PCAOB Proposes Expanded Audit Report

Audit reports may be about to get a whole lot thicker.

The Public Company Accounting Oversight Board has proposed two new auditing standards that would significantly expand the standard pass-fail boilerplate audit report that has existed unchanged since the 1940s. Auditors will be required to say much more in the reports about where they had the greatest problems with difficult judgments, hard-to-obtain evidence, or close calls, under the new PCAOB plan.

One proposal would require auditors to disclose in their audit reports where they identified and dealt with “critical audit matters” in trying to arrive at an audit conclusion. Critical audit matters would include those areas where the auditor had to exercise the most difficult, subjective, or complex judgments, or those areas where the auditor had the hardest time obtaining adequate audit evidence. It also would include any matters that created difficulties for the auditor in forming a conclusion on whether financial statements were fairly stated.

The proposed standard would also require new language in audit reports to explain the auditor's requirement to act with independence, the auditor's responsibilities for fraud and footnotes, and the auditor's tenure with the company. A separate standard would require auditors to evaluate other information that is contained in financial reports beyond the audited financial statements, including management discussion and analysis. Auditors would also be required to search for inconsistencies or mis-statements of fact and report on those findings.

“This is more than a promising start,” said PCAOB Chairman James Doty in a briefing to the media following a public meeting to issue the nearly 300-page proposal. “This is a highly disciplined, highly rigorous, economically analyzed and justified proposal for change.” The board has been performing outreach since 2010 in an effort to balance a host of technical, often contradictory demands from those affected by the changes. The investor community has called for more information from auditors, while the auditing profession remains wary about what it might be required to say, and public companies are already reeling over audit costs and regulatory demands.

Doty is bracing for objections from auditors. Describing the proposal as a “watershed moment” for capital markets, he said: “It will be important to see how the water runs downhill after the watershed.” If auditors protest the changes with concerns about adding costs or increasing their liability or litigation risk, “that will be the wrong way for the water to flow.”

Cindy Fornelli, executive director of the Center for Audit Quality, says she is grateful the PCAOB undertook a rigorous process to propose the standard. Now it's time for auditors, preparers, investors, and others to dig into the details and provide insightful feedback. Auditors have told the PCAOB they believe it is management's role, not auditors', to provide information directly on financial statements, so they would object to rules that would require them to provide analysis of management's decision making.

“The success of the proposal will be dependent upon whether it results in a final rule that requires meaningful changes to the content of the report that provides the type of clarity, utility, and insights from the independent external auditor that are valued by the primary customers.”

—Jeff Mahoney,

General Counsel,

Council of Institutional Investors

“If this is auditors highlighting information that management sets forward in a manner that helps readers understand important issues, then we would be very supportive of this,” Fornelli says. “If this is auditors adding new information which is different from what management is reporting, I stand by the principle that the auditor is not the original source of information.”

John Keyser, national director of assurance services at McGladrey, says it will be a challenge to determine what constitutes a “critical audit matter” for disclosure purposes. “That is going to take some effort on the part of auditors,” he says, involving heavy judgment and analysis, and with the help of legal counsel. “This is certainly going to increase the cost of the audit.”

The PCAOB acknowledges audit costs would likely rise as a result of new audit activity and new audit reporting, but the board believes the cost will be justified by the fact that investors will get more information, reducing the information gap between investors and management, ultimately lowering the cost of capital. “There's a substantial body of evidence that says to the extent you reduce asymmetry, you reduce noise,” said Doty. “The better the information, the more confidence the market has in that information, the better the cost of capital.”

Lorrraine Malonza, director of accounting advocacy and financial research for Financial Executives International, says the preparer community is likely to be pleased that the PCAOB is not asking auditors to provide an auditor discussion and analysis, one of the most extreme ideas the PCAOB initially discussed in its concept release pondering new audit report ideas. Preparers are likely to have little objection to the disclosure of critical audit matters, she says, “so long as they make sure that whatever critical audit matters are put in the report are well communicated with management and the audit committee, so there are no surprises,” she says. Preparers are likely to raise concerns about whether such disclosure will spark investor concerns over issues that have already been resolved, “but I would say it's probably something preparers can live with.”

