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US Securities and Exchange Commission

Group Says ‘Critical Audit Matters’ Have Provided Significant Benefits to Investors

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Soyoung Ho

An influential group representing institutional investors said the requirement for “critical audit matters” (CAMs) has been beneficial, and regulators should not scrap it or water it down. Corporations had vehemently opposed it when the rule was being written.

“As expected, the early evidence indicates that implementation of CAMs has resulted in at least two significant benefits to investors and other market participants: improved internal controls and improved disclosures,” Jeffrey Mahoney, general counsel of the Council of Institutional Investors (CII), said at a meeting of the SEC’s Investor Advisory Committee (IAC) on February 27, 2020, at agency headquarters in Washington. CII represents pensions, endowments, and foundations that manage $4 trillion in combined assets.

His remarks come as the PCAOB has struggled to adopt CAMs. Because of opposition by accounting firms and their public company audit clients, it took more than seven years for the board to finalize an investor-supported rule that requires the auditor to provide more insight into what they did in scrutinizing the financial statements of their clients. The PCAOB ultimately ended up adopting a rule that seemed to be a compromise in June 2017.

However, still unhappy, almost 30 companies and business groups sent a joint letter urging the SEC not to approve the rule, calling it “detrimental” to the companies affected by it with increases in legal liability, stifled auditor-audit committee communications, and auditors possibly divulging sensitive corporate information. And if auditors provide boilerplate disclosures, the requirement would not benefit investors while only adding unnecessary costs, they argued.

The commission, which oversees the PCAOB, must approve all major decisions by the audit regulator board before they become effective. When the SEC approved the rule in October 2017, commission Chairman Jay Clayton in a statement acknowledged the concerns, saying he “would be disappointed” if the new auditor reporting standard only added costs without any benefits. And he urged the SEC and the PCAOB to pay close attention to those issues. He also said that he was pleased that the PCAOB would carry out post-implementation review (PIR) of the standard.

“Depending on the findings of this analysis, including an evaluation of unintended consequences, the Board should be open to making changes, if necessary, to the revised auditing standards, including to the effective date for companies other than large accelerated filers,” Clayton said at the time. “Ultimately, I support a timely and effective PIR for these revised auditing standards, and it will be critical that this PIR is completed as soon as practicable.”

Now about two and a half years later, investors are largely happy with the extra disclosures.

When the standard was being written, investors said adding more auditor insight about a client’s financial condition would make the auditor’s report more relevant for decisions about investments and shareholder votes on board seats, executive compensation, and the selection of the outside audit firm. Auditors know many details about a client’s financial condition, but the pass-fail reporting model that has been in place since the 1940s provides no opportunity for auditors to offer insight to investors. In the aftermath of the 2008 financial crisis, some regulators and investors observed that external auditors said nothing in their reports about companies that soon failed.

The PCAOB defines CAMs as issues that have been communicated to the audit committee, are related to accounts or disclosures that are material to the financial statements, and involved especially challenging, subjective, or complex judgments from the auditor. Auditors of large public companies have been including CAMs since last year. Smaller companies have more time to implement the requirement.

CII’s Mahoney cited an Intelligize report that said 62 percent of audit committees who participated in dry-run discussions have identified and are adding internal controls over financial reporting [ICFR] or considering such changes. Moreover, 52 percent of large companies and 61 percent of all other companies are considering enhancements to their financial statement disclosures because of CAMs.

In a December CII report, Mahoney summarized findings from 330 CAMs in 191 audit reports, which said that “many of the reports provided a robust and useful description in response to three of the four CAM requirements.”

However, “I believe more can and should be done to encourage auditors to provide more information about the outcome of audit procedures and key observations in ways that make clear how those outcomes and observations contributed to the auditor’s opinion and do not imply separate assurance on those matters,” he said.

Separately, financial reporting researchers at Audit Analytics said in a blog that as of February 12, they have seen almost 400 audit opinions under the new CAM requirements, and on average, there are 1.7 CAMs with a high of four audit matters. The most frequently cited CAMs were revenue, followed by intangible assets, business combinations, income taxes, and contingent liabilities.

In the meantime, former director of the SEC’s Division of Corporation Finance, Keith Higgins, said in his experience, the CAMs implementation process went smoothly.

It “may have been the dry runs [test runs before officially applying CAMs], may have been advance planning, and it also may have been simply there wasn’t the friction that some people feared there might be,” Higgins, now chair of the securities and governance practice of Ropes & Gray LLP, said during the IAC meeting. “What remains… [is] how the PCAOB is going to look at these, the inspection reports whether their review and their reactions to them shape how CAMs develop. So far so good, stay tuned.”

SEC and PCAOB officials at an accounting conference last December also said they were encouraged with implementation efforts so far.

 

This article originally appeared in the March 6, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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