June 2, 2017
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."
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 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."
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.
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.
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.
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:
Elizabeth Ising – Co-Chair, Washington, D.C. (+1 202-955-8287, firstname.lastname@example.org)
James J. Moloney - Co-Chair, Orange County, CA (+1 949-451-4343, email@example.com)
Brian J. Lane - Washington, D.C. (+1 202-887-3646, firstname.lastname@example.org)
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, email@example.com)
Michael J. Scanlon - Washington, D.C. (202-887-3668, firstname.lastname@example.org)
Lori Zyskowski – New York (+1 212-351-2309, email@example.com)
Gillian McPhee – Washington, D.C. (+1 202-955-8201, firstname.lastname@example.org)
Michael A. Titera - Orange County, CA (+1 949-451-4365, email@example.com)
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