Here’s What You Need to Know About the PCAOB’s Proposed Makeover to the Auditor’s Report

A group hug photo was not available.This morning the PCAOB held their open meeting to discuss "Proposed Auditing Standards Regarding the Auditor’s Report and the Auditor’s Responsibilities Regarding Other Information." PCAOB Chairman James Doty called it a "watershed moment for the auditing in the United States." And yeah, I suppose it is. I mean, the auditor's opinion hasn't changed in 70 years, so that's probably good enough for "watershed moment."

So what exactly are these proposals? Glad you asked. Here they are, courtesy of a fact sheet provided by the Board:

  • 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: 1) auditor independence; 2) auditor tenure; 3) the auditor's responsibilities for, and the results of, the auditor's evaluation of other information outside the financial statements
The big change, obviously, is the communication of the critical audit matters. The Board describes a "critical audit matter" as those issues 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
The Board went further to state that these should be fairly easy to identify because they are:

  • Included in engagement completion documents
  • Reviewed by the engagement quality reviewer
  • Communicated to the audit committee 
Seems simple, right? And, generally speaking, this information is useful to investors, right? But is it enough?

Board Member Steven Harris didn't think so. While he supported the "publication of the proposed standards to stimulate discussion" he remains "concerned that the proposals are not strong enough to meet the needs of investors." Specifically, Mr. Harris cited a survey from March 2011 conducted by the Board's Investor Advisory working group that reported the following:

Seventy-nine per cent of the respondents identified a need for information about the auditor's assessment of management's estimates and judgments, 67 per cent sought a discussion of unusual transactions, restatements, and other changes, and 65 per cent identified the auditor's assessment of the quality of the issuer's accounting policies and practices. 

Then, after expressing his support for other information including the independence, tenure, and evaluation of information outside the financial statements, Member Harris expressed his discomfort with the "critical audit matters" proposal:

Such a change, if conceived and expressed carefully, might well alter the landscape of the audit report and go a substantial way to meeting the need for communication of areas of high audit risk. The language in today's proposals, however, does not appear to me to create a rule that will be sure to do that. 

There are three reasons. First, the language endorses a subjective standard in determining what a critical audit matter is. It is what the auditor determines it to be, not what it might be seen to be objectively. Significantly, although it is expected that in most audits the auditor would determine that there are critical audit matters, the proposals make clear to an auditor that he or she need not report any, if the work papers document the reason for not doing so. Therefore, even if a matter were important enough to "appear to be" a critical audit matter, and were communicated to the audit committee, discussed with the Engagement Quality Reviewer, or documented in the engagement completion document, it could be left out of the auditor's report. Second, whether the new disclosures will really tell investors anything will depend a great deal on how plainly and directly they are written. Third, I have some concern that effective inspection and enforcement of compliance with a subjective "critical audit matters" standard will not be possible.

These are all valid points. My thought is that anything discussed with the audit committee, EQR, and in the documentation would be a "critical audit matter" wouldn't have any trouble finding its way to the audit report, but it's still possible.

The last two issues brought up by Harris are the ones that would probably cause the most headaches. The "critical audit matters" almost sounds like it will be the equivalent to the "Notes to the Financial Statements" for the audit opinion. That is, they can be an extraordinary resource of useful information if — IF!!! — it's intelligible. Opaque disclosures have become the hallmark of financial reporting to such an extent that there's an entire website dedicated to finding the most notorious ones. Because audit firms have plenty of money to hire lawyers who excel in the abstruse arts, there's no reason they won't transform the "critical auditors matters" into gobbledygook should it be in their best interest.

As for the inspection difficulty, I think this comes out of Harris's first concern about subjectivity. There's far too much room for interpretation on what is a "critical audit matter" is and therefore, the chance that an auditor and PCAOB inspector might completely disagree about it. That's a chief complaint we've heard from those of you that have been through PCAOB inspections and, judging by EY's last inspection report, there are plenty of areas of disconnect.

The Board's Chief Auditor, Martin Baumann, responded to a couple of questions that I had on these matters. Here's his responses via email:

GC: Is there any concern that "critical audit matters" is too broad and could result in an excessively detailed audit report for the most complex issuers? 

MB: The definition of critical audit matters which indicates that they are the “most “ difficult matters addressed during the audit may mitigate this concern somewhat.  In response to comments received during the Board’s outreach activities, investors asked for more information about the audit and some said they would be interested in seeing the entire report to the audit committee attached to the audit report.  So, we are very interested in commenters views about the application of the proposed standard.
 
GC: With that in mind — We've seen a growing number of deficient audits in recent years. Because there could be differences of opinion regarding "critical audit matters" between PCAOB inspectors and auditors, do you expect pushback from the audit profession that there's risk for more inspection deficiencies? 
 
MB: We have tried to make the requirements of the proposed standard, including the documentation requirements, as clear as possible for the benefit of both auditors and inspectors. We are sure we will learn from comments how successful we have been.

You can expect a lot of commentary on these proposals over the next few days and weeks so we'll keep you updated, linking to the best stuff. We'll also keep an eye on the comments that are submitted to the PCAOB to see if there's any interesting feedback.

For now, take a look at the "illustrative audit opinion" on the next page and discuss the proposals. Good times are ahead, auditors.

Illustrative Audit Opinion

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