The Public Company Accounting Oversight Board (PCAOB) is exploring ways to increase the value of the auditor’s report to investors and other financial statement users. To launch the discussion, the Board issued proposed auditing standards (and related amendments to existing standards) in August 2013. Among other things, the proposal requires auditors to report “critical audit matters,” evaluate certain information outside the financial statements and offer information about auditor tenure.
During the comment period, which closed in early May, the Board received feedback on the proposed standards. And in April, it held a public meeting in which issuers, auditors, investors, academics, government representatives and other parties discussed the proposals.
At press time, the Board planned to review this input during 2014’s second and third quarters. Given the widespread concern over the proposed standards’ potential impact on the audit process, the Board may repropose the standards and amendments based on the suggested changes.
Enhancing The Auditor’s Report
The auditor’s report hasn’t changed much since the 1940s. It identifies financial statements that were audited, describes the nature of the audit and expresses the auditor’s opinion on whether the statements are fairly presented, in all material respects, in accordance with applicable accounting standards. This approach is often referred to as the “pass/fail” model because a company’s financial statements are either presented fairly or they’re not. The auditor doesn’t otherwise “grade” the quality of the financial statements.
To provide investors with more useful information, the PCAOB proposed a new standard: The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion. The proposal keeps the pass/fail model but requires auditors to report critical audit matters (CAMs). These are audit matters “that involved the most difficult, subjective, or complex auditor judgments or posed the most difficulty to the auditor in obtaining sufficient appropriate audit evidence or forming an opinion on the financial statements.”
The idea is to share auditors’ insights on certain matters with financial statement users to help them make better-informed investment decisions. But commenters have raised significant concerns about CAM reporting. Such reporting shifts responsibility for certain disclosures from management to auditors and, in some cases, may require auditors to reveal information in their reports that otherwise wouldn’t be disclosed.
For example, what if the auditor struggled with a potentially illegal act but ultimately concluded that it was lawful? Or what if the auditor performed additional audit steps after identifying a significant internal control deficiency?
Describing these matters in the auditor’s report could confuse investors or cause them to conclude that unlawful or fraudulent activity has occurred in spite of an unqualified audit opinion. Having this information in the auditor’s report may also raise confidentiality issues, particularly when it involves pending litigation for which no accrual or disclosure would otherwise be required.
The PCAOB is considering suggestions for alleviating these concerns. Some stakeholders have suggested listing CAMs but limiting details about the considerations behind them. Others have suggested limiting CAMs to matters determined to be “significant audit matters” and communicated to the audit committee. The proposal would add other items to the auditor’s report, including statements regarding auditor independence and auditor tenure. (See the sidebar “Does auditor tenure matter?”)
Evaluating “Other Information”
Currently, auditors are required to “read and consider” certain information outside a subject company’s financial statements. The PCAOB proposed a standard to require auditors to evaluate “other information.” This refers to information in a company’s annual report filed with the SEC that also includes the company’s audited financial statement and auditor’s report. Under the proposed standard, The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report, auditors would evaluate other information for material inconsistencies with the audited financial statements or material misstatements of fact.
Although promoting such consistency is a laudable goal, some commenters have criticized this proposal because it would expand the scope of the audit, increase the auditor’s liability risk and raise certain practical concerns. Evaluating — as opposed to reviewing and considering — other information would require more audit steps. Also, the proposal might lead investors to believe that auditors are rendering an opinion on other information, raising liability concerns.
Finally, complying with this standard may be hard from a practical standpoint: “Other information” would include information incorporated by reference from the proxy statement, which typically isn’t filed until after the financial statements and auditor’s report have been filed.
Suggestions for improving this proposal include replacing “evaluate” with “perform limited procedures” and limiting audit procedures related to other information to material information directly related to the financial statements. Another suggestion is to have the auditor describe his or her responsibility for other information — including the performance of limited procedures and identification of material inconsistencies or material misstatements of fact — while emphasizing that such procedures don’t constitute an audit or review of other information.
Keeping An Eye On New Developments
Public companies should keep an eye on future developments in this area. Whatever the final standards look like, they’ll have a huge impact on financial reporting and may affect a company’s ability to raise capital.
Does Auditor Tenure Matters?
The Public Company Accounting Oversight Board's (PCAOB's) proposed audit report standards (see main article) would require an auditor's report to include the "year the auditor began serving consecutively as the company's auditor." But many members of the audit community have expressed concern that this requirement would imply a correlation between audit tenure and audit quality.
In its proposed release, the PCAOB noted that academic studies have yielded inconsistent results. Some studies conclude that audit quality improves as auditors learn more about the subject company, while others indicate that long-term auditor-company relationships adversely affect audit quality. Some stakeholders who oppose this requirement have suggested including auditor tenure information elsewhere, such as in a company's proxy statements or in PCAOB annual reports.