PCAOB’s reporting model proposal poses risks, rewards for audit firms

If public company auditors are required to communicate more information in their reports, there will be more material to second-guess them on if the company they are auditing takes a fall.

That is a concern about a new PCAOB proposal that calls for enhanced communication from auditors—in addition to the traditional pass/fail opinion—in audit reports.

But some experts say the dangers of second-guessing and even litigation might be outweighed for auditors by positive effects of a proposed reporting model that would require auditors to communicate “critical audit matters”—items that posed difficulty during audits.

This opportunity to communicate more information could be perceived as an opportunity for auditors and audit firms to provide more value for investors and users of financial statements.

“The question for the public company auditing profession is, how much do we want to be involved with the information that investors use to make their decision?” said Cindy Fornelli, executive director of the Center for Audit Quality (CAQ), which is affiliated with the AICPA. “… The more that you disclose, in our litigious environment, sometimes the more [risk] exposure you have. But that [additional disclosure] might very well be worth the risk.”

The proposal is open for public comment until Dec. 11 on the board’s website. In addition to requiring the traditional pass/fail opinion, the proposal would require auditors to report on matters addressed during the audit that:

• Involved the most difficult, subjective, or complex auditor judgments;
• Posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or
• Posed the most difficulty to the auditor in forming an opinion on the financial statements.

approved, these would be the first significant changes to the audit report in more than 70 years, according to PCAOB Chairman James Doty. Experts say the changes would represent a huge landscape change for auditors.

“This is a momentous development,” said James DeLoach, CPA, a managing director in consulting firm Protiviti’s business risk solutions division. “I think in the auditing profession itself, I’ve been around a long time, and I don’t recall any standard that has potentially more far-reaching developments than this one does.”

James Comito, CPA, a shareholder and member of the professional standards group at Mayer Hoffman McCann, is optimistic about the chance to be more transparent. He said he already routinely talks to company audit committees about difficult and complex matters that arise during an audit.

“Now the challenge will be, how do I take that, and how do I put that into a report, which by nature isn’t going to be [lengthy like] War and Peace, I don’t think,” Comito said. “But at the same time, there’s a story to be told there. I think that once we get used to it … it will become a very useful tool.”

But there are concerns, too. David Grumer, CPA, co-managing partner of the financial services group with accounting firm Citrin Cooperman, said he thinks the audit profession already has sufficient standards in place to report to the public.

“I do have concerns that we would be asked to write more than we should,” Grumer said. “And I’d like us all to take a chance to talk about that with the PCAOB.”

Do investors want more?

The proposed changes are based on the premise that investors and financial statement users want more information from auditors.

“Right now you never hear anything from the auditor, and I’m not saying that’s because they don’t want to talk,” said W. Howard Morris, CPA/PFS, MBA, president and chief investment officer of The Prairie & Tireman Group and a member of the PCAOB’s Investor Advisory Group. “That’s because of the way the system is currently configured. So I think allowing CPA firms the ability to give a little more insight into their thinking can only help users of the statements.”

The proposed report could enable auditors to provide insight on the way management exercises judgment in its financial reporting, DeLoach said. He said financial reporting is a process that requires lots of estimation, and he said the proposed model could give the auditor a chance to communicate whether management’s judgments are aggressive or conservative.

This could give auditors a better defense against litigation in the event a company falls on difficult times, DeLoach said, although he acknowledged there also may be an increased vulnerability to litigation for auditors if the problem that sinks a company was not identified in the critical audit matters.

DeLoach predicted that CPA firms ultimately will like having the opportunity to communicate more. He said management, meanwhile, may make judgments differently if it knows that auditors will be reporting publicly on contentious matters.

“If an auditor looks management in the eye, and says, ‘These three areas that we have here keep coming up every year, and the reason they come up every year is that you are very aggressive in your accounting policy, and we’re going to comment on that aggressiveness,’ I think a lot of management teams would blink,” DeLoach said. “I really do. They don’t want to see that. They don’t want to see that in an auditor’s report.”

Reaching middle ground

The PCAOB calls for more targeted discussion than an “auditor’s discussion and analysis” concept the board previously considered.

