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The PCAOB’s New Reporting Standard Provides Enhanced Audit Information

July 19, 2017

On June 1, 2017, the Public Company Accounting Oversight Board (PCAOB) adopted a new reporting standard that will provide investors and other financial statement users with more relevant and useful information about the audit.

The new standard is the first major change to the auditor’s report in over 70 years, and will significantly transform the auditor’s reporting model. The final standard is still subject to approval by the Securities and Exchange Commission.

Critical Audit Matters

The standard includes the communication of critical audit matters (CAMs), which will disclose to financial statement users significant matters related to the audit that required challenging, subjective, or complex auditor judgment and the auditor’s responses to those matters.

If there were no CAMs noted during the audit, the auditor’s report should explicitly state that there were no CAMs. Communication of CAMs is not required for audits of brokers and dealers; investment companies other than business development companies; employee stock purchase, savings, and similar plans; and emerging growth companies.

A CAM, as defined in the standard, is a matter 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.

When determining whether a matter involves especially challenging, subjective, or complex auditor judgment, the auditor takes into account certain factors, including the auditor’s assessment of the risks of material misstatement, nature and timing of significant unusual transactions, the nature and extent of the effort required to address the matter, and the degree of auditor judgment related to significant estimates made by management.

The communication of each CAM in the auditor’s report includes:

  1. Identification of the CAM.
  2. Description of the principal considerations that led the auditor to determine that the matter was a CAM.
  3. Description of how the CAM was addressed in the audit.
  4. Reference to the relevant financial statement accounts or disclosures.

Other Matters

The new standard requires the disclosure of the auditor’s tenure, specifically, the year in which the auditor began serving consecutively as the company’s auditor. The phrase, “whether due to error or fraud,” will be also be included in describing the auditor’s responsibility under PCAOB standards to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. Other changes include: the auditor’s report will include a statement that the auditor is required to be independent, the opinion will appear at the beginning of the first section of the auditor’s report, and section titles have been added to guide the reader.

Effective dates of the new reporting standard are as follows:

  • New auditor’s report format, tenure, and other information: audits for fiscal years ending on or after December 15, 2017.
  • Communication of CAMs for audits of large accelerated filers: audits for fiscal years ending on or after June 30, 2019.
  • Communication of CAMs for audits of all other companies: audits for fiscal years ending on or after December 15, 2020.

Effects of the New Reporting Standard

Aside from the stated goals of enhancing the relevance and usefulness of the auditor’s report by providing additional, important information to investors, the implementation of the new reporting standard may result in more robust and meaningful discussions between auditors and audit committees.

Since CAMs will be included in the auditor’s report, the audit committee will pay closer attention to these matters and it may encourage more planning and three-way communication with management to ensure that these audit areas were properly addressed.

More importantly, it will be in the best interest of all parties involved to have a narrative that clearly and concisely details the critical audit matters and explains the estimates and judgments made in a manner that seems accurate and plausible. The new reporting will disclose the auditor’s thought process and the judgment applied; therefore, auditors need to be able to defend actions taken to conclude the audit.

UK Corporate Governance Code

While this may seem new or drastic to auditors and companies in the U.S., a similar requirement has already been in effect in the UK for several years now. The UK’s Financial Reporting Council (FRC) published a survey in March 2015 after the first year of implementation of the extended auditor’s report (applicable principally to FTSE 350 companies).

The survey disclosed that each of the audit firms had adopted different approaches to the extended auditor’s report and also disclosed that auditors appeared not only to have met the new requirements, but in many cases had made further changes beyond those required by the FRC.

For instance, instead of just disclosing the materiality threshold used in the financial statements, some audit firms disclosed how they determined the materiality and why they believe the materiality benchmark used was appropriate.

The FRC published another survey in January 2016 and noted that audit firms had made significant progress in describing risks, producing reports that were more tailored and specific to the audited entity and, therefore, avoiding generic or boilerplate wording.

There were also innovations in the presentation of areas where there was a risk of material misstatement – risks being categorized as event driven or recurring, clear explanation of what changed from the prior year, and use of arrows to indicate whether risks were of more or less concern in the current year, among others.

Conclusion

How auditors adapt to the new reporting standard here in the U.S. remains to be seen – many financial statement users view this as an improvement in the level of information provided, allowing them to make appropriate investment decisions.

U.S audit firms are expected to embrace these new standards, avoiding boilerplate responses and heighted transparency to users. While the audit opinion will remain a pass/fail report, this additional narrative may help users gain some understanding of the complex judgements that are made every day in financial reporting.




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