Since the PCAOB issued its requirements for the reporting of critical audit matters (CAM), there has been much debate about how to interpret and implement the guidance. The authors examined CAM disclosures in SEC filings and found that audit reports with CAMs were often twice as long as those without. The most frequent CAM topics were revenue recognition, goodwill and other intangible assets, and taxes.
On June 1, 2017, the PCAOB adopted AS 3101, The Auditor’s Report on an Audit of Financial Statements when the Auditor Expresses an Unqualified Opinion. Included in that standard, with a delayed implementation date, is the required communication of critical audit matters (CAM). This requirement became effective for years ending on or after June 30, 2019, for large accelerated filers, although early adoption by any registrant was allowed.
This reporting of CAMs follows lengthy PCAOB consideration and represents a shift from the traditionally standardized wording of audit reports.
Howard B. Levy (“The Audit Report Returns to its Roots,” The CPA Journal, February 2018) discussed the disclosures historically included in audit reports, pointing out that “long-form audit reports,” which summarized audit procedures applied, were very frequently issued in the first half of the 20th century. Beginning in 1957, the AICPA’s Statement on Auditing Procedures 27, Long-Form Reports, resulted in less such reporting. Jermakowicz, Epstein, and Ramamoorti (“CAM versus KAM—A Distinction without a Difference? Making Judgments in Reporting Critical Audit Matters,” The CPA Journal, February 2018) provide historical background related to critical (and key) audit matters. They point out that the inclusion of CAMs in audit reports is not without controversy and anticipated challenges, including cost, liability, and misinterpretation.
This article summarizes the PCAOB guidance on the nature of critical audit matters and the related audit report communication requirements. It then provides illustrations of the manner in which CPAs currently interpret the guidance, as evidenced by CAM disclosures in several recently issued audit reports included in SEC Form 10-K filings.
The Nature of CAM
PCAOB AS 3101 presents the concept of a critical audit matter and its requirements. The definition hinges on three requirements: 1) communication to the audit committee, 2) material financial statement accounts or disclosures, and 3) especially challenging, subjective, or complex auditor judgment.
Communication to the Audit Committee
PCAOB AS 1301 and AS 1305 present the required communications between the auditor and the audit committee relating to the conduct of the audit and internal control deficiencies. Although CAM reporting does not change these requirements, it uses them as a necessary condition for further CAM consideration of the matter. Per the definition of a CAM: material matters relating to the audit include those that were “communicated, or required to be communicated” to the audit committee. Thus, while a required communicated matter merits consideration, nonrequired matters that were communicated meet the “communication to the audit committee requirement.” In addition, if for one reason or another a required matter was not communicated, it could ultimately be considered a CAM; but one would expect such a matter to be communicated quickly when the omission is identified.
Material Financial Statement Accounts or Disclosures
Although at first glance this requirement may seem obvious, there are several issues to consider. First, the matter has to relate to a financial statement account or disclosure. Second, it is important to remember that the PCAOB’s materiality concept (AS 2105) considers not only quantitative amounts, but also qualitative factors. PCAOB staff guidance (“Implementation of Critical Audit Matters: A Deeper Dive on the Determination of CAMs–Insights for Auditors,” PCAOB, March 18, 2019) provides the following illustrations:
Illustration 1: A potential loss contingency for which management recorded an accrual and/or made a disclosure could potentially be a CAM. However, a potential loss contingency for which the likelihood was appropriately determined to be remote, and which was not recorded in the financial statements or otherwise disclosed, would not be a CAM because it would not relate to an account or disclosure that is material to the financial statements.
Illustration 2: A potential illegal act about which management provided disclosure could be determined to be a CAM. Even if the amounts involved were not quantitatively material, such a disclosure on its own may be qualitatively material. On the other hand, if management appropriately determined that no disclosure or accrual was required in the financial statements, the matter could not be a CAM.
Per the first illustration, implementation of a new IT system would only be considered a CAM if it is tied to a material account or disclosure in the financial statements. This has been suggested as a difference between international and AICPA auditing standards for key audit matters—which do not require an account or disclosure (see Megan Zeitsman, “Regulators and Standards Setters,” The CPA Journal, February 2019; Eva Jermakowicz, Barry Epstein, and Sridhar Ramamoorti, “CAM versus KAM—A Distinction without a Difference?” The CPA Journal, February 2018). Thus, on an overall basis, there must be a financial statement account or disclosure and it must meet the PCAOB standards for materiality.
