On June 1, 2017, the Public Company Accounting Oversight Board ("PCAOB" or "Board") moved ahead and adopted perhaps its most significant new standard since the Board's inception, setting requirements for significant additional disclosures in the auditor's report on an issuer's financial statements. These new disclosure requirements, if adopted by the SEC, will drastically alter the audit reporting model that has been in place for the past seventy years. Specifically, the new standard, available here, retains the pass/fail model present in the existing audit report, but goes well beyond this test and requires the auditor to include new disclosures in the audit report about critical audit matters ("CAMs") that the auditor identifies during the course of the audit. As discussed below, CAMs represent a new concept in audit reporting, and the degree to which this new concept will impact various aspects of the audit process – including on the relationship between audit committees, auditors and management – remains uncertain. The standard also requires new disclosures in the audit report about the length of the auditor's tenure and a statement about the applicable auditor independence requirements.
The Board's new standard will be submitted to the SEC for consideration and notice and comment. If the SEC approves the Board's standard, the requirements for additional disclosure about auditor tenure and independence will be effective for all filers beginning in fiscal years ending on or after December 15, 2017. The CAM reporting requirements will be effective for large accelerated filers beginning in fiscal years ending on or after June 30, 2019, and for all other filers beginning in fiscal years ending on or after December 15, 2020.
The PCAOB has been considering this standard-setting initiative since 2011, when the PCAOB issued a concept release on potential changes to the audit report; that process evolved in 2013, when the PCAOB issued its original proposal on this topic. In 2016, the PCAOB issued a re-proposal that narrowed in some respects the scope of the disclosure requirements for critical audit matters that appear in the audit report, and also dropped a component of the original proposal that would have required the auditor to review and report on matters outside the financial statements. The adopted standard is substantially the same as the 2016 re-proposal, but clarifies some items which had been left unsettled in the re-proposal, including the applicability of the standard to emerging growth companies.
The adoption of the new standard represents an important development in the financial reporting landscape. Issuers and their audit committees should review and consider the Board's new standard in detail, including as described below under "Steps to Consider."
What are CAMs? — New Required Disclosures in the Audit Report about Critical Audit Matters
Under the new standard, 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."
The definition thus has three component pieces. First, a CAM must be a matter that was voluntarily communicated to the audit committee or that was required to be communicated to the audit committee under Auditing Standard 1301 (formerly AS No. 16), Communications with Audit Committees. As issuers and audit committees are well aware, the scope of these required communications is broad, with AS 1301 containing more than fifteen topics and several dozen related paragraphs that specify the topics that must be communicated to the audit committee. Second, a CAM must relate to an account or disclosure that is "material" to the financial statements. Notably, the definition does not require the communication itself to involve a material issue, but rather that the communication must be about an account or disclosure that is material to the financial statements. And third, the definition provides that a CAM must have involved an "especially challenging, subjective, or complex auditor judgment." The standard seeks to inject some objective criteria to help guide this test by laying out a non-exhaustive list of factors that an auditor should take into account in determining whether a matter involved such judgments, specifically:
- 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 determining or 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.
The new standard provides that if the auditor determines that a CAM exists, the auditor must include disclosure in the audit report that: identifies the CAM; describes the principal considerations that led the auditor to determine that the matter is a CAM; describes how the CAM was addressed in the audit; and identifies the relevant financial statement accounts and/or disclosures that relate to the CAM. Disclosure satisfying these criteria is required for each CAM identified in the audit. Where no CAM is identified, the auditor must include disclosure stating as much.
By incorporating the concept of matters required to be communicated to the audit committee, the standard draws on existing AS 1301 to provide some guideposts for determining those matters that may be treated as CAMs. However, given the lengthy list of required communications in AS 1301 and given that the standard includes both required communications and those that are voluntarily communicated to the audit committee, the range of matters that could be CAMs remains quite broad and could lead to significant new disclosures in the audit report, as discussed in more detail below under "Steps to Consider."
Additional New Disclosures in the Audit Report
Auditor Tenure. The standard requires the auditor to include in its report "[a] statement containing the year the auditor began serving consecutively as the company's auditor." Under this requirement, auditor tenure includes the years the auditor served as the company's auditor both before and after the company became subject to SEC reporting obligations. Although the Board unanimously adopted the standard, several Board members indicated they were not certain that auditor tenure disclosure is useful to investors. These sentiments were expressed in part because many issuers have voluntarily included enhanced audit committee-related disclosures in their proxy statements and such disclosures often include information about the length of service by the auditor.
Independence. The standard also requires a statement in the audit report that the auditor "is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC and the PCAOB."
