On October 23, 2017, the Securities and Exchange Commission (“SEC”) unanimously approved (the “Approval Release”) the Public Company Accounting Oversight Board’s (“PCAOB”) proposal to adopt a new auditing standard, AS 3101, The Auditor’s Report on an Audit of Financial Statements When Auditor Expresses an Unqualified Opinion, and related amendments to other auditing standards. As discussed in the Approval Release, the PCAOB adopted the new standard in final form on June 1, 2017, subject to SEC approval, following a PCAOB concept release, proposal and reproposal process beginning in 2011.
The new standard will require auditors to provide additional information about the audit that is intended to make the auditor’s report more informative and relevant to investors and other users of financial statements. While the new standard retains the pass/fail opinion of the existing auditor’s report, it requires significant changes and additions as described below.
Critical Audit Matters (“CAMs”)
The new standard requires the auditor to communicate in the auditor’s report any CAMs arising from the current period’s audit or state that the auditor determined that there are no CAMs. A CAM is any matter arising from the audit of the financial statements that (1) was communicated or required to be communicated to the audit committee, (2) relates to accounts or disclosures that are material to the financial statements and (3) involved especially challenging subjective or complex auditor judgment.
Especially Challenging, Subjective or Complex Matters
In determining whether a matter involves especially challenging, subjective or complex auditor judgment, the new standard requires the auditor to take into account the following factors and other audit-specific factors:
- The auditor’s assessment of the risks of material misstatement, including significant risks;
- The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty;
- The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions;
- The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures;
- The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; and
- The nature of audit evidence obtained regarding the matter.
New Audit Report Disclosure of CAMS
The new standard requires discussion of each CAM within the auditor’s report under the heading Critical Audit Matters, including:
- Identifying the CAM;
- Describing the principal considerations that led the auditor to determine that the matter is a CAM;
- Describing how the CAM was addressed in the audit; and
- Referring to the relevant financial statement accounts or disclosures.
Additional Changes to the Auditor’s Report
The SEC also approved other changes to the auditor’s report that are primarily intended to clarify the auditor’s role and responsibility, provide additional information about the auditor and make the auditor’s report easier to read. These include the following:
- Auditor Tenure: a statement disclosing the year in which the auditor began serving consecutively as the company’s auditor;
- Independence: a statement regarding the requirement for the auditor to be independent;
- Addressee: the auditor’s report will be addressed to the company’s shareholders and board of directors or equivalents (additional addressees are also permitted);
- Amendments to basic elements: certain standardized language in the auditor’s report has been changed, including adding the phrase “whether due to error or fraud,” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and
- Standardized form of the auditor’s report: the opinion will appear in the first section of the auditor’s report, and section titles have been added to guide the reader.
Communication of CAMs in auditor’s reports will not be required for audits of emerging growth companies (EGCs), certain broker and dealers reporting under Exchange Act Rule 17a-5, investment companies other than business development companies and employee stock purchase, savings and similar plans. However, the other changes to auditor’s reports apply to all audits performed under PCAOB standards, including audits of EGCs.
Effective Date and Preparation
Discussion of CAMs in auditor’s reports will first be required for:
- Large accelerated filers: for audits of fiscal years ending on or after June 30, 2019; and
- All other companies to which the new rules apply: for audits of fiscal years ending on or after December 15, 2020.
The other changes to the auditor’s reports will first be required for audits of fiscal years ending on or after December 15, 2017, which means that the non-CAM changes to auditors’ reports will be required in upcoming annual reports with financial statements for fiscal years ending December 31, 2017.
While the new CAM disclosure is not required in audit reports until 2019, affected companies, their management and audit committees should discuss possible CAMs with their auditors and establish plans for preparation and review of CAM disclosure. Also, while the rules do not require a specific form or topics of CAM disclosure, U.S. issuers seeking to understand the types of disclosures that may be required should consider disclosures of key accounting matters that audit reports have included for non-U.S. public companies under similar standards of the International Auditing and Assurance Standards Board (“IAASB”), the European Union (“EU”), and the Financial Reporting Council in the United Kingdom (“FRC”).