In describing a CAM, auditors are not ordinarily expected to provide information that has not been made publicly available by the company, unless the information is necessary to describe the principal consideration that led the auditors to determine that the matter is a CAM.
Especially Challenging, Subjective, or Complex Auditor Judgment
By definition, a CAM involves “especially challenging, subjective, or complex auditor judgment.” The PCAOB provides the following guidance, indicating that while accounting estimates may often qualify as CAMs, there are other items of judgment, including:
- The auditor’s assessment of the risks of material misstatement, including significant risks
- The degree of auditor judgment related to areas in the financial statements that involved 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 needed consultations outside the engagement team regarding the matter.
- The nature of audit evidence obtained regarding the matter.
For each CAM identified in the current year audit, the auditors must include the following information in the audit report:
- A description of the CAM that includes—
- Identification of the matter
- Description of the principal considerations that led the auditor to determine that the matter is a CAM
- Reference to the relevant related financial statement accounts and disclosures
- A description of how the CAM was addressed in the audit.
“Must,” as used in PCAOB (or AICPA) auditing standards, indicates an unconditional responsibility/requirement (PCAOB Rule 3101, AICPA AU-C 200.25). An auditor must fulfill responsibilities of this type in all cases in which the circumstances exist to which the requirement applies; thus, including information on each of the four above bullets is required.
PCAOB AS 3101 provides more guidance related to a description of how the CAM was addressed in the audit, stating that the auditor may describe using one or more of:
- The auditor’s response or approach that was most relevant to the matter
- A brief overview of the audit procedures performed
- Key observations with respect to the matter
- An indication of the outcome of the audit procedures.
“May” here differs significantly from “must.” Notice that the first two items are essentially satisfied if an indication of audit procedures performed is provided, and that the third is very general. The final item is potentially very informative as auditors might, for example, provide an indication of amounts they derived (e.g., perhaps a range of possible amounts related to an estimate).
Selected Additional Communication Issues
The PCAOB’s guidance also addresses a number of related issues. In describing a CAM, auditors are not ordinarily expected to provide information that has not been made publicly available by the company, unless the information is necessary to describe the principal consideration that led the auditors to determine that the matter is a CAM. In addition, the PCAOB requires auditors to include CAMs only for the current audit period, not all periods for which financial statements are presented. Nevertheless, CAMs of prior periods that are presented may be included. For example, when prior-year financial statements are being made public for the first time, a decision may be made to also communicate prior-year CAMs.
A question arises as to whether deficiencies in internal control, such as significant deficiencies and material weaknesses, represent CAMs. The severity of the deficiency does not in and of itself determine whether it is a CAM: A CAM exists when the deficiency affects one or more material financial statement accounts or disclosures that require especially challenging, subjective, or complex audit judgment.
Prior-year CAMs should again be included in the current-year audit report if they continue to meet the criteria. While this may often be the case (e.g., with difficult accounting estimates), this does not always happen. For example, implementation of a new accounting standard or accounting for a significant unusual transaction may require such judgment only in the year in which it occurs, but not thereafter. Finally, if the auditors determine that there are no CAMs on an audit, a paragraph is included in the report defining the term and then indicating that there are none.
Exhibit 1 lists the CAMs analyzed by the authors. The audit reports of the 12 companies included a total of 20 CAMs, for an average of 1.67 per audit report.
Critical Audit Matters
As indicated earlier, required CAM coverage includes a description of each CAM and a description of how the CAM was addressed in the audit. To obtain a quantitative measure of depth of coverage, the authors totaled the number of words for each, acknowledging that in some reports the division is not precise. In each audit report, as required by AS 3101, a general introduction on CAMs was included—that introduction averaged approximately 100 words. As indicated in the totals in Exhibit 2, the CAM description averaged approximately 203 words, while the manner in which it was addressed averaged 166 words. Thus, for an average audit report with one CAM, the total length related to the CAM would be less than 500 words (100 + 203 + 166 = 469).
Breakdowns of Critical Audit Matters
To place the word total in perspective, a “standard” audit report without any CAM discussion is approximately 400 words long (e.g., Microsoft at 389). Thus, one CAM more than doubles the length of the audit report.
Exhibit 1 reveals that no audit report included more than two CAMs. This number is lower than international key audit matters (KAM) reporting, which averaged 2.93 in recent analysis (“Trends in the Number of Key Audit Matters Reported,” Audit Analytics, August 27, 2019). While the definitions of critical and key audit matters do differ somewhat, the authors had not anticipated the average to be so much lower.
