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Proposed Auditor Evaluation of Other Information Elicits Mixed Reaction

April 4, 2014

The PCAOB wants auditors to “read and evaluate” other information outside the financial statements to check for inconsistencies. The current guidance requires auditors to “read and consider,” and a Big Four auditor said during a public meeting that the revision will make auditors’ jobs harder, raise their costs, and further confuse investors about exactly what the auditor did. However, analysts said having auditors scrutinize information outside financial statements will be helpful because some key metrics outside financial statements are rife for management discretion.

The audit regulator is getting mixed responses to its August 2013 proposed requirement for the auditor to closely scrutinize other information outside the financial statements to check for inconsistencies.

A somewhat less-noticed provision in Release No. 2013-005, Proposed Auditing Standards on the Auditor’s Report and The Auditor’s Responsibilities Regarding Other Information and Related Amendments, holds some risk for accounting firms if they’re expected to more closely review the information in a regulatory filing that’s not part of the financial statements, Michael Gallagher, managing partner for assurance quality with PricewaterhouseCoopers LLP, said during a public forum hosted by the PCAOB on April 3, 2014.

If the proposed requirement goes through, auditors would have to evaluate information in the client’s exhibits to its regulatory filings and its written disclosures. Existing rules require auditors to “read and consider” the material. The proposal institutes a higher standard to “read and evaluate,” and includes specific procedures for auditors.

Auditors have for years reviewed the nonfinancial information as part of a normal audit procedure to make sure that it’s consistent with the financial statements. If the PCAOB’s more stringent requirement is finalized, they would need to affirmatively say in the audit report that there are no material misstatements or misrepresentations in the filing. Auditors would have to look at the entire filing and not just the management’s discussion and analysis section and make sure the numbers align.

Audit firms said this would add to their work and increase their liability risks, resulting in higher audit and reporting costs.

Moreover, Gallagher said the proposed standard will increase the expectation gap between what an auditor does and what the public thinks the auditor does. There is also the risk of inconsistent execution by the use of the term “evaluate” which, in his view, is ambiguous and susceptible to varying interpretation.

Evaluate “could be misread to mean the auditor is expressing an opinion on the other information or performing audit-type procedures,” Gallagher explained. The term “is more commonly associated with the auditor’s responsibility in an audit to determine whether the evidence obtained is sufficient and appropriate to support the opinion to be expressed in the auditor’s report.”

Gallagher suggested the proposed standard include an overall requirement that the auditor read all of the other information and do a prescriptive set of procedures similar to what’s done in comfort letter procedures, on material other information related to the audited financials. The audit report should also explicitly describe limited procedures the auditor performed instead of expressing a conclusion. This would decrease the expectation gap, he said.

However, Jeremy Perler, who has spent 17 years analyzing companies that use aggressive accounting and manipulative reporting to embellish their financial performance, said the board’s plan would bring tremendous value to investors.

“This is a weak spot in our financial reporting system that allows issuers to bypass the traditional audited financial statements and engage in an unscrutinized parallel conversation with investors,” said Perler, director of Research with Schilit Forensics. “By not participating in this conversation, the audit function is weakened and investors are worse off.”

Perler said management commonly presents self-made non-GAAP metrics as more relevant proxies for earnings and cash flow performance.

Usually these metrics are the most important data to investors, and often they give insight into a company’s operations, such as organic growth for an acquirer or earnings excluding a big litigation settlement.

“However, in many cases they don’t, like something called ‘steady state free cash flow before special items,'” he said. “Regardless of their legitimacy, these metrics are unaudited and susceptible to the whims of management discretion in definition and disclosure.”

For example, when Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is no longer flattering, Perler said, it becomes “adjusted EBITDA,” then “adjusted cash EBITDA,” and finally “adjusted cash EBITDA less one-time items.”

Enhancing auditor responsibility over other information, in his view, will strengthen financial reporting process and lead to fewer cases of willful or negligent misrepresentation.

Michael Young, a partner with Willkie Farr & Gallagher LLP, said he opposed expanding the auditor’s reporting other information because it will ultimately become less useful for investors.

For example, he said Warren Buffett’s most recent letter to shareholders said that Berkshire Hathaway’s write-down was economically meaningless. Young believes Buffett’s letters are interesting, useful, provides candor, and tell the reader what’s going on at the company. In an earlier shareholder letter, it said that one thing the company knows about its reserve is that the number is wrong.

If the proposal is adopted, however, “that statement would not be in there,” Young said. “My concern is the lawyers will take over. The lawyers will go over the disclosure, and they will look at the risks, …[and] get the statement out.”

Peter Nachtwey, CFO of Legg Mason, Inc., disagreed and said the requirement, when appropriately crafted, will be beneficial.

“You don’t want to limit what Warren Buffett could write, but those kind of subjective things are not really purview of audit firms,” Nachtwey said. “I think it’s much more about reporting what they already do and make it clear to investors where the auditor was involved with in other information.”

Legg Mason’s key performance indicator is assets under management, which gets significant attention in management discussion and analysis, but related numbers are not audited. However, he said auditors do more work related to asset under management given its direct impact on revenues.

“So, the proposal provides an opportunity for auditors to educate the public on what their processes around Other Information actually entails,” he said. “The public in general believes that auditors are already involved in some way with verifying information outside of the audited financials. As a consequence, investors may have an over- or under-stated view of what auditors actually do.”

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