Clarification of Auditor Responsibilities. Under the standard, the auditor also has to include in its audit report the phrase "whether due to error or fraud," when describing the auditor's responsibilities under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements. This phrase is not included in the existing auditor's report. When inclusion of the phrase was proposed as part of the 2016 re‑proposal, the PCAOB said that the phrase is added to clarify that the auditor is responsible for detecting material misstatements, whether such misstatements are due to error or fraud.
Applicability to Filers
The standard specifies that CAMs would not have to be disclosed in audit reports issued in connection with audits of emerging growth companies; brokers and dealers; investment companies other than business development companies; or employee stock purchase, savings, and similar plans. It notes that auditors of these entities may consider voluntarily including communication of CAMs as described in the standard.
Steps to Consider
With this new standard, the PCAOB is requiring changes to the pass/fail model that has served as the basis for audit reports for many decades. As a result, even though the new standard still has to go through the SEC notice-and-comment process and its ultimate adoption thus hinges on SEC approval, issuers and their audit committees would be well served to review in depth the new disclosures mandated by the standard—particularly as they are disclosures for which the auditor will have the final say; and consider the potential implications of the new standard, including the issues discussed below.
- Scope of the New CAM Definition. During the standard-setting process, the PCAOB made efforts to reign in the breadth of its original concept for CAMs, but aspects of the final CAM definition still present concern. The audit standard governing communications that the auditor is required to make to the audit committee is itself expansive, as noted above. The definition also includes any communication made to the audit committee outside of the required communications. It also appears that CAMs may not be limited to communication about material issues, but also could include disclosure of an issue that may not itself be material but that may involve a material account or disclosure. And, the question of whether an issue was "especially challenging, subjective, or complex auditor judgment" by its terms will be a subjective matter for audit teams. Discretion in making this determination of course could cut either way, but issuers and their audit committees should understand there will likely be a fair degree of variability in how the CAM definition may be applied, at least at the outset, given its potential breadth and subjectivity.
- Auditor Disclosure of Original Information. In reviewing the PCAOB's original proposal and 2016 re-proposal, a number of commenters expressed concern that the standard would place the auditor in the position of being the source of disclosure of original information about a company—in other words, having to make disclosures before a company itself has made the disclosure or, in effect, forcing a company's hand to make disclosures. The Board's final standard appears to give little heed to this concern. The final adopting release acknowledges the tension, and observes that an auditor will not be obligated to provide original information about a CAM identified in the audit report "unless it is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit." But disclosure of the CAM itself could result in disclosure of original information; and it would seem that auditors will not infrequently determine that disclosure is needed to describe the considerations that led to the determination that the matter is a CAM and how the matter was addressed, each of which could result in disclosure of original information. On this point, the Board observed that it believes it is in the public interest for auditors generally to disclose information that is necessary to describe the principal considerations that led the auditor to determine that a matter is a CAM and how the CAM is addressed in the audit, even if such information would not otherwise be disclosed by the issuer. Thus, issuers and audit committees will want to consider possible scenarios where the new standard might put the auditor in a position of having to make disclosures in the first instance, and prepare in advance for how to address these situations.
- Uncertainty in Application. A number of other concerns expressed during the standard-setting process appear not to have been fully addressed in the final standard. For example, because the standard may require disclosure of matters that have been voluntarily reported to the audit committee, some expressed the view that the standard could lead auditors to hesitate in raising matters to audit committees as it would then trigger potential CAM reporting. Conversely, some expressed concern that there will be a tendency to over-disclose the existence of CAMs given the subjectivity in the standard and the potential adverse consequences for the auditor associated with being second-guessed in whether a CAM should have been disclosed. Still others expressed concern that the range of CAM disclosure practice among firms and engagement teams will lead to unhelpful variability across audit reports. Additionally, some have expressed concern about the increased strain on audit committee resources, as well as concerns about the impact of the new disclosures on timing for completing the audit – for example, when financial reporting or audit-related issues that have CAM implications arise at the last moment.
In considering these issues, issuers and audit committees should engage with their auditors now to gain insights into the anticipated impacts on the audit process for their particular audit, including what the new standard might mean for the timing of audit completion and when and how the issuer and audit committee will have the opportunity to review proposed CAM audit reports. In doing so, audit committees and issuers also may consider asking the auditor what types of issues in prior audits may be considered CAMs under the standard and what corresponding disclosures would have looked like if they had been disclosed in connection with those prior audit reports.
Given the numerous questions that arise from the dramatic shift in the auditor reporting model in light of the Board's new standards, issuers and audit committees may wish to consider submitting comments to the SEC on the new standard.
Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any lawyer in the firm's Securities Regulation and Corporate Governance practice group, or any of the following:
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