On the path to a new audit report, regulators have an uphill climb to craft a solution that meets the competing demands of conflicting capital market interests.
During two days of roundtable discussions to explore a U.S. proposal for new auditor disclosures, preparers and board members voiced more objection than auditors, who seemed uncharacteristically conciliatory when addressing demands that auditors tell investors more about what they find during the course of their work.
Frustration on the part of the Public Company Accounting Oversight Board became apparent as Chairman James Doty tried to comprehend objections that investors won't understand the new disclosures. “This is something investors want,” he said. “How do you face your investors and say we think you can't handle the information, we don't believe you can use it, we don't think that it's useful, and we think it may confuse you?”
The PCAOB is working to overhaul the standard audit report—which has changed very little in more than 70 years—to compel auditors to say more than simply whether a given audit passes or fails in fairly representing the company's financial position. The board's proposal would require auditors to list and describe the “critical audit matters” (CAMs) that arose during the course of the audit, or those matters where arriving at an audit opinion was difficult, perhaps because of tricky judgments or difficulty obtaining evidence.
The proposal also would require auditors to take a closer look at information outside of financial statements, such as management discussion and analysis, and evaluate it alongside the financial statement assertions. In addition, auditors would be required to say how long they've served as the company's audit firm, that they are required to be independent from the company as they scrutinize its financial information, and what their responsibilities are with respect to fraud and footnotes.
Regulators want auditors to address such information in audit reports because they hear demands from investors to get more insight into what happens during an audit and what auditors learn along the way. “To arrive at an opinion as to whether financial statements are fairly presented, the auditor amasses a great body of evidence and, based on that evidence, gains unique insights,” said Doty. “Investors call for those insights to inure to their benefit, to make the auditor's report more relevant and useful.”
What Investors Want
Many on the corporate side, such as preparers or audit committee members, said the new audit report as envisioned by the PCAOB will create confusion over who has what duties and what's truly important in financial statements.
“The way the proposal is worded, it would be a very broad population of CAMS that would take a lot of time for auditors to sift through and report.”
—Joseph Ucuzoglu,
National Managing Partner,
Deloitte
Wallace Cooney, vice president of finance and chief accounting officer for media and education company Graham Holding Co., offered several reasons, for example, of why he thinks the proposal will misdirect investor attention. Investors will see CAMs as a shortcut to reading the financial statements themselves, he said, and examples of CAMs outlined by the PCAOB suggest auditors would address immaterial matters or control deficiencies that companies would not be required themselves to disclose. “Given the volume and complexity of the current disclosure framework, and investor concerns about disclosure overload, investors may be challenged in evaluating new information, alongside the other information provided by management,” he said.
Some are even uncomfortable that auditors would be required to disclose anything about the company itself. “It feels strange to have the auditor giving information other than the basic audit steps,” said Monty Garrett, vice president of finance for Verizon. “If there's a shortfall, it seems up to the company to beef up disclosures. If it was hard to audit, it was also hard to account for. We've got to look as issuers internally at where we're failing and where we need an auditor to pick up for us.”
Investor advocate Lynn Turner, former chief accountant for the Securities and Exchange Commission, said neither investors nor auditors are confused. “The crux of the issue is not one of understanding,” he said. Instead the question is: “Are you going to produce a product that investors want?”
What Auditors Want
PROPOSAL CONCERNS
In the excerpt below, Graham Holding Co. Chief Accounting Officer Wallace Cooney provides the PCAOB with a list of why the PCAOB's audit proposal will misdirect investor attention.
1. My primary concern relates to preserving and not confusing the distinct roles of
management, auditors, and audit committees. Management is responsible for the
preparation of the financial statements and notes, and in ensuring full disclosure
of important qualitative and quantitative financial information, including the
MD&A. Open communication between auditors, management, and the audit
committee is vital to this process ...
2. Further, written auditor communications are the beginning part of a dialogue
between auditors and audit committees. These written reports have limited value
without the important discussion that takes place between auditors and audit
committees, as well as management …
3. As I mentioned earlier, the CAM examples in the proposal are of significant
Concern—they include the following:
- Disclosure by the auditor of a significant deficiency. This disclosure is not
currently required, thus the example is in direct conflict with existing rules.
- Discussion of an immaterial corrected error. This detail does not seem
appropriate for discussion as a “critical audit matter.”
Since management isn't required to disclose these matters, I don't believe it's
appropriate for the audit report to provide details on these items …
4. I'm concerned that auditors will err on the side of including too many CAMs and
auditors will spend significant time documenting why certain matters should not
be included as CAMs …
5. Much of the work on CAMs is expected to be completed near the end of the
audit, which may be a significant distraction for the auditors and management
during a critical phase of the audit; this could impair the quality of a company's
financial reporting as well as audit quality.
6. The proposal is unclear but through the examples, seems to imply that a
discussion of audit procedures with respect to critical audit matters is preferred.
In my view, auditor discussion about audit procedures is more appropriate than
auditor discussion about the company's financial statements.
7. The cost/benefit analysis should include increased legal exposure for auditors,
the Company, the Company's board and management that may be the result of
the proposed reporting. The unique U.S. litigation environment needs to be
considered carefully in the analysis. Costs should also include incremental audit
efforts. As a preparer, I'm skeptical that the audit fee increases will be justified.
8. Lastly, there is no substitute for actually reading the financial statements and the
notes to the financial statements. There is risk that an expanded auditor's report
that included CAMs could be perceived or interpreted as a shortcut, a “cheat
sheet” that investors would rely on to dummy down the extensive and important
information an investor gains from actually reading the entire 10-K.
Source: Wallace Cooney Statement.
Auditors as a whole have put up less resistance to making the new disclosures, although they are concerned about how large the potential universe of CAMs could become. Deloitte says its initial field testing of the proposal with large public companies revealed that for some companies the potential CAM list numbered upwards of 120 issues to disclose and explain.
The field test revealed the idea can be put into practice, but some guidance is order to narrow the possible list of CAMs, says Joseph Ucuzoglu, national managing partner for Deloitte. “The way the proposal is worded, it would be a very broad population of CAMS that would take a lot of time for auditors to sift through and report,” he says. “If you limit those to matters reported to the audit committee, those are the most important matters. That would greatly narrow the population and take some time and effort out of this.” Deloitte would also like to see the PCAOB direct auditors to focus only on material issues to further focus the disclosures.
Audit regulators from the United Kingdom and Europe shared with the PCAOB the early results of their efforts to elicit such disclosures overseas. “The new audit report can create some tensions between auditors and management, and it's a good thing,” said Nick Land, chairman of the Audit and Assurance Council with the U.K. Financial Reporting Council, where an expanded audit report is already required. “We are beginning to see some healthy competition among the firms in terms of who can come up with the most appropriate audit report.” The Council offered a recent audit report for Rolls Royce as an example of what it considers to be an excellent expanded audit report that gives greater insight into the audit and financial reporting as a result of the new requirements.
Dan Goelzer, a former member of the PCAOB now partner with law firm Baker & McKenzie, says there appears to be plenty of support conceptually for revising the audit report but still several different views along a continuum as to how it should be done. “There are so many tough issues that have to be resolved,” he says. “I would hope they will issue another proposal.”
A PCAOB spokesman said it's too soon to say whether the board's next move will be to issue a final standard or a revised proposal. The board is continuing to accept comments through May 2.
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