Volume 24, Issue 16

by Megan Zietsman, Jennifer Burns, Lisa Smith, and Sasha Pechenik, Deloitte & Touche LLP

On June 1, 2017, the PCAOB adopted a new auditing standard¹ on the auditor’s report (the “standard” or “release”). While retaining the current “pass/fail” opinion of the existing auditor’s report, the standard includes several significant modifications, which are discussed below. These changes are intended to increase the informational value, usefulness, and relevance of the auditor’s report.

In a statement announcing the standard, PCAOB Chairman James Doty stated the following:

[The new standard] will make the auditor’s report more relevant, useful and informative to investors and other financial statement users in light of the progress of history. The new standard will breathe new life into a formulaic reporting model.

At the same meeting, PCAOB Board member Steve Harris stated the following:

Today’s action is a direct response to calls from investors for the Board to expand the auditor’s report to include information about the difficult parts of the audit, and information that the auditor gained from the audit that he or she would like to know as an investor — basically what “kept the auditor awake at night.”

The PCAOB will submit the new auditor reporting standard and related amendments to the SEC for its consideration. The SEC’s approval process typically includes an additional public comment period. This Heads Up provides an overview of the standard.

Key Changes to the Auditor’s Report

The key changes to the auditor’s report under the standard are:

• Standardized ordering and inclusion of section headers, with the opinion section appearing first.
• Enhanced descriptions of the auditor’s role and responsibilities, including a statement regarding independence requirements.
• Communication of critical audit matters (CAMs).
• Disclosure of auditor tenure — The year in which the auditor began serving consecutively as the company’s auditor.

PCAOB Chief Auditor and Director of Professional Standards Martin Baumann stated his belief that:

[T]his new auditor reporting standard will make the audit report more informative and relevant, adding to the total mix of information that investors use to make investment decisions.

Appendix A in the attached PDF contains an example of an illustrative auditor’s unqualified report that highlights the changes to the current report. The final standard is not significantly different from the requirements and guidance previously proposed by the PCAOB in May 2016 (the “2016 reproposal”).

In developing the standard, the PCAOB considered feedback received from comment letters, roundtables, public outreach activities, and discussions with its advisory groups.² In addition, the Board considered the efforts undertaken by several international and non-U.S. standard setters and regulators.

Appendix B in the attached PDF compares various aspects of the PCAOB’s standard to similar requirements adopted by the International Auditing and Assurance Standards Board (IAASB), the European Union (EU), and the Financial Reporting Council in the United Kingdom (FRC).

Communication of CAMs

Overview of CAMs

A CAM is defined in the standard as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective, or complex auditor judgment.”

The release also states that CAMs could include matters that were (1) required to be communicated to the audit committee and (2) actually communicated, even if not required.

Editor’s Note We believe the requirements in the new standard for determining CAMs allow the auditor to identify and communicate those matters that would be of most interest and importance to investors. In particular, we support the steps the auditor takes to identify CAMs, beginning with the population of those matters that were communicated or required to be communicated to the audit committee, and then identifying those matters that relate to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective, or complex auditor judgment. PCAOB AS 1301, Communications With Audit Committees, and other applicable rules and standards require communication to the audit committee of matters arising from the audit that are relevant to the audit committee’s oversight of the financial reporting process.

Further, the standard includes a nonexclusive list of factors for the auditor to take into account, alone or in combination, in determining whether a matter involved especially challenging, subjective, or complex auditor judgment. (See Appendix C in the attached PDF for an illustration of the process for determining CAMs.)

Editor’s Note We support the inclusion of the nonexclusive list of factors provided in the final standard and their use in determining whether a matter involved especially challenging, subjective, or complex auditor judgment. Some comments received on the 2016 reproposal suggested that the selection of CAMs from the matters that involved “especially challenging, subjective, or complex auditor judgment” will depend on the auditor’s experience and skill level and may result in inconsistent application of the requirements of the standard, potentially leading to investor confusion. The PCAOB explained that the CAM definition is grounded in “auditor’s expertise and judgment, which is directly responsive to investor requests for information from the auditor’s point of view.” The release further explains that the determination of CAMs “is principles-based and the final standard does not specify any items that would always constitute [CAMs].” For example, the standard does not provide that all matters determined to be “significant risks”3 under PCAOB standards would be CAMs, because not every significant risk would necessarily involve “especially challenging, subjective, or complex auditor judgment.”

Auditor Reporting of CAMs

CAMs will be identified and described in a separate section in the auditor’s report titled “Critical Audit Matters.” Specific language will precede the description of the CAMs, stating that (1) CAMs do not alter the opinion on the financial statements and (2) the auditor is not providing a separate opinion on the CAMs or the accounts or disclosures to which they relate. The release states that for each CAM communicated in the auditor’s report, the auditor will be required to:

• “Identify the [CAM].”
• “Describe the principal considerations that led the auditor to determine that the matter is a [CAM].”
• “Describe how the [CAM] was addressed in the audit.”
• “Refer to the relevant financial statement accounts or disclosures that relate to the [CAM].”

The release also states that the determination of a CAM “should be made in the context of [a] particular audit, with the aim of providing audit-specific information rather than a discussion of generic risks.” It is expected that in most audits to which the CAM requirements apply (see applicability information below), the auditor would identify at least one CAM. If no CAMs are identified, the auditor would be required to make a statement to that effect in the auditor’s report.