CAMs by Company Size, Topic, and Auditor
Exhibit 2 also breaks down our results by company size (Part A), CAM topic (Part B), and auditor (Part C). Part A reveals that, for this admittedly small sample, CAM frequency was independent of company size. The average length of descriptions was somewhat higher for the larger companies.
Although in some cases topics may overlap, the authors divided the CAMs by topic, as presented in Part B of Exhibit 2. Revenue recognition issues were most frequent.
Part C of Exhibit 2 reveals that, on average, descriptions were longer for audits performed by Deloitte & Touche and PricewaterhouseCoopers. But bear in mind that this is a small sample that displayed wide variability in length even within companies.
CAM Disclosure Illustrations
Questions have been raised as to whether CAM disclosures are likely to provide important information or to be so general as to be of limited or no use (e.g., “boilerplate” disclosure). Although all of the 20 CAMs are available through the SEC web-site (SEC.gov), two are specifically provided in Exhibit 3—the shortest (Paylocity) and the longest (Procter & Gamble)—in order to illustrate the actual nature of CAM audit report disclosures. The specific disclosures for identified CAMs begin with a description, followed by how it was addressed in the audit.
Sample Critical Audit Matters
Illustration 1: Company: Paylocity Holding Corporation Auditor: KPMG
Determination of capitalized internal-use software development costs
As discussed in Notes 2(g) and 6 to the consolidated financial statements, the Company capitalizes certain internal-use software costs related to new products as well as existing products when those costs will result in significant additional functionality. The Company’s capitalized internal-use software asset, net of accumulated amortization, was $27 million as of June 30, 2019. The Company capitalized $23 million of internal-use software costs during the year ended June 30, 2019.
We identified the determination of capitalized internal-use software development costs as a critical audit matter because of the degree of subjectivity involved in assessing which projects met the capitalization criteria.
The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s process to capitalize internal-use software development costs, including controls over the determination of which software development projects met the capitalization criteria. We evaluated the Company’s current year software project capitalization conclusions, and discussed the objective and status of the software projects with IT department management to assess those conclusions. We also assessed the reliability of the Company’s conclusions through confirmations with a sample of individual software developers regarding the nature of their development activities.
Illustration 2: Company: Procter & Gamble Auditor: Deloitte & Touche
Goodwill and intangible Assets—Shave Care Goodwill and Gillette Indefinite Lived Intangible Assets—Refer to Notes 1 and 4 to the financial statements;
Critical Audit Matter Description
The Company’s evaluation of goodwill and indefinite lived intangible assets for impairment involves the comparison of the fair value of each reporting unit or indefinite lived intangible asset to its carrying value. The Company estimates fair value using the income method, which is based on the present value of estimated future cash flows attributable to the respective assets. This requires management to make significant estimates and assumptions related to forecasts of future net sales and earnings, including growth rates beyond a 10-year time period, royalty rates and discount rates. Changes in the assumptions could have a significant impact on either the fair value, the amount of any impairment charge, or both. The Company performed their annual impairment assessments of the Shave Care reporting unit as of October 1, 2018 and the Gillette brand indefinite-lived intangible asset (the “Gillette brand”) as of December 31, 2018. Because the estimated fair values exceeded their carrying values, no impairments were recorded. Given recent reductions in cash flows caused by currency devaluations, changing consumer grooming habits affecting demand and an increase in the competitive market environment, the Company revised their cash flow estimates and updated their fair value estimates for both the Shave Care reporting unit and the Gillette brand as of June 30, 2019 and determined the carrying values exceeded the fair values resulting in an impairment of the Shave Care Goodwill and the Gillette brand. The Company measured the impairment of goodwill using the two-step method which requires management to make significant estimates and judgments to allocate the fair value of the Shave Care reporting unit to its identifiable assets and liabilities including estimating the fair value of property, plant and equipment, and intangibles. The residual fair value of the Shave Care reporting unit was compared to the carrying value of its goodwill with the excess in carrying value of $6.8 billion before and after tax recorded as an impairment. The impairment of the Gillette brand of $1.6 billion before tax and $1.2 billion after tax was measured as the difference between its fair value and carrying value. As of June 30, 2019, after recording of the impairments, the Shave Care reporting unit goodwill was $12.6 billion, and the Gillette brand was $14.1 billion.
