The Public Company Accounting Oversight Board’s (PCAOB) Investor Advisory Group (IAG) presented a set of recommendations to improve auditors’ reporting of critical audit matters (CAMs) both in terms of quality and quantity, including a request for the staff to revise a 2019 guide in determining the matters.
This comes as investor advocates say that CAMs have not been valuable because of boilerplate language used as well as the shrinking number of matters disclosed over the years.
Rather than providing insight into the financial statements by describing the auditor’s observations, the disclosures describe “more of the audit procedures that are performed,” IAG member Sandra Peters, senior head for global advocacy of the CFA Institute, said during a virtual meeting on Oct. 10, 2023.
An interim analysis in 2022 by PCAOB economists found that the average number of CAMs per audit report has declined over time, and the proportion of reports that have a single CAM has increased.
There were 1.69 CAMs per audit report on average from June 2019 to June 2020 period for larger companies. That average went down to 1.61 from June 2020 to June 2021. It dropped even more to 1.43 from June 2021 to May 2022.
Smaller companies reported even fewer CAMs. From December 2020 to December 2021, the average was 1.23 CAMs. From December 2021 to May 2022, it dropped to 1.12.
But the PCAOB wrote the CAMs requirement in 2017 in response to investor demand to make the audit report more useful. At the time, this represented a major change to the brief pass-fail auditor reports that had been in place for decades.
The auditing standard in question is No. 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. A CAM 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.”
Revise Staff Guidance: ‘relative basis within the specific audit’
The IAG recommended a small revision in Staff Guidance, Implementation of Critical Audit Matters: A Deeper Dive on the Determination of Cams, published in March 2019 when the board was led by William Duhnke. Investors criticized the PCAOB during his tenure, claiming that the board was too lenient toward audit firms even though its only mission is investor protection. Today, the board is led by Erica Williams who has put investor protection front and center.
The IAG believes that the latter part of this sentence in the staff guidance may be problematic: “The standard uses the word especially,’ instead of ‘most’ as originally proposed, to convey more clearly that there could be multiple CAMs and that matters are assessed on a relative basis within the specific audit.”
In particular, Peters said the PCAOB should consider removing or amending the phrase “on a relative basis within the specific audit.” She presented the recommendations to the board.
“That language is bad,” said Marty Baumann in an interview. “Let’s assume that everything you reported to the audit committee was material. You have 10 items to report to the committee that are all candidates for CAMs. Each of those CAMs should be evaluated individually against the factors in paragraph 12 of AS 3101. There’s a whole list of factors, the degree of difficulty, the amount of subjectivity, did it involve a risk of material misstatement. Each of the matters communicated to the audit committee should be evaluated against those factors.”
He was the chief auditor of the PCAOB when CAMs were developed. He left in May 2018 before the staff guidance was published.
“There’s nothing in the literature that says they should be evaluated against each other,” said Baumann who is an adjunct professor with The Washington Campus. “What it does say is you take anything that qualifies for a CAM—that’s anything communicated to the audit committee and relates to material accounts or disclosures—and then evaluate that matter against the factors.”
It is unclear why the staff in 2019 included the questionable language. When the board issued a second round of proposal in 2016 before CAMs were finalized, it included the phrase. But as Baumann said, the 2017 final release does not retain it.
Peters also pointed out that the staff guidance was issued even before any CAMs were reported since the standard went into effect a couple of years after it was approved by the Securities and Exchange Commission which oversees the board.
Inspection Findings
The IAG’s second recommendation asks the board to issue a report that summarizes inspection findings on CAMs.
“We believe that the PCAOB inspection staff should execute a large-scale examination of audit workpapers and see how CAM determinations are being made and documented relative to the standard broadly, and more specifically as to whether CAM determinations are being made under relative rather than absolute basis upon a separate assessment of each matter against the factors in the standard,” Peters said.
Because the standard requires documentation, inspectors can examine workpapers related to any material matter communicated to the audit committee, look at how the auditor assessed that matter against the factors set forth in AS 3101 and examine things such as related correspondence with the national office about how challenging the matter was, the level of engagement quality review of the matter, the degree of subjectivity and difficulty of the matter and evaluate the auditor’s basis for not including that material matter reported to the audit committee as a CAM.
Revise Language in Standard Itself
Another problem with the standard is the term “especially challenging” because it may be too high of a threshold. And Peters said it should be revised to either “more challenging” or just “challenging” because “we believe the notion of especially challenging is reducing the number of CAMs to possibly just the one that we are seeing when in fact it is not.”
“We want disclosure of the things that were challenging for the auditor to do to make an assessment or conclusion on,” she added.
The next recommendation is to require auditors to describe their observations, not simply audit procedures.
In particular, a note in the standard states that in describing how the CAM was addressed in the audit, “the auditor may describe: (1) the auditor’s response or approach that was most relevant to the matter; (2) a brief overview of the audit procedures performed; (3) an indication of the outcome of the audit procedures; and (4) key observations with respect to the matter, or some combination of these elements.”
“They are not required because there is a ‘may’,” Peters said. For “virtually all critical audit matters, there’s a report on what was done, but nothing with respect to what was found, and investors—in their original asking for a request for critical audit matters—had asked to know what auditors found.”
IAG member Jeffrey Mahoney, general counsel of the Council of Institutional Investors, requested the PCAOB to take on a narrow-scope project to revise paragraph 14 of the standard. He has already expressed his concerns during a previous IAG meeting.
The board can pursue broad or narrow standard-setting projects. Moreover, CAMs are under the board’s post-implementation review.
The language revision “would address the two issues that many have raised about how 3101 is not being implemented consistent with the intent,” Mahoney said about the term “especially” and the note in paragraph 14. “I would respectfully request a narrowly scoped project that could change as little as 10 words in the standard to fix the two main problems with 3101 and how it’s been implemented,” he said.
But a standard-setting project will likely take a lot of time even if it is a narrow one. It would require the board to draft a proposal for public comment and analyze feedback. The auditing profession and companies, who never fully supported the initiative, might even question the need for CAMs if costs outweigh benefits.
In Baumann’s view, the change to the staff guidance and a report on inspection observations will result in near-term improvements because the PCAOB can take action in the next couple of months.
“The PCAOB can make meaningful action before year end by updating the staff guidance and by issuing a board document on inspection observations on the implementation of critical audit matters,” he said. “That would significantly affect the quality of audit reports coming out in February and March 2024.”
This article originally appeared in the October 20, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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