues.

Strauss then turned to the new requirement to name the audit partner, noting that on large engagements, the named audit partner might not necessarily have been involved with every part of the report. “There’s some concern by the individual about what it means for them if they’re associated with a restatement, but to date we haven’t seen any problems,” Jones said, adding that EY has been publicly supportive of this disclosure. LaMonte quipped, “I doubt that our analysts are going to the PCAOB website, getting the name of the audit partner and then googling that audit partner’s name to find out if anything interesting is in their background. Our analysts have plenty to do.”

Asked by Strauss about the level of difficulty meeting the new requirements, Ovuka said that most of the items are “pretty noncontroversial,” adding, “Preparers are pretty supportive of the rewording and some of the reformatting as well.” Strauss also noted that the PCAOB’s staff guidance includes a redlined version of the auditor’s report that shows where the changes are supposed to go.

Critical Audit Matters

The most significant new requirement in the auditor’s report, the panel agreed, was the disclosure of critical audit matters (CAM). Combs detailed the background of this requirement, starting with the definition of “critical” as it relates to material accounts or disclosures and involves especially challenging, subjective, or complex auditor judgments. “What are the things that are most important from an audit standpoint?” he summarized, noting that all three of the PCAOB’s listed criteria must be true for a matter to qualify as a CAM. “We agree with the concept that you should consider the relative complexity of a potential CAM in the context of the audit,” he added.

Continuing, Combs said that he expects to see a correlation between critical accounting estimates and CAMs. “As we ran our pilots over the last year,” he said, “we’ve seen a lot of interrelationship between the various factors.” He gave an example of a complex acquisition happening near the end of a fiscal year that may require a high degree of subjectivity or necessitate the use of specialists on the audit. He added that PwC plans a larger dry run with large accelerated filers in the current year, saying, “We think that’s important for both our audit teams and audit committees.”

Strauss then asked Brown about the SEC’s approval process for this standard. Brown was quick to note that the SEC chairman had voiced concerns that reporting of CAMs would be boilerplate and stressed that the information in them needs to be both meaningful and specific to the audit. “We were instructed to pay close attention to these issues going forward, and to complete a post-implementation review as soon as possible,” he said. Brown also said that, as the PCAOB moves toward implementation, inspectors are looking at firms’ preparation efforts, particularly at training and communications with audit committees. After implementation, he said, there will be an analysis of CAMs’ impact on investor perception of the quality and credibility of financial statements.

LaMonte said that audit reports already receive little attention from the Moody’s analysts and that CAMs will receive attention in the first few years of reporting, but that “if the analysts find it to be largely boilerplate, they will never look at it again.” He added that analysts are, by and large, more interested in the company’s results and future outlook than the difficulty of auditing a particular matter. Ovuka responded to this by saying that preparers will be paying close attention to analysts’ responses to the information disclosed in the new report.

Implementation of the New Audit Report

Ovuka and Jones both emphasized the importance of early preparation, with Ovuka specifically noting that the effective dates are sandwiched in between those for the new leasing standard and the new current expected credit loss standard. “It’s absolutely a big undertaking,” Jones said, although he added that large multinational firms will have experienced implementing similar requirements in other countries. He also said that companies are already interested in preparing not only for the new auditor’s report, but also for how it will affect their own presentation of the financial statements and how investors will receive the information on CAMs.

Combs returned to the question of how to determine which audit matters are and are not critical. “It’s going to be about stepping back and thinking about where we spent most of our time,” he said. “What was most complex? What were we spending the most time talking to the audit committee about? What kept us up at night?” He added that this process would not be too different from judgment calls applied elsewhere in the audit, such as risk assessments and identification of internal control deficiencies. He noted that “the PCAOB has been saying that they expect a minimum of at least one CAM in every audit report,” and he expects the number of CAMs to range from one to four.

Jones said that much of the quality control process is still being developed. EY has already begun developing methods to control quality and consistency, he said, such as a writing guide to standardize reporting of CAMs across multiple firm locations. “You want to try to make sure that we all have a common understanding, at least within our firm, around how we articulate CAMs and how we address them,” he said. He also said that the process of creating and reviewing reports will have to be integrated into the overall audit process at an earlier stage.

Brown spoke about the process from the PCAOB’s side, specifically about the role of inspectors, who will also need training so that inspections are performed consistently across companies. He also talked about the “struggle against boilerplate,” positioning the PCAOB as the party responsible for steering companies away from that route. “We will have to take a long, hard look at that and try to think how we can help in a significant way,” he said.

