Audit, Compliance and Risk Blog

Significant New Auditing Standards—Part 1, Critical Audit Matters

Posted by Ron Pippin on Fri, Aug 23, 2013 and taxOn August 13, 2013, the Public Company Accounting Oversight Board (PCAOB) issued a lengthy, 294-page proposal that would create two new auditing standards and amend several existing rules. If finalized, it will likely increase the work load of auditors. Presumably, the PCAOB proposed these rules, not to “help” the pocketbooks of auditors but rather to provide more useful information to investors. Much of this proposal resulted from feedback the PCAOB received on its June 21, 2011, “concept release” on possible changes to the auditor’s reporting model. The PCAOB has now answered my question from a prior blog article, “Where Is the Regulator of Auditors of Public Companies?"

This article is one of two articles on the proposal. In this one, I discuss a new concept—requiring the auditor to discuss “Critical Audit Matters” or CAMs. The second article will discuss the requirement in the proposal to disclose how long the company has been audited by the current auditor, and also the proposed requirement to have the auditor perform and report on certain procedures concerning “other information” outside the financial statements—for example, Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) in a Form 10-K filing.

Background—Roles of the PCAOB and AICPA

Prior to the creation of the PCAOB in 2002, auditing standards in the United States were developed and issued by the American Institute of Certified Public Accountants (AICPA), a professional trade association of CPAs. When the U.S. Congress enacted the Sarbanes-Oxley Act of 2002, which included the requirement to establish the PCAOB, legislators were trying to put more distance between companies and their auditors to address real or perceived abuses by accountants that audits the books of companies. Currently, the PCAOB issues auditing standards and rules and also monitors the quality of work by auditors of U.S. public companies, whereas the AICPA continues to perform those roles for audits of all other U.S. nonpublic companies.

Content of Audit Opinions Today

Presently, a public company’s outside auditor is required to express an opinion as to whether the company’s financial statements (including footnotes) present fairly the information set forth. It is basically a “pass-fail” concept that many believe falls short of what investors need.

Specifically, the standard audit report for public companies is typically four paragraphs long, including a paragraph addressing internal controls. As a result, many believe that unless the report is other than four paragraphs in length, there is no need to read it, and that is probably a fair assessment—the PCAOB effectively prescribes what the paragraphs should state, so one opinion will read just like another audit opinion. Some might even call these paragraphs “boilerplate.” However, if the report has additional paragraphs, investors will likely read it as the auditors may be questioning the carrying amount of an asset the company holds, uncertainty over significant litigation, or worse—the company’s ability to survive!

A New Concept: Critical Audit Matters (CAMs)

The PCAOB proposal includes a requirement for the outside auditor to add a section to its audit opinion to discuss CAMs. This provision in the proposal would likely add several more paragraphs to today’s standard audit opinion and might trigger investors and other financial statement users to actually read the auditors opinion! However, this concept will likely be controversial as it is highly subjective—although the PCAOB has identified some existing audit documentation that would minimize “auditor pain.”

It could happen that the auditor does not believe its client has any CAMs, but if true, the PCAOB proposal would require the auditor to affirmatively state that belief in its opinion. In my view, it is highly unlikely that an auditor would so conclude. First, most audits of public companies aren’t that straightforward, and secondly, such a statement from the auditor might give a plaintiff’s lawyer impetus to “look for something” that the auditor might have missed and should have been a CAM.

The 2011 concept release suggested that maybe an auditor should be required to issue a supplemental “auditor’s discussion and analysis” (AD&A), similar in concept to the SEC’s MD&A requirement. The PCAOB apparently decided against that, in part because of pressure felt from audit firms, and is now proposing the CAM concept. In short, this concept would require the auditor to state:

  • What were the most difficult, subjective, or complex parts of the audit.

  • What posed the most difficulty to the auditor in obtaining sufficient evidence.

  • What posed the most difficulty to the auditor in forming the opinion on the financial statements.

Currently, audit firms typically prepare certain “engagement memorandums,” have a concurring internal audit review (frequently termed a “second partner review”) of findings that are also documented in a memorandum, and communicate certain issues in a memorandum to the company’s audit committee. All of these memorandums would be in the auditor’s supporting workpapers or files. The PCAOB believes that the starting point for CAMs would be these memorandums, so the auditor does not have to “reinvent the wheel.” The PCAOB proposal specifically states that it does not expect that each matter included in any one or more of these memorandums would be critical audit matter—they are just a starting point.

The PCAOB discusses at some length in Appendix 5 of the release three hypothetical accounting issues that may result in a CAM: (1) allowance for sales returns, (2) valuation allowance for deferred tax assets, and (3) fair value of fixed maturity securities held as investments that are not actively traded. In each scenario, the PCAOB presents the background facts of the issue, the related proposed disclosure by the registrant in its financial statements or footnotes, and finally a discussion of how the auditor evaluated the accounting issue and the resultant disclosure in the auditor’s report.

Auditor Reaction to the CAM Concept

One never knows how a regulatory proposal will be received by a stakeholder, in this case, the independent auditor. Arguably, the audit firm may view this proposal as a way to increase its audit fees and blame the regulator rather than its own billing rates or other factors. This time around, this probably will not happen. An audit firm will probably not be keen on displaying its “hard work” in the audit opinion, not because the work isn’t already being done; rather, among other sources of pain, it adds another potential hurdle the auditor will have to clear in justifying the audit report to a PCAOB reviewer.

Specifically, each registered audit firm with the PCAOB is subject to a quality review (inspection), or some would say “second guessing” by the PCAOB. During such a review, the PCAOB staff reviews the work of the auditor to establish whether the auditor followed PCAOB rules and used good professional judgment in the audit. The sticky part of this issue is the PCAOB has the benefit of hindsight, as its reviews are conducted several months, and in some cases years, after the fact.

For example, an audit firm performs its annual audit of the ABC Company that has a year-end of December 31, 2013. The auditor completes its work and issues an opinion dated February 5, 2014. The auditor had identified a few CAMs, specifically excluding the allowance for sales returns. The auditor used various testing procedures, accepted management’s evaluation that the allowance was adequate, and concluded it was not worthy of being a disclosed CAM. In March 2014, new information comes to attention of management that indicates the allowance was inadequate at December 31, 2013. In June 2016, the PCAOB selected the 2013 audit of ABC Company when reviewing the work of this audit firm. PCAOB staff members review the auditor’s testing and conclude that the audit firm should have identified the accounting issue as a CAM and included a discussion of it in the audit report.

Summary Thoughts

The PCAOB will consider comments on its proposal until December 11, 2013. Constituents should take advantage of the comment period whether they agree or don’t agree with the PCAOB proposal. As noted above, the proposed concept of CAMs will likely be controversial. As discussed in Part 2 of this article, the proposed disclosure of auditor tenure and requiring certain audit procedures on “other information” in an annual report, should be less controversial.

Like What You've Read? Subscribe to Our Blog Now

About the Author Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.

Tags: Corporate Governance, Business & Legal, SEC, Accounting & Tax, Audit Standards, Accountants