We identified the Company’s impairment evaluations of goodwill for the Shave Care reporting unit and the Gillette brand as a critical audit matter because of the recent reductions in cash flows and the significant judgments made by management to estimate the fair values of the reporting unit and the brand, and to estimate the fair value of the reporting unit’s assets and liabilities for purposes of measuring the impairment of goodwill. A high degree of auditor judgment and an increased extent of effort was required when performing audit procedures to evaluate the reasonableness of management’s estimates and assumptions related to the forecasts of future net sales and earnings as well as the selection of royalty rates and discount rates and the estimation and allocation of fair value to the reporting unit’s assets and liabilities including the need to involve our fair value specialists.
How the Critical Matter Was Addressed in the Audit
Our audit procedures related to forecasts of future net sales and earnings and the selection of the royalty rates and discount rates for the Shave Care reporting unit and the Gillette brand included the following:
- We tested the effectiveness of controls over goodwill and indefinite lived intangible assets, including those over the determination of fair value, such as controls related to management’s development of forecasts of future net sales, earnings, the selection of royalty rates, discount rates, and allocation of the reporting unit fair value to its identifiable assets and liabilities.
- We evaluated management’s ability to accurately forecast net sales and earnings by comparing actual results to management’s historical forecasts.
- We evaluated the reasonableness of management’s forecast of net sales and earnings by comparing the forecasts to:
- Historical net sales and earnings
- Underlying analysis detailing business strategies and growth plans
- Internal communications to management and the Board of Directors
- Forecasted information included in Company press releases as well as in analyst and industry reports for the Company and certain of its peer companies.
- With the assistance of our fair value specialists, we evaluated the reasonableness of the valuation methodology, net sales and earnings growth rates, royalty rates, discount rates and estimation and allocation of the reporting unit fair value to its identifiable assets and liabilities by:
- Testing the source information underlying the determination of net sales and earnings growth rates, royalty rates, discount rates, estimation and allocation of the reporting unit fair value to its identifiable assets and liabilities and the mathematical accuracy of the calculations.
- Developing a range of independent estimates for the discount rates and comparing those to the discount rates selected by management.
The CAM regarding Paylocity’s determination of capitalized internal-use software development costs provides only very limited information. Alternatively, the CAM from Procter & Gamble’s report goes into much greater detail for both the description and how it was addressed, as well as descriptive titles. Nonetheless, notice that it does not include any indication of the outcome of audit procedures. This is true of all 20 CAMs, but sometimes the outcome of the procedures might be considered implicit. For example, in the final section of Table 3 (highlighted in the Exhibit), the report indicates: “With the assistance of our fair value specialists, we evaluated the reasonableness of the valuation methodology.” If the items were not reasonable, one would expect auditors to modify the report accordingly.
CAMs versus SEC Critical Accounting Estimates
CAM reporting and financial statement accounts and disclosures are not the only source of information on subjective matters such as accounting estimates and policies. SEC Release 33-8350 requires registrants to provide disclosure of critical accounting estimates in the management discussion and analysis (MD&A) section of Form 10-K. Disclosure is appropriate when:
- The nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and
- The impact of the estimates and assumptions on financial condition or operating performance is material.
Although the above requirements differ from the PCAOB’s CAM definition, there is overlap. The PCAOB acknowledges this overlap, but suggests that the CAM concept is broader because it includes all matters communicated to the audit committee and is not restricted to accounting estimates (PCAOB, Implementation of Critical Audit Matters: A Deeper Dive on the Determination of CAMs: Insights for Auditors, March 18, 2019). The 12 companies surveyed here accounted for 63 critical accounting estimates, versus 20 CAMs.
Exhibit 4 presents Paylocity’s MD&A disclosure relating to capitalized interest-use software development costs and the company’s financial statement notes as referred to in the highlighted position of the CAM shown in Exhibit 3. A more thorough comparison of PCAOB-required CAMs and SEC-required critical accounting estimates reveals similar disclosures. One might notice that the brief CAM indicates the degree of subjectivity involved in the area, whereas the SEC disclosure emphasizes the probability that the project will be completed and the software used as intended. Nonetheless, whether the CAM provides additional information is a judgment best made by financial statement users.
Paylocity MD&A and Financial Statement Disclosure
Critical Accounting Policies and Significant Judgments and Estimates Capitalized Internal-Use Software Costs
We apply ASC 350-40, Intangibles—Goodwill and Other—Internal-Use Software, to the accounting for costs of internal-use software. Software development costs are capitalized when module development begins, it is probable that the project will be completed, and the software will be used as intended. Costs associated with preliminary project stage activities, training, maintenance and all other post implementation stage activities are expensed as incurred. We also capitalize certain costs related to specific upgrades and enhancements when it is probable the expenditures will result in significant additional functionality. The capitalization policy provides for the capitalization of certain payroll costs for employees who are directly associated with developing internal-use software as well as certain external direct costs. Capitalized employee costs are limited to the time directly spent on such projects.