Strauss then moved on to a list of common concerns about the CAM requirement. The largest concern, LaMonte said, was the increased time to prepare the report; he noted that the amount of time currently devoted to that task was perhaps limited to “five minutes to change the dates in your audit report from 2016 to 2017.” He did clarify, however, that the time spent on reports would still be a small portion of the overall engagement.

Ovuka discussed the likelihood that the new disclosures would effectively be duplicating information already disclosed in the notes to financial statements. “It makes sense,” she said, “given the definition of a CAM, the requirement preparers already have to disclose information about critical accounting policies and critical estimates, and the general obligation to disclose the most complex and judgmental areas in their financial statements. I don’t think, from a preparer perspective, that that is a negative thing.” LaMonte noted that the critical accounting policies requirement, while well intended, “basically has over time migrated to boilerplate.” He cautioned that “this could end up going down the same path.”

Asked by Strauss whether the new requirements might delay signing off on the report, Combs said, “I would not expect this in any way, shape, or form to slow up the audit report.” He reiterated LaMonte’s point about the report still being a small portion of large audit engagements, and said that, with proper preparation, including the dry runs being undertaken by firms like EY and PwC, issuing reports on time should not be a problem.

Returning to the boilerplate question, Brown stressed that both the SEC and the PCAOB will be paying close attention to disclosures to prevent them from becoming rote and generic. “In some of the reports I’ve read, the quality has gotten better over time. People get experience with it and the quality gets better,” Brown said. “It’s a learning experience, something new for us here in the United States. One of the things that makes me optimistic is that there’s a lot of discussion going on between the firms and the audit committees.”

Other Matters

Strauss then turned to internal controls, noting that debate has continued for years about whether the PCAOB is too strict in its evaluation of controls. Ovuka said that preparers do feel tension in the process, ascribing it to the preponderance of non-specific guidance. “Internal control is the foundation of good reporting,” she said, “and preparers are looking for more help to better understand what good internal control looks like and how it can be more consistently applied across companies.” Brown added that he has received feedback to that effect, and that the PCAOB should do more to identify and address common issues that preparers face.

Jones opined that the PCAOB and SEC have gotten better at communicating their expectations from both auditors and preparers, which has in turn led to better audits of internal controls. “It is a challenging process,” he admitted, “and I think if there was some better articulation, that would help both companies and auditors.” He added that if auditors sat down with regulators early in the process and got a clear understanding of their expectations, it would go a long way to improving matters. “I think collectively we all have a role to play,” he said.

Jones also discussed the PCAOB’s proposed amendments on the auditing of estimates. The focus, he said, was to consolidate the three existing standards and provide a cohesive framework for auditors to use, as well as guidance on some specific areas. The guidance will reinforce the need to examine estimates for management bias. Auditors will need to challenge the basis for management’s assumptions and ensure they have a sound basis. “To the extent there are changes in how companies change their process for evaluating or determining assumptions, or the methods they use … we are expected to understand why they made a change,” Jones continued. “Not just evaluate whether the change itself is a reasonable way to determine an estimate, but to really understand why that change was made.”

On the subject of the fairness of PCAOB inspections, Combs described the process as “rigorous, hard, and challenging,” but ultimately fair. “Most of the time we agree with the facts of the comments,” he said, adding, “We do get into some debate about the importance of a finding, but a lot of times they point out things we are not executing on a consistent basis and need to look at internally.”

Finally, Strauss asked the panel to comment on any other PCAOB activities, such as auditors’ use of specialists, non-GAAP measures, and the impact of technology on conducting audits. Brown said that, in his opinion, the most important issue is technology, noting that firms are spending significant amounts of money on technology, even as auditing standards remain unchanged. “This is an area that needs to be one of the highest priorities,” he said.

Audience Q&A

As the panel concluded, an audience member asked Brown about the possibility of improving direct communication between audit committees and the PCAOB. Brown replied that, while inspectors sometimes do talk to the audit committee, the system in place puts the audit committee in the SEC’s jurisdiction, and that the PCAOB’s focus is on the auditors themselves. He did say, however, that the PCAOB is always willing to answer any question put to it by audit committees and their directors.

Norman Strauss is distinguished lecturer of accountancy at Baruch Collegel.
Jay Brown is a board member of the PCAOB.
Josh Jones is a partner at Ernst and Young.
Mark LaMonte is managing director at Moody’s Investors Service.
Sarah Ovuka is a professional accounting fellow at Financial Executives International.
Leonard Combs is a partner at PricewaterhouseCoopers.