CRITICAL AUDIT MATTERS

Below is an excerpt from the PCAOB's auditing proposal fact sheet that explains critical audit matters.

The proposed standard would require:

the communication of critical audit matters as determined by the auditor

enhancements to existing language in the auditor's report related to the auditor's responsibilities for fraud and notes to the financial statements

the addition of new elements to the auditor's report related to:

—auditor independence

—auditor tenure

—the auditor's responsibilities for, and the results of, the auditor's evaluation of other information outside the financial statements

Critical Audit Matters

Critical audit matters are those matters the auditor addressed during the audit of the financial statements that:

Involved the most difficult, subjective, or complex auditor judgments

Posed the most difficulty to the auditor in obtaining sufficient appropriate evidence

Posed the most difficulty to the auditor in forming an opinion on the financial statements

Critical audit matters ordinarily are matters of such importance that they are:

Included in engagement completion documents

Reviewed by the engagement quality reviewer

Communicated to the audit committee

Factors that the auditor should take into account in determining critical audit matters:

The degree of subjectivity involved in determining or applying audit procedures to address the matter or in evaluating the results of those procedures

The nature and extent of audit effort required to address the matter

The nature and amount of available relevant and reliable evidence regarding the matter or the degree of difficulty in obtaining such evidence

The severity of control deficiencies identified relevant to the matter, if any

The degree to which the results of audit procedures to address the matter resulted in changes in the auditor's risk assessments, including risks that were not identified previously, or required changes to planned audit procedures, if any

The nature and significance, quantitatively or qualitatively, of corrected and accumulated uncorrected misstatements related to the matter, if any

The extent of specialized skill or knowledge needed to apply audit procedures to address the matter or evaluate the results of those procedures, if any

The nature of consultations outside the engagement team regarding the matter, if any

The description for each critical audit matter in the auditor's report would:

Identify the critical audit matter

Describe the considerations that led the auditor to determine that the matter is a critical audit matter

Refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter, when applicable

Source: PCAOB.

Investors will be interested to see how the rule-making process leads to a final rule, says Jeff Mahoney, general counsel for the Council of Institutional Investors. “The success of the proposal will be dependent upon whether it results in a final rule that requires meaningful changes to the content of the report that provides the type of clarity, utility, and insights from the independent external auditor that are valued by the primary customers,” he says.

Closing the Gap

Jim DeLoach, managing director at consulting firm Protiviti, says auditors are likely to benefit from the proposal because it will close the classic “expectations gap,” or the gap between what investors tend to expect from an audit and what they actually get. The disclosures proposed will “potentially put investors on notice as to the true nature of the auditing process,” he says. Having auditors disclose where they encountered difficulties may give them a trail of evidence that will prove helpful if they need to defend against litigation, he says.

PCAOB member Jay Hanson, a former auditor who raised numerous questions and doubts during the PCAOB's open meeting, sees the expectation gap another way. He worries the requirement to review other information may give investors a false sense of assurance that auditors have checked and verified every fact in the filing. In truth, the standard would require auditors to check what they can based only on whatever audit evidence they've already gathered to perform the financial statement audit. “Will investors understand what the auditor actually did with respect to the other information?" he asked. “Will they understand that the auditor is unlikely to have information or audit evidence to substantiate some of the numbers reflected in the other information?"

Hanson and PCAOB member Jeannette Franzel also questioned the relevance of requiring disclosure of audit tenure. PCAOB Chairman James Doty championed a drive to require mandatory rotation as a way to cut long-standing ties between companies and auditors, but that measure is all but dead. Disclosing auditor tenure, the PCAOB says in its audit reporting proposal, would satisfy investor demand for the information, even if research hasn't established a correlation between tenure and audit quality. “The mere fact that the board requires a disclosure about auditor tenure, however, might suggest that the board believes the information to be meaningful,” Hanson said.

The PCAOB will be accepting comments on the proposal through Dec. 11 and is considering holding another roundtable on the topic in 2014.