After more than seven years of work, the PCAOB unanimously adopted a rule on June 1, 2017, to expand the auditor’s report in an SEC filing and make it more useful for investors.
In a major change to the brief auditor reports that have prevailed since the 1940s, external auditors of public companies will have to discuss the critical audit matters (CAMs) that arose during their audits of clients and provide information about clients’ financial reporting practices. The requirements are defined in Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards.
The new format becomes effective for audits of fiscal years ending on or after Dec. 15, 2017.
Auditors will have to start communicating CAMs of public companies with more than $700 million in market value for audits for fiscal years ending on or after June 30, 2019. For companies below that threshold, the effective date is Dec. 15, 2020, but the requirements will not apply to audits of emerging growth companies, which have less than $1 billion in revenue. This class of companies created by the JOBS Act gets a host of regulatory breaks for five years after becoming public. Sec. 1 of PL112-106
In Release No. 2017-001 the PCAOB adopted a revised Auditing Standard (AS 3101) 3101: The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, to eliminate or replace much of the guidance in AS 3101, Reports on Audited Financial Statements, formerly AU Section 508, “Reports on Audited Financial Statements.” The guidance that survives from the existing AS 3101 is being shifted to a new standard AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances.
The regulatory board expects that the new AS 3101 will address the issues that arise in the overwhelming majority of audit reports. The board does not believe that AS 3105 will be applied very often except for the handful of rare instances in which an auditor issues a qualified opinion.
The PCAOB defines critical matters as issues 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 judgments from the auditor.
“The changes adopted today breathe life into the audit report and give investors the information they've been asking for from auditors,” PCAOB Chairman James Doty said in his prepared remarks before the vote.
The current model for an auditor’s report is a simple pass-fail statement, and many investors said the addition of more information to the report may be one of the most important things the board can do for them. Auditors know many details about a client's financial condition, but the reporting model that has been in place since the 1940s provides no opportunity for auditors to offer insight to investors. In the aftermath of the 2008 financial crisis, some regulators and investors observed that external auditors said nothing in their reports about companies that soon failed.
The PCAOB added that the expanded report was needed to aid investors given the significantly increase in the business world’s complexity during the 70 years in which the current model for auditor reports has prevailed.
"The communication of critical audit matters in the auditor's report will mark a new era in the way auditors communicate with investors," said PCAOB Chief Auditor Martin Baumann. "Investors will have a view inside the audit and will be armed with useful information when making important decisions."
The final rule requires accounting firms to disclose the number of years they have been a company’s auditor, a measure that was controversial while the PCAOB worked on the rule. Investors said they want the information about an audit firm’s tenure because it will help them assess the potential risks to the independence of an auditor. Some investors believe long-term relationships between accounting firms and clients create a conflict of interest that causes auditors to identify too closely with clients and not the investors they are supposed to represent. In their view, the risk of a conflict of interest undermines the quality of the auditor’s work.
But PCAOB member Jeanette Franzel was skeptical that investors are as concerned about an accounting firm’s tenure as proponents of the requirement say.
“I am concerned that including this information in the auditor’s report may convey an implication that there is a generalizable relationship between auditor tenure and audit quality and/or auditor independence, assumptions that may not be valid,” Franzel said.
The revised AS 3101 requires that the audit reports include the phrase “whether due to error or fraud” in describing the auditor’s responsibility to ensure that the financial statements are accurate. An auditor’s report also has to include a statement that the auditor is required to be independent. The final rule standardizes the form of the auditor’s report with the opinion appearing in the first section. Section titles have been added to guide the reader, and the report will be addressed to the company’s shareholders and board of directors.
The new standard is subject to approval by the SEC, which is required by the Sarbanes-Oxley Act of 2002 to approve all major PCAOB decisions, including its rules.
The Center for Audit Quality (CAQ), an affiliate of the AICPA, applauded the PCAOB’s action.
"We appreciate the board's responsiveness to concerns raised and recommendations made by the CAQ and the audit profession throughout the proposal process, including observations from the CAQ's field testing of the expanded model,” Cindy Fornelli, CAQ’s executive director, said in an emailed statement. “This is a positive step toward continuous improvement of the audit to better serve investors and our capital markets.”
The final rule is largely based on the proposed requirements in Release No. 2016-003, Proposed Auditing Standard—the Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, which was issued in May 2016. The PCAOB began the project in 2010 with outreach to investors, auditors, audit committee members, and companies about changing the auditor’s report.
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