The Auditors' "Little Speech" about Critical Audit Matters

By Cydney Posner

According to former SEC chief accountant Lynn Turner, "the auditor's report is based on a model that ‘has not changed significantly since the last Ford Model A rolled off the production lines in the early 1930s.'" As discussed in this CFO.com article, "[j]ust as they did 80 years ago, auditors still adhere to a pass/fail model that requires them to state whether their clients' financial statements are presented fairly (pass) or not (fail). They can also provide a ‘qualified' opinion, meaning that they couldn't deliver a full opinion because some aspects of a client's accounting failed to adhere to generally accepted accounting principles or contained incomplete information. But that, essentially, is it."

Following the financial crisis, the fact that clean audit reports were given to a number of failed or failing companies, together with the lack of transparency in the current form of audit report, led to a demand for a new look at whether the pass/fail report model might be improved. The result was a proposal from the PCAOB to require the auditor to communicate "critical audit matters" (CAMs) in the auditor's report, defined as matters that the auditor addressed during the audit that

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

(See these news briefs.)  Essentially, the concept is intended to capture the matters that "kept the auditor up at night." Some of the factors to be considered might be, for example, the difficulty of obtaining adequate audit evidence or matters that required outside consultation. The article observes that the "desire for even that information, however, strikes fear into the hearts of CFOs and audit committee members. That's because it threatens to upset the venerable power structure of financial reporting," under which management discloses information about the company's performance and the auditor opines as to whether the information complies with GAAP. In contrast, the proposal imposes an independent reporting obligation on auditors regarding CAMs. As one auditor commented in the article, under current practice, "the auditor ‘just provided his report in accordance with GAAP and the PCAOB and left the stage'…. But under the proposal, the auditor ‘can't leave the stage anymore. He's got to give a little speech.'"

In addition, a CFO may not be thrilled about the prospect of the auditor's sharing with the investing public just how complex the company's policies are or how difficult the audit was to conduct. And, the article observes, by "providing a dissenting view of the audit, the report on critical audit matters could send a mixed message. [According to one academic,] ‘What are we signaling to the users of financial statements when the auditor has to say, ‘Well, I reached that conclusion, but boy, it was really tough'?...Does it tell you that you ought to be more uncertain about that? What is it that you want me to think about when I consider loaning money to the company or investing in it?'"

Moreover, auditors are concerned that a public filing of their assessments of the audit could open the door to litigation even wider, particularly with regard to the judgment calls auditors must make in deciding what CAMs to disclose. As observed in this article from the same publication, , some auditors are advocating that their reporting of critical audit matters should be limited to those matters that they have reported to the audit committee, rather than all of the matters that kept them up at night. In a field test of the PCAOB's proposal performed by the Center for Audit Quality involving 51 audits and nine accounting firms, 98% of "critical audit matters" identified were previously communicated to the audit committee. According to the executive director of the CAQ, the audit teams in the study "'observed that using matters communicated to the audit committee as the only source for identification of CAMs might be more effective and may result in the identification of those matters important to the audit in a more effective and efficient manner….'"

As reported in Compliance Week, the same field test "found big spreads in the number of CAMs that different auditors would identify on different engagements, with potential CAMs ranging from 1 to 45 and actual CAMs numbering zero to eight." The study also demonstrated that "the new requirements will produce a new crunch in the closing phase of the audit," and, as a result, "auditors will need to ramp up audit activity primarily during the wrap-up phase of the audit after going through the audit to determine what the CAMs actually were and how they should be communicated and reported." According to the CAQ, "'[t]his could occur at a time when auditors, management and audit committees are focused on a number of other issues in connection with a particular filing, and the finalization of CAM communications may delay, or cause distractions in, the resolution of these issues…"' Narrowing the focus to "issues that are communicated to the audit committee [could] make the exercise more effective and more efficient."

The CAQ also suggested that the concept of materiality be added to the standard as a relevant consideration in CAM determination to provide more guidance to auditors. According to the CAQ, "auditors will benefit from some clarification around how to effectively communicate factors that were most important to determining that a particular matter was in fact a CAM, which might help promote consistent application of the final standard. " While the CAQ is reportedly supportive of the PCAOB's efforts to update the auditor's reporting model, it also favors "certain enhancements [that] would make the PCAOB proposal more practical and better aligned with the board's stated objectives…."

Fierce opposition to the proposal from some quarters notwithstanding, a number of large institutional investors are pushing for the change. According to one former auditor quoted in CFO.com, at the end of the day, "shareholders are getting little value for the huge sums that public companies spend on audits. ‘We don't know what the auditor does, but we know they've spent thousands and, in some cases, hundreds of thousands of hours auditing a major corporation, and we know the fee can be in the $20 million to $60 million range for a major corporation….And all we get out of them is, ‘We finished our audit.'"

If the SEC approves the CAM proposal, the new auditing standard would be effective for audits for fiscal years beginning on or after December 15, 2015.

But that's not the whole story. As discussed in this article, the PCAOB plans to vote by year end on whether to adopt a new auditing standard that would require disclosure (perhaps in the audit report, perhaps elsewhere) of the name (although not a signature) of the engagement partner who oversees an audit as well as other participants in the audit who are not with the principal audit firm. The proposal is intended to enhance accountability, provide more information to investors about which engagement partners are responsible for the audit, as well as the extent to which external resources were used to perform the audit. The concept has been proposed and reproposed in various guises since 2009, but has been fiercely resisted because of professional liability concerns. Even the PCAOB has been divided on the topic, with two members opposing the concept because of the absence, in their view, of a clear connection to audit quality.

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