Proposed Auditor Reporting Standard
The first of the two proposed standards is “The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion” (Proposed Auditor Reporting Standard). This proposed standard would keep the “pass/fail” model of the existing auditor’s report but, among other things, would make the following changes:
- The auditor would be required to add disclosures relating to auditor independence and auditor tenure—meaning the number of years that the audit firm had served as the company’s auditor.
- The auditor would be required to address its report both to the investors and to the company’s board of directors.
- The phrase “whether due to error or fraud” would be added to the standardized language in the auditor’s report describing the auditor’s existing responsibility under applicable professional standards to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud.
- The auditor would be required to communicate in the auditor’s report “critical audit matters” that were addressed during the audit.
- The auditor would be required to discuss its responsibility for, and evaluation of, other information in annual reports containing the audited financial statements and auditor’s report.
Auditor independence and tenure. Currently, neither the auditor nor the company’s management or audit committee is required to disclose to users of the financial statements how long the audit firm has served consecutively as the company’s auditor. The proposed standard would require the auditor’s report to contain “[a] statement that the auditor is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company in accordance with the United States federal securities laws and the applicable rules and regulations of the SEC and the PCAOB,” and would also require “[a] statement containing the year the [audit firm] began serving consecutively as the company’s auditor.” PCAOB Release, app. 1, ¶ 6(h), (i).
Recognizing that whether auditor tenure is a positive or negative influence on audit quality continues to be open to debate, the PCAOB also acknowledged that investors have nonetheless expressed strong interest in having this information. PCAOB Release, app. 5, at A5-16. The PCAOB has requested comment as to whether information regarding auditor independence and auditor tenure would be useful to users of the financial statements and whether it is more likely to be useful if it is included in the auditor’s report in addition to the Electronic Data Gathering, Analysis and Retrieval (EDGAR) database and other sources. Id. at A5-20 to 21.
Addressees on auditor’s report. Under the proposed standard, the addressees of the auditor’s report must “include, but are not necessarily limited to, (1) investors in the company, such as shareholders, and (2) the board of directors or equivalent body.” PCAOB Release, app. 1, ¶ 6(b). Under existing standards, the auditor’s report may be addressed to the company whose financial statements are being audited, its board of directors, or shareholders. AICPA Professional Standards, AU § 508.09.
Noting that many commenters during the concept-release phase referred to investors as “the ‘key customers’ of the auditor’s report, ‘the real client of the auditor,’ or ‘ultimately the ones paying for the auditor’s opinions,’” the PCAOB stated that this proposal to require investors to be among the addressees of the auditor’s report “might serve as a reminder to the auditor that the auditor’s ultimate customer is the investor.” PCAOB Release, app. 5, at A5-9.
The PCAOB has invited comment as to whether there are any others to whom the auditor’s report should be required to be addressed. Id. at A5-20.
“Whether due to error or fraud.” The proposed standard would require the auditor’s report to state that “PCAOB standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud.” PCAOB Release, app. 1, ¶ 6(l).
The PCAOB stated that the proposed addition of the phrase “whether due to error or fraud” to the auditor’s report “does not modify the auditor’s existing responsibilities with respect to fraud in a financial statement audit.” PCAOB Release, app. 5, at A5-11 (citing AICPA Professional Standards, AU § 110.02).
Critical audit matters. This portion of the proposed standard is likely one of the two most significant proposed changes to the existing auditor’s report. Under the proposed standard, the auditor “must determine whether there are any critical audit matters in the audit of the current period’s financial statements based on the results of the audit or evidence obtained.” PCAOB Release, app. 1, ¶ 7. While the PCAOB acknowledges the possibility that no critical audit matters might be identified, it expects that “in most audits, the auditor would determine that there are critical audit matters.” Id. The auditor then would be required to communicate critical audit matters in the auditor’s report or state that no critical audit matters were identified. Id. ¶ 10.
The required communication would focus on those matters that the auditor addressed during the audit that “(1) involved the most difficult, subjective, or complex auditor judgments; (2) posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or (3) posed the most difficulty to the auditor in forming an opinion on the financial statements.” Id. ¶ 9. “Critical audit matters ordinarily are matters of such importance that they are included in the matters required to be (1) documented in the engagement completion document; (2) reviewed by the engagement quality reviewer; (3) communicated to the audit committee; or (4) any combination of the three.” Id. ¶ 8.
The auditor’s report, under this proposed standard, would identify each critical audit matter, describe the considerations that led the auditor to determine that the matter is a critical audit matter, and refer to the relevant accounts and disclosures in the financial statements that relate to the critical audit matter. Id. ¶ 11.
The PCAOB states that it “expects that the communication would be tailored to the audit and thus would avoid boilerplate language and reflect the specific circumstances of the matter in relation to the audit of the company’s financial statements.” PCAOB Release, app. 5, p. A5-35. “While the same audit matter may be determined to be a critical audit matter from one year to the next or from one audit to another, the auditor would be expected to tailor the communication of the critical audit matter to the specific facts and circumstances that existed during that particular current period’s audit.” Id.
The PCAOB release states that including a discussion of critical audit matters “could help to alleviate the information asymmetry that exists between company management and investors.” PCAOB Release at 6.
