The SEC has approved the Public Company Accounting Oversight Board’s (“PCAOB”) new standard for audit reports on public company financial statements. The new auditor reporting standard will require more information about the audit with the stated intention of making the auditor’s report more informative and relevant to investors.
The standard includes the communication of critical audit matters, referred to as CAMs, which will provide information about matters arising from the audit that required especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters.
Communication of CAMs is not required for audits of emerging growth companies; brokers and dealers; investment companies other than business development companies; and employee stock purchase, savings, and similar plans.
The new standard also makes other changes to the audit report with respect to disclosures regarding auditor tenure, independence, addressees and other enhancements.
CAMs will be required to be included in audit reports for large accelerated files for fiscal years ending on or after June 30, 2019. CAMs will be required to be included in audit reports for other issuers for fiscal years ending on or after December 15, 2020. Auditors may elect to comply with the standard before the effective date. All provisions other than those related to critical audit matters will take effect for audits for fiscal years ending on or after December 15, 2017.
Public companies may want to take the following steps now that the PCAOB standard has been approved by the SEC:
- Ascertain wither the auditors intend to disclose CAMs in audit reports prior to the required effective time.
- Become familiar with the changes to the audit report that will be effective during the upcoming reporting season.
Critical Audit Matters
The new standard requires the auditor to communicate in the auditor’s report any critical audit matters arising from the current period’s audit of the financial statements, or state that the auditor determined that there were no critical audit matters.
A CAM is defined as a matter that was communicated or required to be communicated to the audit committee that:
- Relates to accounts or disclosures that are material to the financial statements, and,
- Involved especially challenging, subjective, or complex auditor judgment.
When determining whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor takes into account certain factors, including the auditor’s assessment of the risks of material misstatement, the degree of auditor judgment applied, and the nature and timing of unusual transactions.
The communication of each CAM in the auditor’s report includes:
- identification of the CAM;
- description of the principal considerations that led the auditor to determine that the matter was a CAM;
- description of how the CAM was addressed in the audit; and,
- reference to the relevant financial statement accounts or disclosures.
Public companies are sensitive to disclosures about loss contingencies or possibilities of illegal acts for fear that they will encourage litigation. The final standard provides that each critical audit matter must relate to accounts or disclosures that are material to the financial statements. According to the PCAOB, a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a critical audit matter; it does not relate to an account or disclosure in the financial statements, even if it involved especially challenging auditor judgment. The same rationale would apply to a potential illegal act if an appropriate determination had been made that no disclosure of it was required in the financial statements; the matter would not relate to an account or disclosure that is material to the financial statements.
The PCAOB does not believe the new rule will lead to additional litigation against companies and their auditors. Commenters had expressed concern that communication of CAMs could result in an increase in “meritless claims” under the securities laws against auditors and issuers. While mandating disclosure of critical audit matters will, by design, entail new statements in the auditor’s report, the Board noted that any claim based on these new statements would have to establish all of the elements of the relevant cause of action (for example, when applicable, loss causation and reliance). The Board also noted that the disclosure of risks and challenges required by CAMs could alternatively be used to combat litigation by effectively providing a defense to securities laws claims against auditors. In addition, the final standard provides that the auditor is not expected to provide information about the company that has not been made publicly available by the company unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit.
Further, any matter that will be communicated as a critical audit matter will already have been discussed with the audit committee, and the auditor will be required to provide a draft of the auditor’s report to the audit committee and discuss the draft with them. In addition, as the auditor determines how best to comply with the communication requirements, the auditor could discuss with management and the audit committee the treatment of any sensitive information.
Other Changes to the Auditor’s Report
The final standard also includes a number of other changes (the PCAOB describes them as “improvements”) to the auditor’s report that are primarily intended to clarify the auditor’s role and responsibilities related to the audit, provide additional information about the auditor, and make the auditor’s report easier to read:
- Auditor tenure — The auditor’s report will include a statement disclosing the year in which the auditor began serving consecutively as the company’s auditor;
- Independence — The auditor’s report also will include a statement that the auditor is required to be independent;
- Enhancements to basic elements — Certain standardized language in the auditor’s report has been changed, including adding the phrase, “whether due to error or fraud,” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements;
- Standardized form of the auditor’s report — The opinion will appear in the first section of the auditor’s report. Section titles have also been added to guide the reader; and,
- Addressees — The auditor’s report will be addressed to the company’s shareholders and board of directors or equivalents (additional addressees also are permitted).
Now that the new standard has been approved by the SEC, the final standard and amendments will take effect as follows:
- All provisions other than those related to critical audit matters will take effect for audits for fiscal years ending on or after December 15, 2017; and,
- Provisions related to critical audit matters will take effect for audits for fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply.