Audit firms are privy to much more information about a client's financial condition than ever gets released to investors in their audit reports. Now regulators are opening a broad debate on how best to pry loose more of that data and make it available to the public.
The Public Company Accounting Oversight Board published a concept release last week to flesh out ideas on how to require auditors to give investors a better understanding of where they believe companies may have the greatest risks in their financial statements. The goal is to change the culture of auditing to one where auditors work for investors rather than the public companies that pay the audit bill, PCAOB Chairman James Doty said. “It's about how audits can provide investors more insightful assessments of management stewardship,” he said.
One idea raised in the concept release is to require auditors to prepare an “auditor's discussion and analysis,” a narrative report where auditors would give a high-level summary of the most significant issues in the financial statements. Auditors might describe their assessment of the financial statements, areas that are based on significant judgments or estimates, accounting policies and practices, difficult or contentious issues, and significant risks. Audit firms are sure to consider this one of the more aggressive suggestions of the release.
On the opposite end of the spectrum, the release also asks if all that's needed is a disclaimer that the audit isn't the same as a guarantee of fiscal health and it won't catch every instance of fraud.
Other ideas fall in a range between those two. Regulators ask if auditors should be required to make more use of “emphasis paragraphs,” which are now permitted but rarely used, to call special attention to the most significant issues in the financial statements. The PCAOB also asks if auditors should be required to assess and give their opinions on information that falls outside of financial statements, such as management's discussion and analysis, earnings releases, non-Generally Accepted Accounting Principles information, or other data.
Jeff Mahoney, general counsel to the Council of Institutional Investors says he's been advocating for improvements to the auditor's report since the Treasury Advisory Committee on the Auditing Profession issued its report calling for changes in 2008. The report would be more useful, according to Mahoney, if auditors included an assessment of management's critical accounting judgments and estimates underpinning the financial statements. Even further, investors would benefit if auditors included an assessment of the quality, not just the acceptability of how management set and applied its accounting policies.
The standard audit report has been under assault for decades, PCAOB member Steven Harris said in a speech accompanying the release, but the recent financial crisis makes change imperative. “The events of the last few years have been a case study of the inability of auditors to provide investors with any meaningful signal about increases in financial reporting risks,” he said.
According to Harris' research, including findings of the PCAOB's research and analysis office, auditors issued only two going-concern warnings before the 10 largest bankruptcies during the financial crisis. The combined market capitalization of the eight companies that failed without warning plunged from $75.5 billion to $700 million, sticking investors with a 99 percent loss in value.
“Writing clearly and concisely while communicating everything of importance to investors will be a real challenge. This will not come cheap.”
—Jay Hanson,
Board Member,
PCAOB
Of the top 10 institutions to receive government-funded bailouts, none received going-concern opinions from auditors, nor were there any going-concern findings for any of the major institutions that eventually were forced into mergers at ruinous valuations, he said. “If auditors were correct in not issuing going-concern opinions or in not sending any other message to investors about the financial and accounting issues they were seeing inside these institutions, what does that say about the relevance and usefulness of the current auditor reporting model?” Harris asked.
The PCAOB's newest auditing standards, issued last summer, focus on risk assessment and require auditors to understand the company's environment so that they know where the significant risks of material misstatement are, Harris said. “Under the current reporting standards, however, there is no effective means for auditors to pass on any of that information to investors and other users of the company's financial statements,” he said.
POTENTIAL CHANGES
What follows is an excerpt from the Public Company Accounting Oversight's Board concept release on potential alternatives for change to the auditor's report:
The concept release presents several alternatives for possible changes to the auditor's report and is seeking specific comment on these or other alternatives that could provide investors with more transparency into the audit process and more insight into the company's financial statements or possibly other information outside the financial statements. All of the alternatives presented would retain the pass/fail opinion of the standard auditor's report. These alternatives are not intended to alter, in any way, the auditor's ultimate responsibility to obtain sufficient appropriate audit evidence to support the audit opinion. Nor are these alternatives intended to qualify or piecemeal the auditor's opinion or to shift the requirement to assess the risk of material misstatement of the financial statements from the auditor to investors or other users of financial statements.
The alternatives presented in the concept release are:
A. Auditor's Discussion and Analysis
This alternative would require that an Auditor's Discussion and Analysis ("AD&A) be included with an auditor's report. An AD&A would be a supplemental narrative report to the auditor's report and would provide the auditor with the ability to discuss his or her views regarding significant matters. The AD&A could include information about the audit, such as audit risks identified in the audit, audit procedures and results, and auditor independence. It also could include a discussion of the auditor's views regarding the company's financial statements, such as management's judgments and estimates, accounting policies and practices, and difficult or contentious issues, including "close calls." An AD&A, as contemplated in the concept release, is not intended to provide separate assurance on individual balances, disclosures, transactions, or any other matters discussed. Rather, an AD&A is intended to facilitate an understanding of the auditor's opinion on the financial statements taken as a whole.
