Changes to Public Company Audit Reports (PCAOB)
Posted by Laura Anthony, Esq. on March 13, 2018
Changes to Public Company Audit Reports (PCAOB)- In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.
The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. 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: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”
For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.
The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.
Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed. The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.
The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.
In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.
All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.
The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.
The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.
All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.