PCAOB Office of the Chief Auditor Presentation Recommending Adoption of an Auditing Standard on the Auditor’s Report

Date:
Jun. 1, 2017
Speaker:
Martin Baumann, Chief Auditor
Event:
PCAOB Open Board Meeting
Location:
Washington

Martin F. Baumann, Chief Auditor and Director of Professional Standards

Good morning, Mr. Chairman and Board members Harris, Ferguson, and Franzel.

The Office of the Chief Auditor is pleased to recommend that the Board adopt a new standard, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and related amendments to PCAOB standards, to provide new information about the audit and make the auditor's report more informative and relevant to investors and other financial statement users.

Investors are the beneficiaries of the audit, and the auditor's report is the primary means by which the auditor communicates with them. However, as currently designed, the auditor's report conveys little of the information obtained and evaluated by the auditor as part of the audit. And while the auditor's report has generally remained unchanged since the 1940s, companies' operations have become more complex and global, and the financial reporting frameworks have evolved toward an increasing use of estimates and fair value measurements. As part of the audit, auditors often perform procedures involving challenging, subjective, or complex judgments, but the auditor's report does not convey this information to investors.

Internationally, the form and content of the auditor's report have undergone significant change. In recent years, several international regulators and standard setters, including the International Auditing and Assurance Standards Board, the European Union, and the Financial Reporting Council in the United Kingdom, have adopted requirements for expanded auditor reporting that go beyond the binary pass/fail model. We are now seeing expanded auditor reporting as the norm around the world.

The final standard would require, among a number of other other improvements, communication of critical audit matters that would inform investors and other financial statement users of matters arising from the audit that involved especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters. We believe that critical audit matters are likely to be identified in areas that investors have indicated would be of particular interest to them, such as significant management estimates and judgments made in preparing the financial statements; areas of high financial statement and audit risk; unusual transactions; and other significant changes in the financial statements.

In short, I believe this new auditor reporting standard will make the audit report more informative and relevant, adding to the total mix of information that investors use to make investment decisions.

Before I turn the floor over to Jennifer Rand and Jessica Watts to provide more information about our recommendation, I'd like to express my appreciation to the many people within the PCAOB who were essential to the development of this standard. First, I'd like to thank the team that led this project – Jennifer Rand, Jessica Watts, Elena Bozhkova, Ekaterina Dizna, and Karen Wiedemann in the Office of the Chief Auditor.

I would also like to thank our colleagues from other divisions for their significant contributions, in particular–

  • Andres Vinelli and Patrick Kastein in the Office of Economic and Risk Analysis,
  • Gordon Seymour and Jennifer Williams in the Office of the General Counsel, and
  • Our colleagues in Inspections and Enforcement.

Finally, I would like to thank the staff at the Securities and Exchange Commission for their support and timely assistance with the project.

Jennifer Rand, Deputy Division Director and Deputy Chief Auditor

Thank you, Marty.

The final standard before the Board is supported by more than six years of outreach and public comment. The PCAOB commenced its standard-setting project on the auditor's reporting model in 2010 with outreach to different stakeholders, including investors, financial statement preparers, and auditors. Since then, the PCAOB –

  • Issued a concept release in 2011;
  • Held a full-day public roundtable in 2011 to discuss comments received on the concept release;
  • Issued a proposal in 2013;
  • Held a two-day public meeting in 2014 to discuss comments received on the proposal,
  • Issued a reproposal in 2016; and
  • Discussed changes to the auditor's report at numerous meetings of the PCAOB's Standing Advisory Group and Investor Advisory Group.

Additionally, the project has been informed by academic research and initiatives of other regulators and standard setters.

The staff has taken into consideration all comments and we have worked closely with our Office of Economic and Risk Analysis to integrate economic analysis into all aspects of the rulemaking. We believe our approach responds to investor requests for additional information about the financial statement audit without imposing requirements beyond the auditor's expertise or mandate.

The final standard we recommend for adoption is substantially the same as the Board's 2016 reproposal. It retains the pass/fail opinion of the existing auditor's report but makes significant changes to the existing auditor's report.

First and most significantly, the final standard requires communication in the auditor's report of any critical audit matters arising from the audit of the current period's financial statements.

A critical audit matter is defined as a matter that was communicated or required to be communicated to the audit committee and that:

  1. relates to accounts or disclosures that are material to the financial statements; and,
  2. involved especially challenging, subjective, or complex auditor judgment.

