In Brief

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.

Exhibit 1

Example of an ISA Key Audit Matter Taken from the 2016 Audited Financial Report of Unilever PLC

Revenue recognition Refer to page 42 (Audit Committee Report) and pages 90–92 of the Notes to the Financial Statements. The risk: Revenue is measured net of discounts, incentives, and rebates earned by customers on the Group's sales. Within a number of the Group's markets, the estimation of discounts, incentives, and rebates recognized based on sales made during the year is material and considered to be complex and judgmental. Therefore, there is a risk that these arrangements are not appropriately reflected, and as a result revenue is misstated in the Financial Statements. There is also a risk that revenue may be overstated due to fraud through manipulation of the discounts, incentives, and rebates recognized resulting from the pressure local management may feel to achieve performance targets. Revenue is recognized when the risks and rewards of the underlying products have been transferred to the customer. There is a risk that revenue may be overstated due to fraud resulting from the pressure local management may feel to achieve performance targets at the reporting period end. The Group focuses on revenue as a key performance measure, which could create an incentive for revenue to be recognized before the risks and rewards have been transferred. Our response: Our audit procedures included considering the appropriateness of the Group's revenue recognition accounting policies, including those relating to discounts, incentives and rebates and assessing compliance with the policies in terms of applicable accounting standards. In response to the risk of fraud, we tested the effectiveness of the Group's controls over the calculation of discounts, incentives, and rebates and correct timing of revenue recognition. We assessed sales transactions taking place at either side of the year end, as well as credit notes issued after the year-end date, to assess whether that revenue was recognized in the correct period. We also developed an expectation of the current year revenue balance based on trend analysis information, taking into account historical weekly sales and returns information and our understanding of each market. We then compared this expectation to actual revenue and, where relevant, completed further inquiries and testing. Within a number of the Group's markets, we compared current year rebate accruals to the prior year and, where relevant, we completed further inquiries and testing. We reconciled a sample of claims and rebate accruals to supporting documentation and challenged management's assumptions used in estimating rebate accruals. We performed testing over manual journals posted to revenue to identify unusual or irregular items. We also considered the adequacy of the Group's disclosures (in note 2) in respect of revenue.

Exhibit 2

Sample Presentation of a Critical Audit Matter

Critical Audit Matter (CAM) Allowance for loan losses—new loan product As more fully described in Note 7 to the financial statements, during 2014, the Company [a mid-size regional bank] began actively marketing a nine-year auto loan in addition to the three-and five-year auto loans historically marketed. At December 31, 2015, the nine-year loans represented approximately 18% of the auto loan portfolio. The Company estimates and records an allowance for loans that are impaired but are not yet specifically identified (collective impairment allowance) by developing a loss rate based on historical losses and other factors, including qualitative adjustments to historical loss rates based on relevant market factors. Since management has limited historical loss data for the nine-year loans, it developed a new model to estimate this allowance using historical loss data from its auto loans of shorter terms and loss data from external sources for auto loans of longer terms to model a loss rate for the nine-year loans. In addition, management made qualitative adjustments to the historical loss rates to reflect lower borrower quality and higher risk of collateral impairment compared to its shorter term loans and for economic factors, primarily due to increasing unemployment in the markets served. There was a significant amount of judgment required by management when developing the model, which in turn involved our significant judgment. Principal Considerations in Determining CAM The principal considerations for our determination that the allowance for loan losses for nine-year auto loans is a critical audit matter are that it is a new loan product with limited historical loss data and auditing the estimated allowance for losses on these loans involved our complex and subjective judgment. How the CAM Was Addressed in the Audit Our audit procedures related to the collective impairment allowance for the nine-year loans included the following procedures, among others: We tested the effectiveness of controls over the Company's new model, the historical loss data, and the calculation of a loss rate. We also evaluated the qualitative adjustment to the historical loss rates, including assessing the basis for the adjustments and the reasonableness of the significant assumptions. We tested the accuracy and evaluated the relevance of the historical loss data as an input to the new model. We used a specialist to assist us in evaluating the appropriateness of the new model and to review the loss data from external sources used by the Company to determine its relevance to the Company's nine-year loan portfolio and consistency with external data from other sources. Finally, with the assistance of the specialist, we evaluated the incorporation of the applicable assumptions into the model and tested the model's computational accuracy. Source: Megan Zietsman, Jennifer Burns, Lisa Smith, and Sasha Pechenik, “PCAOB Adopts Changes to the Auditor’s Report,” Heads Up, June 20, 2017,

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.

Other Changes

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.

Exhibit 3

Sample New Unqualified Audit Report

To the Shareholders and Board of Directors of X Company Opinion on the Financial Statements We have audited the accompanying balance sheets of X Company (the “Company”) as of December 31, 20X2 and 20X1, the related statements of [titles of the financial statements, e.g., income, comprehensive income, stockholders' equity, and cash flows] for each of the three years in the period ended December 31, 20X2, and the related notes [and schedules] (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of [at] December 31, 20X2 and 20X1, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20X2, in conformity with [the applicable financial reporting framework]. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters [if applicable] The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. [Include critical audit matters, which generally contain three columns: (1) the CAM; (2) Principal Considerations in Determining the CAM; and (3) How the CAM Was Addressed in the Audit.] We have served as the Company's auditor since [year]. [City and State or Country] [Date] [Signature] 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.

Alan Reinstein, CPA, CGMA is the George R. Husband Professor of Accounting at the school of business administration at Wayne State University, Detroit, Mich.
Gerald W. Hepp, CPA is CEO of Gnosis Praxis Ltd., Novi, Mich.
Thomas R. Weirich, PhD, CPA is the Campbell Endowed Professor of Accounting at the college of business administration at Central Michigan University, Mt. Pleasant, Mich.