As auditors prepare for a new auditing standard requiring the disclosure of critical audit matters (CAMs) in their reports, they are traveling in uncharted territory and contemplating new information that they will be providing to investors.
The new auditing standard AS 3101, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, adopted by the PCAOB in 2017, is predicated on enhancing the relevance and usefulness of the auditor's report. The first phase of implementation affects PCAOB audits of companies with fiscal years ending on or after Dec. 15, 2017, and includes disclosing auditor tenure and other changes to the form and content of the auditor's report.
The second phase of implementation requires CAMs to be disclosed in the auditor's report beginning with fiscal years ending on or after June 30, 2019, for audits of large accelerated filers, and for all other applicable companies for fiscal years ending on or after Dec. 15, 2020. The phased implementation date gives audit firms time to develop processes around determining which items they will disclose as CAMs, which are matters that:
- Have been communicated to the audit committee;
- Are related to accounts or disclosures that are material to the financial statements; and
- Involved especially challenging, subjective, or complex auditor judgment.
At present, audit firms are developing processes to ensure all their engagement partners have a consistent method to identify CAMs.
"As with all changes in our audit methodology, we will distribute implementation guidance and tools for engagement teams to implement the new standard," said Dave Sullivan, CPA, national managing partner for quality and professional practice at Deloitte & Touche LLP. "We also plan to design and implement controls to monitor the adoption of the CAM disclosures and assure that engagement teams have considered all the requirements of the new standard while applying it to their unique client situation."
OPPORTUNITIES AND CHALLENGES
The standard is intended to provide investors with more comprehensive information for investment decisions and is an opportunity for auditors to provide more information of value during the audit. AS 3101 requires auditors to identify a CAM, describe the principal considerations that led to its selection as such, describe how the CAM was addressed in the audit, and refer to the relevant financial statement accounts or disclosures in making these determinations. While CAMs may be matters that were traditionally discussed with audit committees, they were not discussed in an auditor's report.
Sullivan provided an example of a CAM that might not have been disclosed in past auditor reports. "Let's say a company with a lot of goodwill on its books is struggling," he said. "It's going through the process of predicting future earnings to determine whether or not the goodwill will be impaired. The projections may involve revenue and expense calculations 10 years into the future. This would fit the definition of a critical audit matter, as it is material to the financial statement and could be subjective, complex, and involve auditor judgment."
The new standard creates several challenges for auditors, audit committees, and preparers of financial statements. First, the PCAOB did not provide an all-inclusive list of what might constitute a CAM. Rather, it is the auditor's responsibility to make this determination.
"The new framework is broad enough that on one level you might think that 'goodwill impairment' is a difficult judgment that would always be a CAM, yet this is not the case," Sullivan said. "A company could be so profitable that this is not a difficult, complex, or subjective judgment. But if the company the next year has a truly bad year, then goodwill impairment could be a CAM."
Other possible CAMs include a company's valuations of hard-to-value securities and investments in nonliquid assets, assuming in both cases that they are material to the balance sheet, Sullivan said. "While the firm anticipates some effort in reporting the CAMs the first year of compliance, we're very supportive of the new audit model and the goal of giving investors additional information to assist their valuations," he added. "By separating out such issues for specific attention by investors, they're better aware that this was a significant estimate by management and one of the most challenging areas in the audit for the auditor."
A second challenge is how many CAMs an auditor must detail in the report. "Auditors will first look to the definition of a CAM in the auditing standard," said Cindy Fornelli, executive director of the Center for Audit Quality (CAQ), which is affiliated with the AICPA. "A CAM is any matter arising from the audit of the financial statements that is communicated or required to be communicated to the audit committee, that relates to accounts or disclosures material to the financial statements, and that involved especially challenging, subjective, or complex auditor judgment. There is no set number for CAMs for the auditor to communicate."
Boilerplate language is another area that will represent a challenge for auditors related to this standard. SEC Chairman Jay Clayton issued a warning of sorts when the new standard was issued. He said he would be disappointed if CAMs result in boilerplate communications that snuff out the potential for the new standard to deliver meaningful information to investors.