Internal-use software is amortized on a straight-line basis, generally over a 24- or 36-month period. We evaluate the useful lives of these assets on an annual basis and test for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to capitalized internal-use software during the years ended June 30, 2017, 2018, or 2019. We capitalized $15.4 million, $18.0 million, and $23.3 million of internal-use software costs for the years ended June 30, 2017, 2018, and 2019, respectively, including stock-based compensation costs of $1.8 million, $2.0 million, and $2.8 million for the years ended June 30, 2017, 2018, and 2019, respectively. We amortized $9.4 million, $14.3 million, and $16.9 million of capitalized internal-use software costs for the years ended June 30, 2017, 2018, and 2019, respectively. In fiscal 2017, fiscal 2018, and fiscal 2019, we developed significant additional functionality in several of our modules. This development resulted in an increase in capitalized internal-use software costs in fiscal 2019 as compared to fiscal 2018 and in fiscal 2018, as compared to fiscal 2017.
(2) Summary of Significant Accounting Policies: …
(g) Capitalized Internal-Use Software
Capitalized internal-use software costs are amortized on a straight-line basis over the estimated useful lives, generally over a 24- or 36-month period. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. …
(6) Capitalized Internal-Use Software (omitted here—includes beginning and ending totals)
MD&A=management discussion and analysis
Procter & Gamble’s MD&A disclosure on overall goodwill and intangible assets exceeds 1,500 words. In the authors’ opinion, the descriptions of the CAM seem to provide little information beyond what is disclosed in Form 10-K’s MD&A and financial statements—yet the information is definitely not identical.
The portion of the CAM that describes the manner in which it was addressed in the audit is clearly the auditor’s, with no direct MD&A or other management disclosure. In Exhibit 3, note that those procedures are summarized as Paylocity’s auditors having:
- Tested internal controls
- Evaluated current-year software project capitalization conclusions and discussed the objective and status of software projects
- Assessed the reliability of the conclusions through confirmations.
The above are very general; again, their value should be addressed by the users of the financial statements. Proctor & Gamble’s CAM, while much longer, might be viewed by many as quite general.
It was noted above that none of the CAMs analyzed included an explicit description of the outcomes of related audit procedures performed. Providing such disclosure is a may requirement, in contrast to a must. Given this lack of a description of outcomes, financial statement users should realize that the auditor’s procedures led to a conclusion that the estimate (or other type of account) is reasonably stated, otherwise the auditor would have to modify the audit opinion. Yet one wonders whether a more complete summary of where the uncertainty lies, and to what degree, might result in a more valuable product. As a simple example, an auditor’s development of an interval as possible for an estimate might have value to users—but none of our 20 CAMs surveyed provided such information. As noted above, because the audit opinion is on the financial statements, the profession has traditionally been reticent to provide information beyond what is included in those financial statements. Also, the earlier noted concern about potential increased liability for auditors might be a concern.
One wonders whether a more complete summary of where the uncertainty lies, and to what degree, might result in a more valuable product.
Although the general nature of CAM descriptions might be questioned, there are nonetheless circumstances where they still have value to users:
- Providing the auditor’s perspective on the matters, even when discussed by management, may have value.
- Management’s knowledge that auditors will report CAMs might affect their MD&A disclosures related to this topic—both their disclosure itself and the details provided.
- Although general, auditors’ descriptions of how the CAM was addressed may be informative and have value beyond MD&A disclosures.
Summarizing CAM Reporting
The authors’ analysis found that, on average, an audit report with one CAM is approximately twice as long as prior to the CAM reporting requirement. The 12 audit reports surveyed included a total of 20 CAMs, and no report including more than two. Although not required, auditors may include the outcomes of their CAM-related audit procedures—none did so. The audit reports of the largest six companies included the same number of CAMs as the audit reports of the smaller six companies (10 CAMs), although the CAM disclosures for the larger six were longer in terms of total words.
The most frequent CAM topics were revenue recognition, goodwill and other intangible assets, and taxes. When compared to the SEC’s required MD&A reporting of critical accounting estimates (policies), CAM disclosures were shorter and less frequent.