Thursday, November 16, 2017
SEC APPROVES NEW PCAOB AUDIT STANDARD CALLING FOR SIGNIFICANT CHANGES TO THE FORM OF AUDITOR’S REPORT
On October 23, 2017, the Securities and Exchange Commission (the “SEC”) approved a new audit standard of the Public Company Accounting Oversight Board (“PCAOB”) that significantly modifies and expands the form of auditor’s report to be issued by auditors of SEC registrants. The most significant change to the report is the addition of a requirement to discuss “critical audit matters” (or “CAMs”).
Changing the Standard Auditor’s Report
Historically, the auditor’s report for public companies involved a “pass/fail” model whereby a company would receive either a clean auditor’s report (i.e., the financial statements are fairly stated in accordance with GAAP), or a modified report (qualified, adverse, or disclaimed opinion), which generally describes the circumstances that precluded a clean report. A great majority of companies have received clean auditor’s reports, which convey very little useful information beyond the fact that the financial statements were fairly stated.
The new standard retains the pass/fail model but expands the auditor’s report by requiring the auditor to identify and comment on CAMs, regardless of whether the company is otherwise receiving a clean auditor’s report. The PCAOB has commented that they believe that few companies will have no CAMs, and most commentators believe that most companies will have perhaps 4 to 6 CAMs discussed in each auditor’s report.
Defining Critical Audit Matters
A CAM is defined as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements, and (2) involved especially challenging, subjective, or complex auditor judgment.
In determining whether a matter involved especially challenging, subjective, or complex auditor judgment, the new standard states that the auditor should take into account, alone or in combination, the following factors, as well as other factors specific to the audit:
- The auditor’s assessment of the risks of material misstatement, including significant risks;
- The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty;
- The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions;
- The degree of auditor subjectivity in 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, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; and
- The nature of audit evidence obtained regarding the matter.
For each CAM reported, the auditor’s report must: identify the CAM; describe the principal considerations that led the auditor to determine that the matter is a CAM; describe how the CAM was addressed in the audit; and refer to the relevant financial statement accounts or disclosures.
The SEC received approximately 50 comment letters on the new standard. Commenters raised concerns about the usefulness of the new CAM information, the related costs and benefits, the difficulty in identifying CAMs, potential chilling effects on auditor communications with the company and potential liability. In particular, some commenters expressed concerns that the requirements for auditor reporting of CAMs will increase litigation risk for both auditors and companies. In response to commenters, the SEC acknowledged that the reporting of CAMs likely will create an incremental risk of litigation and potential liability, but stated that the benefits of the additional disclosure for investors justify the increased risks. The SEC Chair indicated that the SEC staff will work with the staff of the PCAOB to monitor compliance with the new standard and address these concerns. Many observers have noted that the new requirement is likely to cause an increase in audit fees, although supporters of the new standard have suggested that any such increase will be immaterial.
The new CAM reporting requirement is similar in many respects to existing requirements in many foreign jurisdictions (including the European Union and the United Kingdom) to report on “significant assessed risks,” “key audit matters” or similar items. We expect that the development of best practices around CAMs will be informed by the European experience with these matters.
Additionally, the AICPA is working on a proposed exposure draft to provide for the reporting of “key audit matters” for nonpublic entities, and is currently taking the approach of making it optional at the discretion of management of the entity being audited. The timing of the issuance of the exposure draft is uncertain, but appears to be sooner rather than later. If adopted, the private company standard would affect financial statements prepared for private targets in acquisitions.
The requirement to report on CAMs does not apply to emerging growth companies, brokers and dealers, investment companies other than business development companies, or employee stock purchase, savings and similar plans.
Other New Requirements
The new standard also includes requirements to disclose the auditor’s tenure (i.e., the year in which the firm began serving consecutively as the auditor), a statement that the auditor is required to be independent and some additional enhancements to the format of the report (e.g., required section headings).
Effective Dates for the New Standard
The effective dates for the new standard are as follows:
- New auditor’s report format, tenure and other information: audits for fiscal years ending on or after December 15, 2017
- Discussion of CAMs for audits of large accelerated filers: audits for fiscal years ending on or after June 30, 2019
- Discussion of CAMs for audits of all other companies: audits for fiscal years ending on or after December 15, 2020
Recommendations for Companies
We recommend that management teams and audit committees review recent communications with their audit firms to begin developing a deeper understanding of items that are likely to become CAMs once the new standard becomes effective. They can also have preliminary discussions with auditors to consider potential CAMs. The company’s periodic disclosures should be reviewed to consider any needed revisions in light of the auditor’s anticipated disclosure of CAMs. Audit committees should confirm that the company’s internal controls involving such matters are sufficiently robust to be relied upon with confidence. Audit committees will also need to consider potential increases in audit fees related to the new standard.
Please contact a member of the Maynard Securities Regulation and Corporate Finance Team with any questions regarding this latest SEC rule proposal.