Nothing If Not Critical

A proposal to require auditors to disclose “critical audit matters” in their reports has generated apprehension among audit firms and pushback from...
David KatzJuly 1, 2014
Nothing If Not Critical

Recently, Gaylen Hansen recalled how he started out in the auditing profession with a Big Eight accounting firm in Los Angeles, working in a two-story brick building “without a single window.” The lack of a view embodied the firm’s commitment to confidentiality, Hansen was told. Although the setting “seemed normal” at first, he said, “in retrospect it was just plain weird.”

Now a partner at EKS&H, a Denver-based audit firm, Hansen told his story to make a point. “The auditing profession has a long and storied history of excessive secrecy,” he said on April 2, kicking off two days of public meetings held by the Public Company Accounting Oversight Board on the board’s plan to revamp the way auditors report their findings. “Today’s auditor’s reporting standard is akin to a windowless building lacking visual functionality.”

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That lack of transparency stems from the terseness of the current auditor’s report, according to Lynn Turner, a former chief accountant of the Securities and Exchange Commission and a prominent investor advocate. In his statement prepared for the PCAOB meetings, Turner said the auditor’s report is based on a model that “has not changed significantly since the last Ford Model A rolled off the production lines in the early 1930s.”

Just as they did 80 years ago, auditors still adhere to a pass/fail model that requires them to state whether their clients’ financial statements are presented fairly (pass) or not (fail). They can also provide a “qualified” opinion, meaning that they couldn’t deliver a full opinion because some aspects of a client’s accounting failed to adhere to generally accepted accounting principles or contained incomplete information. But that, essentially, is it.

auditorsIndeed, had the Great Recession not happened, the pass-fail model may not have come in for the kind of intense criticism it has received from institutional investors, credit-rating agencies, and regulators since 2008. But a furor arose when it was learned that financial flops such as AIG, Lehman Brothers, Citigroup, and Washington Mutual had received clean opinions from their auditors despite being on the brink of collapse. That disclosure, in part, led the U.S. Advisory Committee on the Auditing Profession, formed by the Treasury Department in response to the financial crisis, to call on the PCAOB in October 2008 to take “the auditor’s report beyond the current pass/fail model to include a more relevant discussion about the audit of the financial statements.”

After much deliberation, on August 13, 2013, the oversight board issued a proposal that it thinks will reduce what it calls the “asymmetry” between what corporate management knows about a given audit and what the investing public knows. While the proposed standard would retain the pass/fail model, it would also require the auditor to communicate “critical audit matters” in the auditor’s report. The board defines critical audit matters as those “that involved the most difficult, subjective, or complex auditor judgments or posed the most difficulty to the auditor” in gathering evidence or forming an opinion on the financials.

In effect, the proposal would call on auditors to reveal to the public what kept them up at night as they struggled with finance executives and management accountants to make sure companies had gotten their numbers right and were reporting them accurately. If the proposal is eventually enacted, investors will get something they have long been looking for: the ability to see inside the mind of the auditor during an audit.

Uniquely Objective
What can be gained from such a view that isn’t already provided in venues such as the 10-K’s Management’s Discussion and Analysis and quarterly earnings calls?

One answer that advocates of the PCAOB’s proposal give is that auditors provide a uniquely objective perspective. “The auditor is independent and is not going to spin the information the same way that management might,” says Sherman Myers, director of corporate and government ratings at Standard & Poor’s. “So if the auditor is going to discuss a significant estimate, the perception would be there that the auditor should be more balanced.”

Without a rendering of the auditor’s perspective, however, investors lack an independent way to verify the accuracy of management’s qualitative statements. In his remarks, Hansen noted that current audit reports are silent about auditor strategy and overall approach, the extent of the evidence obtained in the audit, and the key audit judgments made. During the financial crisis, investors “witnessed their capital vanishing overnight while those in the know couldn’t or wouldn’t share untapped insight,” he said. “The extant audit report doesn’t offer investors much to reasonably assess the underlying quality of audits.”

More important to many investors than access to the auditor’s thought process, though, is access to the information he or she is privy to. Indeed, many investors want the standard to go beyond requiring the mere revelation of the auditor’s greatest anxieties. They want to mandate that auditors report unique information about the company itself.

During the audit, the auditor “gains a tremendous understanding about the entity being audited, about the system of internal controls, and how that system deals with the way the company operates the business,” says Myers. At clients ranging from copper refineries to ice cream manufacturers, for instance, auditors tour facilities and do such things as perform inventories “in the middle of the plant,” says Myers, noting that the specificity of the information they gain through such tasks “may add value to what investors get today.”

Upsetting the Power Structure
To be sure, the PCAOB’s proposal doesn’t call for auditors to provide original information about a company’s performance and operations, notes Martin Baumann, the board’s chief auditor and standards director. It simply wants them to disclose the significant issues they dealt with in the course of doing an audit.

The desire for even that information, however, strikes fear into the hearts of CFOs and audit committee members. That’s because it threatens to upset the venerable power structure of financial reporting. Explains Ira Solomon, dean of Tulane University’s A. B. Freeman School of Business: “There’s a long tradition of a very bright line [in public accounting]. Management discloses information about its company’s operations and performance, and the auditor weighs in by opining on whether or not this information is in conformance with generally accepted accounting principles in some significant way.”

But under the proposal, auditors would have to provide their own disclosures of critical audit matters. Even if an auditor omits to cite significant issues with the audit, that would still be saying something. Finance chiefs much prefer the current situation, in which management is the sole communicator of information to the public.

