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Monday, November 12, 2018

Are You Ready for the Changes to the Auditor’s Report?

The Securities and Exchange Commission (SEC) will soon require auditors to issue expanded reports for public companies. Some companies are having their accounting firms conduct dry runs on previous years’ financial statements to ensure compliance with the new-and-improved auditor’s report. By testing the standard before the effective date, auditors and companies can understand what the audit report might look like with the new information.

Large accelerated filers will see changes to their auditor’s report for fiscal year 2019. Smaller publicly traded entities will have to wait an extra year. Although private companies aren’t subject to the SEC requirements, some larger ones might ask their auditors to voluntarily issue an updated auditor’s report for fiscal year 2019 or 2020, in case they decide to go public or merge with a public company in the future.

Expanded auditor’s report

In 2017, the Public Company Accounting Oversight Board (PCAOB) unanimously adopted a rule to expand the auditor’s report in filings with the SEC. The goal is to provide investors with more useful information.

The current pass-fail model for an auditor’s report has prevailed since the 1940s. Although auditors know many details about a client’s financial condition, the current reporting model 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 were on the brink of failure.

Audit challenges

The revised model requires auditors to discuss critical audit matters (CAMs) that arose during an audit and provide information about the company’s financial reporting practices. The PCAOB defines CAMs as issues that:

  • Have been communicated to the audit committee
  • Are related to accounts or disclosures that are material to the financial statements
  • Involved especially challenging, subjective or complex judgments from the auditor

Essentially, CAMs are the most difficult issues the audit team faced as they examined a company’s financial statements. Examples include complex valuations of indefinite-lived intangible assets, uncertain tax positions, goodwill impairment, and manual accounting processes that rely on spreadsheets, rather than automated accounting software.

Beyond CAMs

In addition to CAM disclosures, the new rule requires that 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 will include a statement that the auditor is required to be independent.

The new rule will standardize the form of the auditor’s report, with the opinion appearing in the first section. Section titles will be added to guide the reader, and the report will be addressed to the company’s shareholders and board of directors.

Additionally, the new rule requires accounting firms to disclose the number of years they have been a company’s auditor. Why? Investors want information about an audit firm’s tenure to help them assess the potential risks to auditor independence.

Some investors believe long-term relationships between an accounting firm and a company can create a conflict of interest that causes auditors to identify too closely with the company and not the investors they’re supposed to represent. In the view of some investors, the risk of a conflict of interest undermines the quality of the auditor’s work.

However, some people argue that long-term relationships between an accounting firm and a company can make audit fieldwork more efficient and cost-effective, as well as improving the auditor’s understanding of the company’s operations.

Effective dates

Under existing SEC standards, auditor communication of CAMs is permissible on a voluntary basis. However, disclosure of CAMs in audit reports will be required for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers with market values of $700 million or more. For all other companies to which the requirement applies, CAMs must be disclosed for fiscal years ending on or after December 15, 2020.

The new rule doesn’t apply to audits of emerging growth companies, which are companies that have less than $1 billion in revenue and meet certain other requirements. This class of companies gets a host of regulatory breaks for five years after becoming public, under the Jumpstart Our Business Startups Act.

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