An AD&A would likely be among the most expansive form of reporting of the alternatives presented and could require the auditor to communicate some of the same information that the auditor communicates to the audit committee.
B. Required and Expanded Use of Emphasis Paragraphs
This alternative would require inclusion of an expanded emphasis paragraph in all audit reports that would highlight the most significant matters in the financial statements and to identify where these matters are disclosed in the financial statements. Under current PCAOB standards, emphasis paragraphs are not required but may be added, solely at the auditor's discretion, to emphasize a matter regarding the financial statements.
Emphasis paragraphs could be required in areas of critical importance to the financial statements, including significant management judgments and estimates, areas with significant measurement uncertainty and other areas that the auditor determines are important for a better understanding of the financial statement presentation. With respect to each matter of emphasis under this alternative, the auditor also could be required to comment on key audit procedures performed pertaining to the identified matters.
C. Auditor Assurance on Other Information Outside the Financial Statements
This alternative would require auditors to provide assurance on information outside the financial statements, such as management's discussion and analysis (MD&A) or other information (for example, non-GAAP information or earnings releases). An auditor providing assurance on information outside the financial statements could improve the quality, completeness, and reliability of such information and provide investors and other users of financial statements with a higher level of confidence in that information.
Currently, there is no requirement for the auditor to provide assurance on earnings releases, non-GAAP information, or MD&A. However, PCAOB attest standards provide requirements for the auditor concerning the performance of an attest engagement with respect to MD&A, if the auditor is engaged to attest on MD&A. The additional reporting by the auditor on earnings releases, non-GAAP information, the entire MD&A, or portions thereof, could be based on certain aspects of the current attest standard and report, but they do not represent the only alternative for reporting on MD&A or portions thereof …
Comments
The Board is interested in comments on the alternatives presented in the concept release and other possible alternatives in connection with its deliberations on changes to the auditor's report. The concept release is located on the PCAOB's website at: http://pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf. Comments on these and other issues in connection with the Board's deliberations on changes to the auditor's report are due by no later than September 30, 2011.The Board also will hold a public roundtable in the third quarter of 2011 to discuss the alternatives addressed in the concept release or other alternatives.
Source: PCAOB Concept Release Summary Fact Sheet.
Cost, Benefit
PCAOB staff warned the board there will be plenty of issues and consequences to work through as they consider changes to audit reports. Perhaps most significantly, the cost of an audit will certainly go up, depending on how extensive those changes may be. Staff members said feedback is likely to raise plenty of additional concerns about confidentiality, liability, effort, and whether some of the responsibility for increased reporting to investors should fall to management or audit committees rather than auditors.
The lone auditor on the board, Jay Hanson, said he recognizes the need for change, but also highlighted the concerns and complications that auditors are sure to raise. Accounting and auditing are morphing from the “industrial age,” where asset values could be readily defined by historical costs and depreciation, to the “information age,” where values are pinned more to subjective estimates and judgments, he said. When answers fall within ranges, and investment and business structures become increasingly innovative, even the experts struggle to interpret financial results.
Hanson warned that some of the requirements envisioned in the concept release would lead to a steep learning curve for auditors, becuase they are not trained to evaluate and communicate the business and strategic risks of the companies they audit.
Ernie Baugh, national director of professional standards at Mayer Hoffman McCann, said the idea of an ADA in particular will be problematic. “The AD&A would be just a blueprint for the plaintiff's bar,” he says. “No major firm is going to allow engagement partners to write whatever they think without putting it through a stringent review. It's going to be expensive.” Emphasis paragraphs might be more achievable, he says, but auditors will worry that their judgments about what to emphasize will become targeted for second guessing by regulators and litigators.
Harris isn't so convinced that new reporting should lead to significant added cost. “Investors are not looking for more audit work to be performed by auditors but for a public discussion of those things that should be obvious to an auditor following a well-performed audit,” he said. “All investors are asking for is what auditors already know.”
Doty is bracing for wailing over cost as well. He expects comments to raise concerns that new reporting will lead to new audit work, which will increase fees. “To be sure, increasing procedures or scope involves cost, but so does investor doubt about the reliability of management's statements,” he said.
Hanson wondered if additional audit work could be completed within the current reporting time frame. “With filing dates as early as 60 days after year-end, increasing complexity and judgments in almost all accounting areas, the concentration of calendar year-end companies, and no excess capacity in the audit profession, how will it all get done?” he asked.
The board is accepting comments on the concept release through Sept. 30, with a pledge to introduce some kind of new standard afterward. Based on feedback to the concept release, the board might also make recommendations to other bodies, such as the Securities and Exchange Commission, that might consider rules for other disclosures to be provided by management or audit committees.
While audit committees may have something meaningful to share with investors, says Harris, auditors still should face some new reporting obligations. “It would not be realistic to ask an audit committee to be a surrogate for the auditor and try to match the level of expertise and acquired judgment that an experienced and independent audit team brings to the table,” he said. “Hearing more from the audit committee, therefore, is not enough.”
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