A foundational concept in the auditing standards has long been that the auditor attests to information provided by management; as stated in the existing auditor’s report, “These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits.” The PCAOB acknowledges a concern that requiring audit firms to discuss critical audit matters in the audit report “could include information about the audit or the financial statements that otherwise would not be required to be disclosed by either the auditor or the company under existing auditor reporting standards or requirements of the applicable financial reporting framework.” PCAOB Release, app. 5, at A5–42.
The PCAOB also recognizes that developing the language of critical audit matters to include in the auditor’s report would likely result in additional recurring costs, including additional time incurred by senior members of engagement teams and the engagement-quality reviewer to prepare and review the report, discussions between the auditor and management or the audit committee regarding the matters to be communicated in the report, updates of firm audit and quality-control methodologies to reflect the new reporting requirements, and developing and conducting training of firm personnel on the new reporting requirements. Id. at A5-40 tot 41.
The PCAOB has requested comment on numerous questions relating to this aspect of the proposed standard, including, among others, (1) what benefits or unintended consequences would be associated with an auditor’s communication of critical audit matters, (2) whether the proposed requirements are sufficiently clear, (3) what additional costs for auditors and companies relating to these proposed requirements should be taken into account, (4) what challenges might be associated with the comparability of audit reports containing critical audit matters, and (5) what effect would such disclosures have on an auditor’s potential liability in private litigation. Id. at A5-44 to 46.
Other Information in Annual Reports
The second of the two most significant proposed changes to the existing auditor’s report addresses the auditor’s responsibility with regard to “other information,” which is information, other than the audited financial statements and related auditor’s report, included in a company’s annual report that is filed with the SEC under the Exchange Act, such as a Form 10-K. Examples of “other information” in a company’s annual report include selected financial data, management’s discussion and analysis (MD&A), exhibits, and certain information incorporated by reference.
Under the existing standards, the auditor’s report is not required to describe the auditor’s responsibility with respect to other information. The proposed auditor-reporting standard would require an additional paragraph to be included in the auditor’s report. This additional paragraph would reflect that the auditor evaluated whether the other information included in the annual report contained a material inconsistency with the audited financial statements, a material misstatement of fact, or both; that its evaluation was based on relevant audit evidence obtained and conclusions reached during the audit; that the auditor did not audit the other information and does not express an opinion on the other information; and (if applicable) that the auditor has not identified a material inconsistency or a material misstatement of fact in the other information. PCAOB Release, app. 1, ¶ 6(p); app. 2, ¶¶ 13–14.
Proposed Other-Information Standard
Under the existing standards, the auditor has a responsibility to read and consider other information in certain documents that also contain the audited financial statements and related auditor’s report, focusing on whether the other information is materially inconsistent with information in the financial statements or contains material misstatements of fact. The existing standards, however, do not specify the procedures that the auditor should perform apart from reading and considering the other information. AICPA Professional Standards, AU § 550.04.
The proposed standard, among other things, would (1) apply the auditor’s responsibility for other information specifically to the company’s annual reports filed with the SEC under the Exchange Act that contain the company’s audited financial statements and related auditor’s report; (2) add procedures for the auditor to perform in evaluating the other information based on relevant audit evidence obtained and conclusions reached during the audit; (3) require the auditor to evaluate the other information for a material misstatement of fact as well as for a material inconsistency with amounts or information, or in the manner of their presentation, in the audited financial statements; and (4) require communication in the auditor’s report regarding the auditor’s responsibilities for, and the results of, the auditor’s evaluation of the other information. PCAOB Release at 20–21; see generally PCAOB Release, app. 2. The proposed standard would also set forth the steps the auditor is to follow if material inconsistencies or misstatements of fact are identified. PCAOB Release, app. 2, ¶¶ 5–12.
The PCAOB acknowledges that the proposed procedures “likely would increase auditor effort and, therefore, costs for firms.” PCAOB Release, app. 6, at A6-17. Among the questions on which the PCAOB has specifically requested comment are whether it is appropriate to require the auditor to evaluate the other information for material inconsistencies and material misstatements of fact; whether such an evaluation would increase the quality of information available to users of the financial statements; whether the proposed procedures are clear, appropriate, and sufficient; whether there are additional costs relating to the proposed additional procedures or to the auditor’s response if material inconsistencies or misstatements are identified; and whether the proposed reporting is appropriate and sufficiently clear. Id. at A6-22, -30, -36.
The PCAOB also recognizes that the proposed other-information standard could raise possible liability considerations for auditors under, for example, section 11 of the Securities Act, section 10(b) of the Exchange Act, and various state-law causes of action. Accordingly, the PCAOB also requests comment on the potential legal liabilities associated with the performance and reporting requirements under the proposed other-information standard. PCAOB Release, Appendix 6, at A6-40 to 41.
Conclusion
The PCAOB is seeking comment on all aspects of the proposed standards as well as on the specific questions it has identified. Written comments on these proposed standards should reference PCAOB Rulemaking Docket Matter No. 034 and must be submitted to the PCAOB by December 11, 2013, by email or through the PCAOB’s website.
Keywords: professional liability litigation, PCAOB, auditor's report, proposed standards, audited financial statements
Amelia Toy Rudolph is a partner of Sutherland Asbill & Brennan LLP in Atlanta, Georgia.