PCAOB Issues Concept Release Rethinking Auditors' Reports and, as a Consequence, the Role of Auditors

By Cydney Posner

This morning, the PCAOB voted to issue a concept release related to alternatives for changing the auditor's reporting model.  (See the article from 6/10/11.) Here is a link to the fact sheet for the release:  The alternatives presented in the concept release are intended to provide investors with more transparency in the audit process and more insight into the company's financial statements (or other information outside the financial statements).

To a large extent, the PCAOB is attempting to address an issue that arose out of the financial crisis: Why were investors not alerted to the risks that triggered the financial crisis? As one PCAOB member noted, out of the ten largest bankruptcies during the financial crisis, only two had received "going concern" opinions. Moreover, none of the top ten institutions accepting TARP funds received "going concern" opinions (although they were ultimately required to accept a combined $295 billion in federal funds) nor did any of the major institutions that, to avoid collapse, were forced into mergers at shockingly low valuations. How did companies that received perfectly clean audit reports immediately prior to the financial crisis implode or almost implode so quickly after it began with no notice to investors? Could more communication from auditors have provided investors with more insight into the risks involved?

According to PCAOB Chairman James Doty, the concept release "represents a significant step for investor protection in response to the financial crisis, and a first step toward a holistic consideration of reforms designed to foster the relevance, transparency and reliability of the audit process." In addition, he commented that the concept release, "together with several other initiatives the Board will consider in the coming weeks, … are intended to spur debate over how to change auditing, from a culture that emphasizes client service to a culture that emphasizes public service."

As you know, the current auditor's report is strictly vanilla on-pager, commonly described as using a "pass/fail model" because the auditor opines on "whether the financial statements are fairly presented (pass) or not (fail)." Apparently, in the last 50 years, only three changes have been made to the report: addition of a statement describing the scope of the audit, inclusion of references to the PCAOB and addition of language regarding internal control over financial reporting.

The alternatives for modifications to the report presented in the concept release retain the pass/fail opinion of the standard auditor's report and do not change the auditor's ultimate responsibility to obtain evidence to support the opinion, nor do they qualify the opinion or shift its risk from auditors to investors. Rather, the alternatives supplement the standard pass/fail opinion. However, as noted by one of the PCAOB members, some of these alternatives do require auditors to go well beyond their traditional role of attesting to information that management prepares. Essentially, the concept release rethinks not only the form of the audit report, in many ways, it rethinks the fundamental role of auditors.

The concept release presents four alternatives, which are not mutually exclusive:

• Auditor's discussion and analysis. As described by the PCAOB, the ADA would be a supplemental narrative report that would provide a platform for the auditor to discuss his or her views regarding significant matters such as audit risks identified in the audit, audit procedures and results, auditor independence, management's judgments and estimates, accounting policies and practices and difficult or contentious issues and "close calls." An AD&A would not provide separate assurances on any matters discussed, but rather is "intended to facilitate an understanding of the auditor's opinion on the financial statements taken as a whole." This alternative is clearly the most contentious as it could require the auditor to characterize judgments and provide subjective views. As one member cautioned, auditors are not analysts or investment advisers and are not trained to evaluate the overall business and strategy of their audit clients. (And of course, if it were written by auditors, could anyone else even understand it? Just kidding, auditor friends.)
• Expanded use of emphasis paragraphs. This alternative would require inclusion of an expanded "emphasis paragraph" in all audit reports highlighting the most significant matters in the financial statements and identifying where in the financial statements they are disclosed. Currently, emphasis paragraphs are permitted but not required. Potential areas for required emphasis paragraphs include significant management judgments and estimates, areas with significant measurement uncertainty and other areas that the auditor would determine to be important for a better understanding of the financial statement presentation. In addition, the auditor could also be required to comment on key audit procedures performed pertaining to the identified matters.
• Auditor assurance on other information outside the financial statements. Under this alternative, auditors would be required to provide assurance on information outside the financial statements, such as MD&A, non-GAAP information or earnings releases. The purpose would be to improve the quality, completeness and reliability of the information and increase investor confidence. An auditor's opinion regarding MD&A might also motivate management to more fully comply with MD&A requirements. Potential models for this additional type of reporting are the PCAOB attest standards that apply to the performance of attest engagements with respect to MD&A.
• Clarification of language in the standard auditor's report. This alternative involves simply clarifying the language of the current auditor's report to describe what an audit represents and the related auditor responsibilities. In this case, the auditor would provide more information about, for example, reasonable assurance, auditor's responsibility for fraud, auditor's responsibility for financial statement disclosures, management's responsibility for the preparation of the financial statements, auditor's responsibility for information outside of the financial statements and auditor independence.

Not surprisingly, auditors are apparently not too thrilled with the ADA supplement concept. From preliminary outreach conducted by the PCAOB prior to issuing the concept release, the PCAOB concluded that the consensus among investors was "that auditors have significant insight into the company and that the auditor's report should provide additional information about the audit and the company's financial statements, based on that insight, to make it more relevant and useful. Most preparers, auditors, and audit committee members indicated that management or the audit committee, rather than the auditor, should provide additional information about the company." Consistent with that view, many investors expressed concern regarding the "boilerplate" nature of current reports and advocated the inclusion of a supplementary discussion by an independent and skeptical professional, the auditor. Non-investor participants, however, preferred limiting the change to a clarification of language in the report.

One of the PCAOB members commented that the changes are driven in part by the complexity of today's financial reporting, which increasingly requires auditors to test valuations and ranges of estimates in financial statements and determine if they are fairly presented; the pass/fail model conveys only a final conclusion but does not convey any nuance regarding issues or risk. At the meeting, PCAOB members expressed concerns regarding a number of issues, in addition to those described above:

• the possibility of substantial increased cost;
• the potential for the new initiatives to regress to boilerplate;
• the potential loss of comparability among issuers;
• the difficulty of structuring the requirements;
• how new auditor requirements could affect the timing of company filing requirements;
• the risk that investors may be more confused than enlightened by potentially conflicting views of auditors and management;
• the possibility of unknown and unintended consequences;
• the risks involved in requiring an auditor to express subjective views about a company's financial condition;
• the difficulty of evaluating the adequacy of the auditor's work in a PCAOB inspection, enforcement action or private litigation;
• the need to preserve management's primary responsibility for financial information; and
• the potential for compromising the independence of auditors.

Comments on the concept release are due at the end of September.

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