Editor’s Note In their comment letters on the 2016 reproposal, some investors that supported CAM disclosures suggested further modifications to the auditor’s report, such as including the auditor’s assessment of the significant accounting judgments and management estimates and requiring auditors to describe specific insights and findings related to each CAM (i.e., disclose the results of the auditor’s procedures with respect to CAMs). The release explains that communication of the auditor’s findings is not required, but “the auditor may choose to include findings as an indication of the outcome of audit procedures or key observations about a matter” as such information may be valuable to investors. In addition, some commenters on the 2016 reproposal expressed concern that the auditor may be in the position of communicating original information about the company (e.g., matters related to significant deficiencies in internal control that are required to be communicated to management and the audit committee but not externally). The release explains that through its definition of a CAM, the PCAOB is attempting to strike an appropriate balance between investor demands for enhanced communication about the audit and potential unintended consequences associated with providing it. The PCAOB notes, and we agree, that because each CAM relates to accounts or disclosures that are material to the financial statements, a matter that does not relate to accounts or disclosures that are material to the financial statements cannot be a CAM. In addition, the release states that while the auditor is required to describe the principal considerations that led the auditor to determine that the matter is a CAM, the auditor may do so in general terms (e.g., if a significant deficiency was among the principal considerations in determining that a matter was a CAM, the auditor may describe the relevant control issues that relate to the matter in the broader context of the CAM without using the term “significant deficiency”).4

See Appendix D in the attached PDF for illustrative examples of communication of CAMs based on the examples in the 2016 reproposal.

Period Covered

In the final standard, the Board has retained the requirement to communicate CAMs only for the current audit period. However, the auditor would not be precluded from including CAMs for prior periods.⁵

Documentation of CAMs

The standard states that for each matter arising from the audit that both (1) was communicated or required to be communicated to the audit committee and (2) relates to accounts or disclosures that are material to the financial statements, the auditor is required to document whether or not the matter was determined to be a CAM (i.e., involved especially challenging, subjective, or complex auditor judgment) and the basis for such determination. The release specifies that the amount of documentation may vary but should be sufficient to facilitate review by others, including the engagement quality control reviewer.

Auditor Tenure

The standard requires the auditor to include a statement in the auditor’s report containing the year the auditor began serving consecutively as the company’s auditor; however, the location for this statement in the auditor’s report is not prescribed.

Editor’s Note In the release, the PCAOB acknowledges that many issuers are already voluntarily disclosing auditor tenure in their proxy statements for annual meetings of shareholders. Deloitte’s review of S&P 100 proxy disclosures in 2016 showed that 67 percent of companies in the S&P 100 currently disclose information about audit firm tenure.6 The PCAOB explains in its release that disclosure of audit firm tenure is intended to add to the mix of publicly available information. It is not intended to create an inference either positively or negatively. In recent remarks at the 36th Annual SEC and Financial Reporting Institute Conference held at the University of Southern California, at which the new requirement was addressed, SEC Chief Accountant Wesley Bricker stated that: [T]he years of experience may be one of the many factors considered by audit committees in their selection and oversight of the external auditor. In doing so, for example, an audit committee might consider an audit firm’s prior service experience in contributing to the firm’s understanding of the company’s business and audit risks. And, also, an audit committee may want to incorporate prior auditor service into its oversight of the auditor’s expertise, incentives and, ultimately, appropriate performance in the conduct of the audit.

Effective Date

The effective date (pending SEC approval) will be phased in as follows:

• All changes except for communication of CAMs:
  • Audits of fiscal years ending on or after December 15, 2017.
• Communication of CAMs:
  • Audits of large accelerated filers (as defined by the SEC⁷): fiscal years ending on or after June 30, 2019.
  • Audits of all other companies: fiscal years ending on or after December 15, 2020.

However, the release states that auditors may elect to comply with the standard before its effective date at any point after SEC approval.

Applicability

Communication of CAMs is not required for audits of brokers and dealers reporting under Rule 17a-5 of the Securities Exchange Act of 1934 (the “Exchange Act”); investment companies registered under the Investment Company Act of 1940, other than business development companies; employee stock purchase, savings, and similar plans; and emerging growth companies as defined in Section 3(a)(80) of the Exchange Act. However, the standard permits voluntary inclusion of CAMs in the auditor’s report for such entities. Note that all other provisions of the standard apply to the audits of these entities.

Considerations for Management and Audit Committees

Although the standard is subject to SEC approval and would be implemented in accordance with phased-in effective dates, management and audit committees will most likely want to start to consider the implications of the new requirements and discuss them with their auditors. Potential questions regarding CAMs may include the following:

• What matters could be CAMs?
• How will management and audit committees engage with the auditor as CAMs are identified and the auditor’s descriptions of the CAMs are developed and finalized?
• How will the timing of auditor communications with management and the audit committee accommodate the discussion of CAMs?
• How do the auditor’s statements regarding CAMs compare to management’s disclosures regarding the same matters?

Appendix A — Example of an Auditor’s Unqualified Report on an Audit of Financial Statements

Please see Appendix A in the attached PDF.

Appendix B — Comparison of Auditor Reporting Standards

Please see Appendix B in the attached PDF.

Appendix C — Illustration of the Process for Determining and Reporting CAMs (Adapted From the Release)

Please see Appendix C in the attached PDF.

Appendix D — Examples of Critical Audit Matters

Please see Appendix D in the attached PDF.

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