Securities Law

Posted on Tuesday, July 25 2017 at 10:01 am by idinerma

Big Changes Coming to the Form and Substance of Auditor’s Reports

By: David A. Stockton

In early June, the PCAOB adopted a new auditing standard (AS No. 3101) that will fundamentally change the format and substance of the audit reports provided by outside auditors to their public company clients.  This is big news in the world of auditor reports, as the standard one-page form of auditor’s report has not been significantly changed in over 70 years.  The lofty goals of the PCAOB were evidenced by Chairman James Doty’s proclamation that “the changes adopted today breathe life into the audit report …”.  The lifelessness he refers to is due to these reports being mere pass/fail statements, providing absolutely no color on significant issues encountered in the audit.

The new standard requires that the audit report describe “critical audit matters” (“CAMs”), which are defined as material accounts or disclosures that involve especially challenging, subjective or complex auditor judgments.  The pass/fail nature of the report still remains, but investors will now have a view inside the audit through a better understanding of the significant issues encountered during the audit.  This view should give investors a better basis to assess the financial condition and results of an issuer and with which to engage management.

The new standard requires that auditors disclose CMAs in a new section of the audit report.  Each identified CAM must be described, along with the principal consideration that led the auditor to believe that the matter constitutes a CAM, how the CAM was addressed in the audit and the relevant financial statement accounts or disclosures related to the CAM.  The new standard contains a non-exclusive list of factors that should be used by an auditor in determining if a matter constitutes a CAM.  The PCAOB expects this determination to be “principles-based” and driven by the nature and complexity of the audit.

Other changes called for by the new standard include addressing the report to the shareholders and board of directors, a statement that the auditor is independent under SEC and PCAOB rules, and a disclosure of the number of consecutive years of service by the auditor for the issuer.

The new standard is proposed to be implemented in stages.  The formatting and tenure changes would be implemented immediately, i.e., for all fiscal years ending on or after December 15, 2017, which is the current fiscal year for most issuers.  Communications of CAMs have a much longer lead time, not being required until 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 public companies.

The first concern of most public company issuers considering the new CAM disclosures is how they will relate to the existing disclosures of critical accounting policies and estimates in an issuer’s MD&A.  The new requirements will result in substantially overlapping accounting topics being addressed separately by the issuer and by the auditors, both in the same SEC filing.  There will clearly need to be very focused advance planning and coordination between the auditors and the issuer regarding the content of these sections.  Care will need to be taken to assure that the auditor’s disclosures do not contain previously undisclosed material information about the issuer or information that is contradictory to or inconsistent with the issuer’s disclosures in any material manner.

Another common concern is that this new requirement will lead to voluminous additional disclosures, but only marginally improve the overall quality of disclosure.  Auditors are already focusing on the possibility of litigation against them for improper disclosure or omission of material information regarding a CAM, or failing to disclose a CAM altogether.  It is safe to assume that any area under audit that has been heavily tested and documented will be identified by the auditor as a CAM.  Once a CAM is identified the auditor will have every incentive to provide a full explanation of why this is the case and how the matter was addressed in the audit.  One can envision a long list, each with a full discussion, of every matter that could qualify as a CAM. This would track trends in Risk Factor disclosures, which tend to list every potential risk because it is better to be safe than sorry.  The one-page auditor report clearly will be a thing of the past. By comparison, similiar London Stock Exchange requirements adopted three years ago have resulted in audit reports typically running ten pages or more.

Given these concerns, many question the relative value of requiring this additional disclosure from auditors.  After all, auditors are already active participants in the preparation of an issuer’s MD&A and are in position to comment on and mold disclosures of critical accounting matters.  Auditors already have the leverage to cause an audit matter that meets the definition of a CAM to be included as a critical accounting policy or otherwise fairly discussed in a filing without these new requirements.

These are some of the many matters that must be addressed and resolved before the new CAM disclosures become effective.  While the proposed standard is subject to approval by the SEC, that process is not expected to result in any substantial modifications.  So the accounting profession and their clients should start right away to take advantage of the long runway before the CAM requirements become effective to achieve a mutually satisfactory product.




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