To assist the auditor in determining critical audit matters, the final standard includes a nonexclusive list of factors for the auditor to take into account in determining whether a matter involved especially challenging, subjective, or complex auditor judgment. Examples of such factors include:

  • 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; and,
  • The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions.

The determination of a critical matter should be made in the context of the particular audit, with the aim of providing audit-specific information rather than a discussion of generic risks.

Finally, communication of each critical audit matter includes –

  • Identifying the critical audit matter,
  • Describing the principal considerations that led the auditor to determine that the matter is a critical audit matter,
  • Describing how the critical audit matter was addressed in the audit, and,
  • Referring to the relevant financial statement accounts and disclosures.

If there are no critical audit matters, the auditor would so state in the auditor's report.

The final standard also includes additional improvements to the auditor's report, to clarify the auditor's role and responsibilities related to the audit of the financial statements, provide additional information about the auditor, and make the auditor's report easier to read. Such improvements include —

  • Auditor tenure - a statement disclosing the year in which the auditor began serving consecutively as the company's auditor. Currently, information about auditor tenure is not required to be communicated to investors by the auditor, management, or the audit committee. However, there is a growing trend toward voluntary disclosure of auditor tenure. The requirement to disclose auditor tenure in the audit report ensures that the disclosure is in a readily accessible and consistent location for all companies. It will also make auditor tenure information immediately available to investors upon filing with the SEC of a document containing the auditor's report;
  • Independence – a statement that the auditor is required 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);
  • Enhancements to basic elements—certain standardized language in the auditor's report has been changed to clarify the auditor's role and responsibilities in the audit under existing auditing standards, 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 misstatements; 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.

I will now turn the floor over to Jessica Watts who will describe –

  • Applicability of the standard to audits of certain entities, including the principal change from the 2016 proposal, which is that the requirements for CAMs will not apply to EGCs, and
  • Effective date.

Jessica Watts, Associate Chief Auditor

Thank you Jennifer.

Applicability

In the 2016 reproposal, the Board solicited comment on the applicability of critical audit matters to emerging growth companies. Commenters generally supported applying critical audit matters to EGCs on the basis that financial statement users would benefit as much or more as they would for other issuers. However, there is an unresolved legal question under the JOBS Act about whether critical audit matters requirements can be made to apply to EGC audits. Because the question remains unresolved, we recommend excluding EGCs from the requirements of critical audit matters at this time.

Similar to the 2016 reproposal, the communication of critical audit matters is not required for audits of brokers and dealers, investment companies except business development companies, and benefit plans.

In cases where critical audit matters are not required, auditors may choose to include them voluntarily.

All other provisions of the final standard will apply to the audits of these companies.

Effective Dates

The final standard provides a phased approach to the effective date.

Critical audit matters would be effective –

  • For audits of large accelerated filers with fiscal years ending on or after June 30, 2019; and
  • For audits of all other companies to which the requirements apply with fiscal years ending on or after December 15, 2020.

The remaining requirements of the final standard, including auditor tenure, will apply to all companies for audits of fiscal years ending on or after December 15, 2017.

This phased approach to the effective date will provide investors and other financial statement users with the new form auditor's report, other than critical audit matters, as soon as reasonably practicable. The later effective dates for critical audit matters provide accounting firms, companies and audit committees more time to prepare for implementation of the requirements that are expected to require more effort to implement.

A mid-year effective date for audits of large accelerated filers will allow auditors to gain experience implementing critical audit matters at a time when fewer audits are being completed.

For audits of companies that are not large accelerated filers, an 18 month delay will allow the auditors of these companies, which are often smaller audit firms, to benefit from the experience of the audits of large accelerated filers.

Auditors may elect to comply before the effective date, at any point after SEC approval of the final standard.

Overall, we plan to monitor the results of implementation. In addition, the phased effective date may facilitate any post-implementation review of the impact of the final standard.

Closing Remarks

In closing, the staff is recommending that the Board adopt a new standard, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and related amendments to PCAOB standards, in substantially the form presented. The staff recommends that the Board authorize the staff to submit the standard and related amendments to the auditing standards to the Securities and Exchange Commission for approval pursuant to Section 107 of the Sarbanes-Oxley Act, and to also request that, with the exception of the requirements related to critical audit matters, the SEC approve the application of the new standard and related amendments to the auditing standards to the audits of emerging growth companies pursuant to Section 103 of that Act.

This concludes our remarks. We would be happy to answer any questions you may have.