By Cydney Posner
As described in my article last week (8/13/13), the PCAOB has proposed important changes to audit reports. If adopted, these changes could be the most significant in 70 years. But so far, the proposals have gotten a cautious reception, as everyone from investor advocates to corporate litigators considers the potential consequences.
Typically, as you know, auditors just give companies a pass/fail grade and provide no description of any issues or problems that occurred during the audit process; those problems are instead taken up with the audit committee. Critics contend that the current report is just boilerplate that "tells investors little of substance about a company's true condition." As former PCAOB member Dan Goelzer commented in this BusinessWeek article, "[t]he concern coming out of the financial crisis was that auditors had more information into judgment calls and business risks than they conveyed in their opinion… Some insight from the auditor about what the challenging part of the audit was and what the risks are would provide some additional insight. The question is, at what cost." The PCAOB had tried to address this concern in its 2011 Concept Release by floating various alternatives, principle among them the "auditor's discussion and analysis." (See my article of 6/21/2011.) But the ADA concept was widely criticized because, among other things, it was viewed as "fundamentally changing the auditor's current role from attesting on information prepared by management to providing an analysis of financial statement information," thus causing the auditors to step into a role of management. As PCAOB member Steven Harris explained, the "challenge of this project is to find a way to balance the need for a different, more useful and communicative, model of the auditor's report with the need not to change what auditors do, but to change how they report on what they do."
Initial reactions by some audit firms to the PCAOB's new proposal for the auditor's reporting model have been surprisingly positive; for example, PwC has gone so far as to announce that it "strongly supports any enhancements to the auditor's report that will address the needs of today's users" http://online.wsj.com/article/SB10001424127887324769704579010561839513086.html (Of course, cynics might view the statement as more noncommittal than it appears at first blush.) However, if the proposal has been welcomed at all by audit firms, it may well be because of what the PCAOB doesn't propose as opposed to what it does. The absence from the proposal of the controversial ADA must certainly have allowed audit firms to breathe a sigh of relief. But it's probably not a full-blown exhale.
As noted in my article of 8/13/13, the proposed new auditing standard is designed to make audit reports more useful to investors by providing more insight into the underlying auditor judgments through a discussion of "critical audit matters" without eliminating the binary "pass/fail" model and without inappropriately stepping into the roles of management or the audit committee. The proposal contends, "[i]mproving the auditor's report through the communication of critical audit matters also would address some commenters' concerns that it is the company's or the audit committee's responsibility, not the auditor's, to provide information, including any analysis, about the company's financial statements to financial statement users. The proposed communication of critical audit matters would not fundamentally change the auditor's current role from attesting on information prepared by management. Rather, the auditor would be communicating information about the audit, based on audit procedures the auditor performed."
As previously noted, the proposed new standard would require the auditor to report on CAMs, generally defined as matters the auditor addressed during the audit that
- involved the most difficult, subjective or complex auditor judgments;
- posed the most difficulty in obtaining sufficient appropriate evidence; or
- posed the most difficulty with respect to forming an opinion on the financial statements.
The PCAOB fact sheet on the proposal explains that the description for each CAM in the auditor's report would identify the CAM, describe the considerations that led the auditor to determine that the matter was a CAM and refer to the relevant financial statement accounts and disclosures that relate to the CAM. To illustrate, the proposal provides this example: "if the auditor identified the valuation of financial instruments with little, if any, market activity at the measurement date as a critical audit matter because the valuation involved the most difficult, subjective, or complex auditor judgments, then communication of that critical audit matter in the auditor's report must describe the considerations that led the auditor to determine that the matter is a critical audit matter, which might relate to the high degree of measurement uncertainty or the significant judgments and estimates involved." Auditors may not disclaim, qualify, restrict or minimize the auditor's responsibility for CAMs. In addition, auditors must provide significant documentation regarding matters determined to be CAMS, as well as the basis for any determination not to report matters that would appear to an experienced auditor to meet the CAM definition.
In their statements at the open meeting, PCAOB members who voted in favor of releasing the proposal nevertheless offered their own critiques. For example, Jay Hanson questioned whether the reporting of CAMs "could result in the disclosure by the auditor of information that specifically was exempted from disclosure by other applicable rules and regulations. By way of example, the determination that a deficiency in internal controls is a significant deficiency rather than a material weakness may have been a critical audit matter. Under applicable securities laws and SEC regulations, depending on the circumstances, a company may not have to disclose a significant deficiency, but the critical audit matter discussion in the audit report may cause that information to be disclosed." Another example might arise in connection with going-concern considerations. http://pcaobus.org/News/Speech/Pages/08132013_Hanson.aspx On the other hand, Steven Harris questioned whether the proposal went far enough. In his view, the use of a subjective standard in determining CAM status permits too much leeway for an auditor to decide not to report any CAMS so long as the work papers document the reason for not doing so. In addition, he worried about whether the new disclosures would be obscured in boilerplate or written clearly enough to tell investors anything. He also expressed concerns about the possibility of "effective inspection and enforcement of compliance with a subjective ‘critical audit matters' standard." He suggested that consideration should instead be given to requiring discussion in the report of specific items such as those recommended by Sir David Tweedie, the former Chair of the International Accounting Standards Board and national technical partner of KPMG: "(i) what kept the auditor awake at night, (ii) what arguments the auditor had with the CFO, (iii) what the big estimates are, (iv) what the contentious accounting policies are, and (v) what the going concern assumptions are?"
