Audit Report Reform Proposal Sparks Debate on Auditor's Role

A proposal to require external auditors to say more in their audit reports has touched off a debate on the role of the auditor and how to deal with the increasing use of judgments in the financial reporting process.

Accounting standards are increasingly requiring the use of estimates and forecasts in financial statements, making it tougher for auditors to remain in their old-school role of strictly verifying what's contained in them. Rather than black and white determinations, auditors must make some judgments too, and investors and regulators want to hear more from auditors about how they arrived at their decisions and where their conclusions may have differed from management.

The Public Company Accounting Oversight Board is currently sifting through more than 200 comment letters to a proposal to require auditors to expand the pass-fail audit report to include, most notably, some insight into the many shades of gray now contained in financial reporting. The PCAOB is considering requirements that audit firms provide more detail on what they found during their audit work and where they encountered trouble in arriving at their audit opinion, and expects to hold a roundtable in the first half of 2014 to gather more feedback.

The proposed standard would require auditors to disclose the critical audit matters they encountered during the audit process, such as any close calls, areas where they had difficulty obtaining evidence, or contentious differences over judgment calls. It also would require auditors to look at information outside financial statements and compare it for consistency and accuracy, and to include disclosures about their independence from company management, their tenure on the audit engagement, and their responsibilities related to fraud and to the footnotes.

Only a handful of investors or investor advocates submitted comment letters on the proposal, most supportive of the board's quest to get auditors to put in writing what they do and what they find during their audit work. The CFA Institute, for example, said its members welcome efforts to upgrade the quality, relevance, and value of the standard auditor's report “to advance a seriously outdated model for communication of important information.” The analyst group says significant effort and cost go into an audit, yet investors get very little information out of it. “Through increased transparency, a revised SAR will facilitate better analysis and heighten user confidence in the audited financial statements.”

Joe Carcello, a professor at the University of Tennessee and director of the university's Corporate Governance Center, says he was surprised more investor groups didn't speak up in support of the PCAOB's proposal, but he speculates it's probably because of lack of resources rather than lack of interest or support. For some investment companies, that's indeed the case. Capital Group Cos., for example, says it's not able to discuss the proposal because it is still studying it and preparing its response.

Who's Job Is It, Anyway?

Most feedback from corporations, directors, or audit committee members is critical of the proposal, insisting it's management's role, not the auditor's, to talk to investors about what's contained in financial statements. They worry that compelling auditors to report on their audit work will chill dialogue between auditors and audit committees and add to the cost of the audit.

“Traditionally, companies haven't had to disclose every nook and cranny of their business decision thinking to auditors,” says Don Norman, senior economist for the Manufacturers Alliance for Productivity and Innovation, who responded to the proposal on behalf of MAPI's corporate members. “Auditors have been asked to assure the financial data was honest and accurate. Here, they're asked to play a different role, almost getting in there and second guessing the decisions made by management. It's just going to cost more money.”

OVERVIEW OF COMMENTS

Below is a synopsis from the CAQ of commenter letters to the PCAOG regarding the proposed auditor's reporting model.

Critical Audit Matters (CAM)

Approximately 10 percent of commenters support CAM as proposed. However, over 20 percent of commenters expressed support for the concept of CAM, i.e. with appropriate modifications.

Preparers/Issuers and Audit Committees account for almost 40 percent of the total comment letters reviewed, with a great majority (over 90 percent) opposing the proposed CAM reporting. Reasons for opposition include that the proposed CAM reporting: (i) would undermine effective corporate governance (e.g., diminish the role of the audit committee), (ii) could result in the auditor providing original information about the company, and (iii) would increases costs with little or no added informational value to financial statement users and with increased liability risks.

Industry and professional associations account for 19 percent of the total comment letters reviewed, with approximately 75 percent opposing CAM, noting that it undermines effective corporate governance (e.g., diminishes the role of the audit committee).

Investors / Users account for 9 percent of letters reviewed, with support for the CAM proposal split.

