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Revised Version of Proposed Expansion of Auditor’s Report Approved for Publication

The PCAOB voted unanimously to issue a revised proposal for an expanded auditor’s report in regulatory filings. The regulatory board believes the reports need to go beyond the pass-fail model that has been in place since the 1940s and add information about a company’s financial condition will make them more useful for investors.

The PCAOB voted unanimously to issue a revised proposal to expand the auditor’s report and make it more useful for investors on May 11, 2016.

Comments are due August 15.

The requirements in the revised proposal are said to be narrower and more focused than the previous version from August 2013 in Release No. 2013-005 , Proposed Auditing Standards on the Auditor’s Report and the Auditor’s Responsibilities Regarding Other Information and Related Amendments . The proposal called upon auditors to disclose critical audit matters (CAMs), or issues that they found the most challenging and complex during an audit.

The revised proposal defines a critical matter as an issue arising from the audit of the financial statements that was communicated or required to be communicated to a client’s audit committee. The information would have to be considered material.

The revised proposal reflects the board’s response to concerns raised by auditors and companies who submitted comments in response to Release No. 2013-005 that the proposed critical matters were too broad and would cause auditors to overstep their authority and reveal information that a company’s management has not disclosed.

“As with the original proposal, the new proposal envisions that auditors describe their critical audit judgments. It does not put them in the position of speaking for management,” PCAOB Chairman James Doty said. “But by focusing on auditor judgments, it does deliver on the Congress’s intention… to further the public interest in the preparation of more informative audit reports for public investors.”

The proposal retains the current pass-fail model that has been in place for decades, but the extra information about a company’s financial condition represents a significant change. Many investors said adding details about a client may be one of the most important things the board can do for them. Auditors know many things about a client’s internal operations and financial health, including the challenges that arose during the audit and the difficulties management and auditors had in reaching conclusions about the information in the financial statements. But the reporting model that has been in place since the 1940s provides no opportunity for the auditors to offer this information to investors.

In the aftermath of the 2008 financial crisis, some regulators and investors observed that the external auditors, who are technically required to act as watchdogs on investors’ behalf, said nothing in their reports about companies that soon failed.

While all five board members voted for the revised proposal, member Steven Harris said he remains concerned with the proposed definition of critical matters. During the vote on the 2013 proposal, Harris said the definition was “not strong enough to accomplish its purpose or to meet the needs of investors.”

The original proposal endorsed a subjective standard in determining a CAM, he said. The effectiveness of the disclosures could vary depending on how they are written. Harris is concerned that effective inspection and enforcement with a subjective critical matter would not be possible. Many investors voiced similar concerns.

Harris said that he agreed that the CAMs should include matters discussed with the audit committee because the directors are responsible for representing investors’ interests in their supervision of the outside auditor.

“The revised definition, however, still contains an element of subjectivity,” Harris said. “In my view, allowing auditors to decide what matters involved ‘especially challenging, subjective, or complex auditor judgment’ still grants them too much discretion.”

The revised proposal retains a requirement for auditors to disclose their length of service on an account, a controversial requirement supported by Doty.

When the tenure disclosure was proposed in Release No. 2013-005 , investors supported the rule and said it could improve audit quality. Some investors believe a long tenure leads to too close a relationship between auditors and their clients and creates a conflict of interest for the auditor. But audit firms and their clients opposed the measure and said there is no established link between quality and tenure.

Nonetheless, since the proposal was issued, a growing number of companies have been voluntarily disclosing their external auditor’s tenure in their proxy filings because of investor demand, and Doty believes a regulatory requirement may be warranted.

The revised proposal excludes a provision in Release No. 2013-005 that required auditors to more closely look at “other information” outside the financial statements, such as financial data and the SEC filing’s management discussion and analysis section, to draw attention to inconsistencies.

Current rules require auditors to “read and consider” the extra material. The 2013 proposal instituted a higher standard to “read and evaluate,” and included specific procedures for auditors to follow. Audit firms in 2013 objected and said it would add to their work, increase their legal liability, and raise their costs. The PCAOB in 2015 decided to cut the provision from the proposed rule and study it further.

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