Not surprisingly, the proposal has raised some concerns among the public. Some critics have pointed out that, notwithstanding the PCAOB's efforts to avoid changing the auditor's current attestation role, the proposal still may require the auditors to provide subjective analysis: As one commentator observed in this Law360 article, the proposal puts auditors in the position "where they are essentially editorializing on the contents of a company's reports," which could well alter the client relationship and "raises key questions about who is responsible for revealing internal company information. ‘The traditional view is that in a company's filing, it is the company that speaks. Not the auditor, not the company's lawyer,'" the commentator added. Similarly, as reported in http://www.accountingweb.com/article/pcaob-proposes-new-standards-enhance-auditor-reporting/222240, some will be evaluating the proposal to determine if it allocates "the burden of transparent reporting onto the auditor rather than management. ‘We need to look at how to make the auditor's report more useful to investors without taking the burden of financial reporting away from management and putting it on auditors….In theory, it sounds like a great idea for investors, but in practicality, we have to make sure the process is managed so that companies retain responsibility for communication about their financial results and that auditors remain objective about that information.'"
Another concern raised is that the proposal could also cause tension between auditors and their clients: according to another commentator in Law360, "It creates tension in the relationship between the auditor and the audit client. It puts pressure on the auditor to say more things, some of them subjective,…" Although the PCAOB has indicated that it wants to provide auditors with flexibility about what they report, according to commentators in Law360, flexibility "adds another layer of potential second-guessing for auditors….It's ‘quite a difficult position to put an auditor in when we're supposed to be objective when it comes to financial statement disclosure and financial statement accounting. Is this what we were trained to do?'"
Further, the new standard may well "give new ammunition to enterprising plaintiffs' attorneys." Allowing a third party to make public "questions arising during the audit process could increase the chance that an enterprising plaintiffs[‘] attorney or regulator could take a second look at that information, and potentially file a lawsuit.' The risk is by having the immediate disclosure, you open yourself up to immediate second-guessing,' " according to another commentator cited in Law360. The WSJ reports that the U.S. Chamber of Commerce sees the PCAOB's proposal as "a fundamental change that can harm both businesses and investors alike, and may drive up liability for management and auditors," according to a Chamber representative. And, as reported in CFO.com, companies "are concerned about potential increases in cost from having more disclosure under the new proposal."
The proposal would also require that auditors "evaluate" information – not just numeric, but also qualitative information -- in a company's annual report other than the financial statements and state, under the caption "The Auditor's Responsibilities Regarding Other Information," whether the auditor identified a material inconsistency or material misstatement based on the auditor's procedures. If, based on the evaluation, the auditor finds a misstatement, the proposal requires the auditor to discuss it first with management and then the audit committee, but if the information is not appropriately revised, the auditor must consider whether to make a 10A report to the SEC, and either identify the misstatement in the auditor's report or withdraw, including potentially withholding the use of the auditor's report for a prior period. According to Martin F. Baumann, chief auditor and director of professional standards at the PCAOB, quoted in CFO.com http://www3.cfo.com/article/2013/8/auditing_auditing-mda-discussion-pcaob-iaasb-caq,: "An auditor will have to think twice when it states, ‘as part of our evaluation we did not identify any material inconsistencies with the financial statements, material misstatements of fact, or both,'" As noted by the WSJ, this component of the proposal would again "take the auditors beyond their traditional role of verifying a company's numbers."
With respect to the proposal regarding disclosure of auditor tenure, a statement from the executive director of the Center for Audit Quality indicated that the PCAOB should expect thorough comments and reminded the PCAOB that "several board members" had noted at the open meeting that "there is no demonstrated correlation between auditor tenure and audit quality.." http://www.accountingtoday.com/news/PCAOB-Proposes-Change-Auditor-Reporting-Model-67721-1.html
While investor advocates might have preferred an ADA requirement, some still maintain that the PCAOB is on the right track. And PCAOB Chair Jim Doty was feeling pretty good about things, characterizing the proposal as a "watershed moment." In the press conference following the PCAOB meeting, as reported in Accounting Today, Doty continued his metaphor: "[I]it's important to know how the water runs downhill after the watershed….This is more than a promising start. This is a highly disciplined, highly rigorous, economically analyzed and justified proposal for a change that involves the most technical and the most focused aspects of audit conduct. We will have a comment process. It will be useful, but we have done those things which people wanted us to do. We have not done those things that people were concerned about. We have avoided the auditor's discussion and analysis. We have not put the auditor into the position of evaluating the audit committee or evaluating the company's own estimates. There are a number of issues set forth in the forepart of this release that delineate clearly why we did not do some of the things that others had spoken of doing.
"But speaking for me,…what I am going to be interested in seeing is whether in this comment process and in this review process, the audit profession seizes the opportunity that this represents, and whether that watershed leads the audit profession to meet the challenges that are discussed in this release, for the audit profession to say, ‘Yes, we want the public to know we are required to be independent. We have the following tenure as the auditor. We have been the auditor continuously since … We perform procedures to assess the risk of material misstatement, whether due to error or fraud. Then here are the critical accounting matters we found and here are the evaluation procedures that we have evaluated.' These are the five new elements of the audit opinion that are set forth clearly. If the audit profession takes the view that they will figure out a way to do this in a way that is meaningful for investors, they will make the right choice and they have a lot of people to help them do that. They have professional associations and professional organizations. If the audit profession takes an approach, which I do not expect them to take, that this is just too tough, the liability risk is too great, the change is too big, if that is where the audit profession goes, it will indeed be a different kind of watershed."
According to The Wall Street Journal, if the proposal is enacted, the first audit reports meeting the new standards would not be required until 2017. The PCAOB is accepting public comments on the proposal through December 11.