Although more than half of audit firms support providing CAMs if appropriate changes were made to the PCAOB's approach, none supported the PCAOB's CAM reporting as proposed, expressing concerns that the proposed CAM framework is overly broad, could result in the auditor providing information that is the preparer's responsibility to provide, and could undermine the auditor's opinion.

Brokers and Dealers account for 14 percent of the total comment letters reviewed; this group opposed the proposed CAM reporting and most requested exemption from it if the proposal were to be approved.

Unaffiliated respondents account for 6 percent of the letters reviewed, with over half of that group opposing CAM, approximately 25 percent supporting CAM, and approximately 25 percent remaining neutral or electing not to comment on this portion of the proposal.

Other Information

Very few commenters (approximately only 5 percent) expressed support for the PCAOB's other information proposal as proposed. Commenters expressed concern primarily with the increased auditor performance requirements in the PCAOB's proposal.

However, about 40 percent of commenters did express some level of support for modified auditor reporting related to other information, e.g. describing in the auditor's report the auditor's performance responsibilities in the audit report.

Frequently cited reasons for opposing OI include that it:

—Significantly expands the auditor's responsibilities with respect to OI.

—Results in significant incremental effort and cost, which far exceed the benefits.

—Expands the expectations gap, as users of the financial statements may falsely assume greater auditor responsibilities and perceive the auditor's “conclusion” on OI as a form of reasonable assurance.

Audit Firm Tenure

Very few commenters (just over 5 percent) support providing the audit firm's tenure within the auditor's report; over 50 percent were opposed, and almost 40% did not express support or opposition.

However, roughly 20 percent support (or do not object to) including tenure outside of the audit report (e.g., proxy statement, Form 2, etc.).

Source: CAQ.

Ken Daly, president and CEO of the National Association of Corporate Directors, says audit committees are generally pleased with the service they get from auditors and believe requiring auditors to produce original reports would confuse the traditional roles of management and auditors. “The party asserting is management,” he says. “The party attesting is the auditor, and the party overseeing is the audit committee. This new reporting really gums up the works.”

According to Carcello, the proposal does nothing to require auditors to take on a new role. “The information auditors would be asked to provide would be information that is already required to be gathered as part of the audit and communicated to the audit committee,” he says. “It's not financial analysis, and it's not investment analysis.”

Audit firms generally weren't as opposed to the proposal as the corporate community, but they, too, are concerned the proposed standard would force them to step out of their traditional role. Cindy Fornelli, executive director of the Center for Audit Quality, says auditors do not believe it is appropriate for them to serve as the original source of information on issues that management is responsible for reporting. Beyond that, auditors might be open to disclosing information about critical areas of the audit, but they're looking for ways to assure the list of new requirements doesn't get out of hand. “What's critical?” she asks. “If you have hundreds or dozens of issues that are seen as critical, it will be difficult for readers to understand what really is critical.”

Auditors also warn there will be a price tag for work that will come with disclosing information on sensitive issues. “There will have to be some type of review process,” says John Keyser, national director of assurance services for McGladrey. Auditors can identify the critical audit issues because they discuss them with the audit committees now, he says. But narrowing the list to the most critical for disclosure will involve more analysis. “That will take some effort, and we'll have to document our thinking on why something is disclosed or not disclosed. There will be back and forth, probably an audit committee review, and legal counsel review, and more discussion. And that will happen at a critical time when it's the end of an audit and you're ready to file.”

Hoyt Stastney, a partner at law firm Quarles & Brady, says on one hand auditors probably like disclosing the tough calls because it may offer them some protection from second guessing in PCAOB inspections and in investor suits. He wonders as well if requiring the auditor to disclose those close calls might cause companies to take less aggressive positions that end up producing those contentious conversations with auditors.

The CAQ is conducting a field test with several major firms looking at approximately 50 audits of 2012 financial statements. Auditors will walk through the requirements of the PCAOB proposal with real scenarios to see how the reporting would work in practice. The results are expected in May, says Fornelli. “We're hoping the results will reflect things like how many critical audit matters were identified and how they related to corporate disclosures,” she says. “This is such a fundamental, profound change to the auditor's reporting model, we thought it was important to try to quantify what this would actually look like.”