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Tuesday, November 8, 2016

Will the PCAOB Expand the Audit Report?


After several years of work, the Public Company Accounting Oversight Board (PCAOB) is close to wrapping up a project to expand the auditor’s report to make it more useful for investors. The PCAOB staff is currently drafting a final standard for adoption in the fourth quarter of 2016.

The PCAOB wants to adopt rules requiring public company auditors to provide more information about what they find while scrutinizing a company’s financial statements during an audit. The current auditor’s report is a simple pass-fail model. But audit firms, companies and members of company audit committees have resisted a broad expansion of the auditor’s report.

Phase 1: 2011 Proposal
Auditors know many details about a client’s financial condition, but the reporting model that has been in place since the 1940s doesn’t provide an opportunity for auditors to offer any insight to investors. In fact, in the aftermath of the 2008 financial crisis, some regulators and investors observed that external auditors said nothing in their reports about companies that soon failed. In June 2011, the PCAOB tried to address these concerns by issuing Concept Release No. 2011-003, Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards.

Many investors responded that they’d prefer to see a supplement to the auditor’s report, often described as an auditor’s discussion and analysis (AD&A) and compared to the management’s discussion and analysis (MD&A) section of SEC filings.

Audit firms, companies and members of company audit committees, however, expressed concerns about auditors openly discussing the financial statements and the potential conflicts that could arise. Auditors were also concerned about the time it would take to address the information in the financial statements and their views on it, including negotiations with management and board audit committees.

Phase 2: 2013 Proposal
In response to these concerns, the PCAOB issued Release No. 2013-005, Proposed Auditing Standards, regarding the auditor’s report; the auditor’s responsibilities regarding other information; and related amendments. This scaled-back proposal called for only the communication of critical audit matters (CAMs). These are defined as the issues auditors found the most challenging and complex.

The comment letters from auditors and companies in response to the 2013 proposal called the proposed CAMs too broad. Moreover, they said disclosing CAMs might cause auditors to overstep their role and reveal information that a client’s management hasn’t disclosed to investors.

Release No. 2013-005 also would have required auditors to disclose in the auditor’s report the number of years they’ve worked for a client. The tenure requirement is controversial because companies and auditors argue that putting tenure on the auditor’s report could give the false impression that there’s a negative link between long tenure and audit quality. In their view, there’s no evidence to support that argument.

Instead, audit firms and their clients believe a long-standing relationship means auditors understand the company’s transactions better in an increasingly complex business environment. The time needed to understand a new client’s business underscores the value of a long auditor-client relationship, they said.

Conversely, some investors want the information because they believe a long tenure leads to a too close relationship between auditors and their clients. A long-standing relationship could compromise an auditor’s skepticism and independence.

As a middle ground, companies and audit firms said the board could put the firm’s tenure on a separate form—called Form AP, Auditor Reporting of Certain Audit Participants—which is primarily used for the disclosure of the lead partner and the other firms that took part in an audit.

Phase 3: 2016 Proposal
In May, the board released another proposed version of the requirements: Release No. 2016-003, Proposed Auditing Standard—The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. Comments were due August 15.

Release No. 2016-003 is a revised version of Release No. 2013-005. It limits CAMs to issues arising from the audit of the financial statements and shared with, or required to be communicated to, the client’s audit committee. To qualify as a CAM, the information would have to be considered material to investors.

In comment letters, companies said they didn’t want the board to move ahead with the proposed changes to the audit report. Meanwhile, investors said the PCAOB conceded too much to companies and their auditors by limiting the disclosure requirements. And audit firms argued that the PCAOB should further narrow the information auditors must provide.

The Next Chapter
In May, PCAOB Chairman James Doty said in a brief interview that the upcoming standard may not be perfect and might need revision. Still, he’s eager to move forward with a completed standard. The project dates back to a recommendation from the Treasury Department’s Advisory Committee on the Auditing Profession (ACAP) from 2008.

Despite the latest timing provided by Chairman Doty, it’s unclear whether the PCAOB will wrap up the project by the end of 2016. The board has to perform a delicate balancing act, given the disparate concerns expressed by investors, auditors and companies on the latest plans.

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