Fornelli shared that auditors may identify the same CAM from one year to the next. "Investors are looking for comparability. So as long as a CAM provides meaningful and accurate information about the audit, it may be OK to use similar language year after year," she said.
Fornelli also said that investors must appreciate that the new PCAOB standard does not provide the same heightened degree of transparency called for in the United Kingdom's auditor reporting standard issued in 2013 by the Financial Reporting Council (FRC). The FRC standard requires auditors to describe the most significant risks of material misstatement, disclose the levels of overall and performance materiality, and explain the scope of the audit.
"They're different standards with different levels of transparency," Fornelli said. "The other caveat I have for investors is that they should not expect the CAMs to be a proxy for the conversations they must still have with management, the audit committee, and the auditors. This is not the purpose of the standard. Nevertheless, investors will get insights into what the auditor has found to be challenging or complex, which is a big step forward."
Given these various challenges, the good news is that the phased effective dates give auditors, audit committees, and preparers time to get ready. While other mandatory features of the new auditing standard, such as disclosure of an auditor's tenure, were phased in on Dec. 15, 2017, the communication of critical audit matters for large accelerated filers is not required until audits of fiscal years ending on or after June 30, 2019, and for all other companies for audits of fiscal years ending on or after Dec. 15, 2020. "That's a pretty good lead time," Sullivan said.
In the meantime, Sullivan said engagement teams are endeavoring to consider all the matters that may be CAMs, to determine which ones will be disclosed as such in the auditor's report. The firm's internal implementation guidance and model workpapers are guiding engagement teams through the process of considering relevant items and documenting their conclusions as to whether or not each matter is, in fact, a CAM. "We'll monitor the application of this guidance and tools as we prepare to implement this portion of the new standard," he added.
The firm also expects to engage in frequent dialogues with the audit committee about what might constitute a CAM disclosure. "We will then take a dry run, going through the process of identifying the matters that could be CAMs and how they might look in a report," Sullivan said. "Once that is done, we would bring everyone together to look at the draft and react to the disclosures."
Sullivan recommended launching this audit planning process early in the fiscal year to discern the challenging, complex, and subjective areas of the audit and discuss them with the relevant parties. "As the year progresses, if circumstances change or something big happens like an acquisition, certain CAMs may drop off the list, but others will remain so there are no surprises two days before the filing," he said.
Lastly, Sullivan advised that auditors exercise restraint in not trying to do too much, too soon. "You need to present important information, not duplicative information," he said. "If there is a very good description of the [entity's] critical estimates in the footnotes, in which the matter's complexities and subjective judgment is detailed, I don't think auditors need to repeat the same words [that are] in the body of the 10-K. They're already voluminous and can be repetitive."
About the author
Russ Banham is a Pulitzer-nominated business journalist and author who writes frequently about finance and accounting issues.
To comment on this article or to suggest an idea for another article, contact Ken Tysiac, a JofA editorial director, at Kenneth.Tysiac@aicpa-cima.com or 919-402-2112.
- "Tips for Understanding Critical Audit Matters," JofA, July 24, 2018
- "Audit Committee Considerations for the PCAOB's New Audit Report," JofA, Dec. 6, 2017
- "PCAOB Issues Staff Guidance on New Auditor's Report," JofA, Dec. 4, 2017
- "PCAOB Expands Auditors' Reporting Duties," JofA, June 1, 2017
- PCAOB Standards and Related Rules (#APCAOB18P, paperback; #WPC-BX, online access)
- Annual Update for Accountants and Auditors (#730794, text; #GT-AUAA, group pricing) Public Company Update: SEC, PCAOB, and Other Developments (#746500, text; #163713, online access; #GT-PCOU, group pricing)
- AICPA Conference on Current SEC and PCAOB Developments, Dec. 10—12, Washington (#SEC18)
For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.
Center for Audit Quality resources