“Most CFOs want to tell their own story in their own words,” says George Victor, a partner with Giambalvo, Stalzer, a CPA firm in Great River, N.Y. If he were a finance chief, he adds, he wouldn’t “want the world to know how complicated my revenue recognition is, or how hard a time the guy had in doing the audit.”

Among finance chiefs who commented on the proposal before it was issued in its current form, Carol Tomé of Home Depot was fairly typical. In her letter to the PCAOB, she wrote that management, “with the oversight and input from the audit committee, is in the best position to determine whether our financial disclosures are complete, accurate, and provide our investor community with appropriate insight into our business.” The auditor, Tomé wrote, “is not well suited to independently report information about the company beyond what is required to be disclosed by management under GAAP and SEC regulations.”

“Ripe for Litigation”
Auditors have tended to feel that way, too. Before, the auditor “just provided his report in accordance with GAAP and the PCAOB and left the stage,” notes Victor. But under the proposal, the auditor “can’t leave the stage anymore. He’s got to give a little speech.”

That prospect fills auditors with more than stage fright. It’s true that under current rules they must prepare and retain an audit completion document that contains what would be considered critical audit matters. But that information is only subject to review by members of their firm, subsequent auditors, and the PCAOB itself. Under the proposal, however, the auditor’s assessment of the audit would be publicly filed, meaning that he or she could be second-guessed—or even sued.

Say an auditor identifies five critical audit matters in the audit report, says Victor. A plaintiff could then claim there were one or two more that should have been identified but weren’t. Yet the question of how many critical audit matters there are in a given audit “is a matter of a high level of judgment that could vary among different professionals,” says Victor. “One auditor could be more critical than another, more quick on the draw to disclose something, where one may not. This is an area that’s going to be ripe for litigation.”

Once on the stand, risk-averse auditors are likely to “sing like a bird” and err on the side of too much disclosure rather than too little, says Victor. That, in turn, could increase the risk to CFOs of having their own reports disputed in court.

The proposal could even have a downside for the investors who have roundly supported it. By providing a dissenting view of the audit, the report on critical audit matters could send a mixed message, contends Tulane’s Solomon.

“What are we signaling to the users of financial statements when the auditor has to say, ‘Well, I reached that conclusion, but boy, it was really tough’?” asks Solomon. “Does it tell you that you ought to be more uncertain about that? What is it that you want me to think about when I consider loaning money to the company or investing in it?”

Given its Time
Given the fierce opposition to the proposal, the PCAOB appears to be in no hurry to produce a final standard, even though European standard-setters are moving quickly to implement similar guidelines.

In April, the European Union added stiff requirements to the auditor’s report. For example, it imposes on auditors “the obligation to report on any material uncertainty related to events or conditions that may cast significant doubt about an entity’s ability to continue as a going concern,” said Sven Gentner, part of the EU delegation to the United States, in remarks prepared for the April meetings. Further, the International Auditing and Assurance Standards Board, the PCAOB’s overseas counterpart, expects to revamp its auditor’s reporting model by the end of 2014.

In the United States, however, “it takes longer to get things done,” says Baumann, noting in particular the need for rulesmakers to take the nation’s appetite for litigation into account. “There’s no time pressure to get this done,” he says. “I don’t think we’re going to be measured by approving something on a certain date.” If it takes issuing a revised proposal to achieve a high-quality, balanced standard, that would be fine, says Baumann.

Nevertheless, Baumann, a former CFO of mortgage giant Freddie Mac and a PricewaterhouseCoopers auditor for 33 years, feels a change in the auditor’s reporting model is long overdue. Noting that large institutional investors such as the California Public Employees’ Retirement System and those represented by BlackRock and the Council of Institutional Investors are pushing to get more information from the auditor’s report, Baumann says that finance chiefs should listen to their investors and support the proposal.

The bottom line, he says, is that shareholders are getting little value for the huge sums that public companies spend on audits. “We don’t know what the auditor does, but we know they’ve spent thousands and, in some cases, hundreds of thousands of hours auditing a major corporation, and we know the fee can be in the $20 million to $60 million range for a major corporation,” says Baumann. “And all we get out of them is, ‘We finished our audit.’”

David M. Katz is a Deputy Editor of CFO.

Ending Audit Asymmetry

What critical audit matters should auditors communicate to the investing public? Here’s part of what the Public Company Accounting Oversight Board proposes.

Critical audit matters are those matters that:

Involved the most difficult, subjective, or complex auditor judgments
Posed the most difficulty to the auditor in obtaining sufficient appropriate evidence
Posed the most difficulty to the auditor in forming an opinion on the financial statements

Critical audit matters ordinarily are matters of such importance that they are:

Included in engagement completion documents
Reviewed by the engagement quality reviewer
Communicated to the audit committee

Factors that the auditor should take into account in determining critical audit matters:

The degree of subjectivity involved in determining or 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
The nature and amount of available relevant and reliable evidence regarding the matter or the degree of difficulty in obtaining such evidence
The severity of control deficiencies identified relevant to the matter, if any
The degree to which the results of audit procedures to address the matter resulted in changes in the auditor’s risk assessments, including risks that were not identified previously, or required changes to planned audit procedures, if any
The nature and significance, quantitatively or qualitatively, of corrected and accumulated uncorrected misstatements related to the matter, if any
The extent of specialized skill or knowledge needed to apply audit procedures to address the matter or evaluate the results of those procedures, if any
The nature of consultations outside the engagement team regarding the matter, if any

The description for each critical audit matter in the auditor’s report would:

Identify the critical audit matter
Describe the considerations that led the auditor to determine that the matter is a critical audit matter
Refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter, when applicable

Source: Public Company Accounting Oversight Board

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