That would have amounted to a free-writing exercise, Comito said, that would have been very difficult to manage. It also might have made the auditor a source of original information, and Fornelli said it’s essential that original information about a company comes from management.

“Investors want to hear directly from management,” Fornelli said. “They don’t want the auditor to drive the company’s strategy and even the company’s disclosures about strategy and risk. I think what investors are looking for, those that want more information, is do the auditors agree with what management says.”

The proposal represents a middle ground between the pass/fail-only model and the “auditor’s discussion and analysis” model, experts said. The proposal also aims to control costs by requiring additional reporting only on work the auditor already is doing, rather than creating additional procedures.

Fornelli said there is a chance, though, that auditors might take a different approach with their audits if they know they have to issue disclosures about critical audit matters, and this might change the calculation of the amount of work an auditor performs. Even if the proposed disclosures do not require additional audit work to be performed, she said, it is naïve to think that there won’t be additional costs borne by preparing the various disclosures contemplated by the proposal.

But Comito said the disclosures described in the proposal might not require much more work if auditors are simply communicating to investors items that already are discussed with the audit committee.

Proposed changes in the treatment of “other information” might require a bit more work from auditors, he said. The proposal would require auditors to “evaluate” rather than just “read and consider” other information outside the financial statements that is filed with the SEC in Form 10-K annual reports.

Auditors would be required to report any inconsistencies or material misstatements they identify in the other information. PCAOB Chief Auditor Martin Baumann said the proposal would represent an incremental change from current standards, but Comito said that might require more work.

“It may require an adjustment for some firms that really haven’t been putting that sort of extra effort into the parts of the document outside of the financial statement,” Comito said. “Do I think that’s going to be incredibly significant, time-wise? No, not really. I think there will be some effort here … It will be a process of refinement.”

Disclosing tenure

One item in the proposal that has generated significant disagreement is a requirement for an audit firm to disclose the year it began serving as a company’s auditor.

Board members Jeanette Franzel and Jay Hanson expressed concern about including that information in the audit report when the board does not have data indicating a correlation or relationship between audit quality and length of an audit firm’s tenure.

The lack of such data has been cited by opponents of mandatory audit firm rotation as a reason for rejecting the concept. The PCAOB’s mandatory rotation discussion was muted when the House of Representatives in July voted in favor of a bill that would prevent the board from imposing a mandatory rotation requirement.

“I don’t think rotation has a future in the United States,” DeLoach said.

Fornelli said tenure is “almost irrelevant to audit quality, in my mind.” But Comito and Grumer wouldn’t be troubled by the inclusion of tenure in the auditor’s report because the information is publicly available through data the SEC keeps already.

Debate to continue

One certainty about the proposal is that much discussion and debate will take place before the PCAOB approves a final standard.

The board is considering holding a public round table on the proposal next year, and Hanson encouraged auditors to work with their clients’ audit committees and management to perform voluntary “mini field tests” to consider what issues might constitute critical audit matters under the proposal.

Hanson said it is possible, if not likely, that the PCAOB will need to issue a reproposal before final standards are adopted. And he said building consensus will be difficult because some investors would like a broad due-diligence report about everything the auditor learned about the company.

In contrast, Hanson said, auditors, audit committees, and management have said information about the company should come from management, with the auditor attesting to it.

“It’s trying to bridge that sharp divide between what we hear investors say they want, and what we hear most auditors, management, and audit committees saying should be the role,” he said. “So that’s why I’m saying it’s not a silver bullet, because we know it’s not going to satisfy everybody. The question is, will it satisfy the constituency enough, give them enough, that we should go ahead with it?”

It’s a proposal that experts say would change the risks audit firms face. But Comito said he is hard-pressed to say that it’s not a good idea to make the investing public aware of the same trials and tribulations that auditors discuss with audit committees.

Fornelli said CAQ research shows that investors have strong trust in auditors and that auditors can provide valuable information to them.

“I think that the profession has to find and embrace ways to help investors have increased confidence in the system. I think they [auditors] play a very large role in the confidence investors have in our markets,” she said. “I, for one, am philosophically very supportive of auditors being more transparent about the work that they do and what they see when they go about working with a company on the financial statement.”

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.