SEC Approves PCAOB’s Proposal to Significantly Change the Form of Audit Opinion
On October 23, 2017, the SEC approved the proposal of the Public Company Accounting Oversight Board (“PCAOB”) to make significant changes to the form of audit opinion issued with respect to the financial statements of public companies. These changes mark the first revisions to the form in 70 years and follow proposals first advanced by the PCAOB in 2011. For public companies with a December 31 year-end, the first of these changes will affect the upcoming audit of their financial statements with the more controversial requirement—the requirement to disclose critical audit matters or “CAMS”—being phased in beginning in 2019 for large accelerated filers and, for all other companies to which the CAMS disclosure is required, for audits of fiscal years ending after December 15, 2020, although, at the option of the auditor, early adoption is permitted.
Whom does this affect?
With the exception of the CAM disclosure, these changes will affect the audits of all public companies and any other audit that is performed under PCAOB standards. For example, audited financial statements filed in connection with an initial public offering must also comply with PCAOB requirements. The CAM disclosure requirement is not applicable to emerging growth companies, brokers and dealers subject to the reporting requirements of Rule 17a-5 of the Securities Exchange Act of 1934, investment companies and other business development companies, or employee stock purchase, savings, and similar plans. Smaller reporting companies are not exempt, however.
While none of these changes are applicable to the audits of non-public companies, it is reasonable to expect that at least some of the formatting changes may be adopted in these audits, particularly when an auditing firm has a mix of both public and non-public company clients.
What are the changes that will affect the 2017 audit?
Addressee. The audit report will be addressed to both the shareholders of the public company and its board of directors or similar governing body.
Tenure and Independence. The opinion must disclose the year in which the auditor began serving consecutively for the public company. For purposes of this disclosure, this would include the period of time the company was audited by a firm that has been merged into or otherwise acquired by the current auditing firm.
The opinion must also include an affirmative statement that the auditing firm is independent from the company under audit as determined in accordance with the U.S. federal securities laws and the rules and regulations of the SEC and the PCAOB.
Standardized Form of Opinion. The PCAOB established a form of audit opinion to be used in connection with the audit of all public companies. This form requires that the opinion itself must now be in the first paragraph of the report. The form also requires that certain headings be used so as to better delineate the subparts of the audit report including the new disclosures.
What is a “Critical Audit Matter”?
The PCAOB defines a critical audit matter or CAM as any matter arising from the audit that:
was communicated, or required to be communicated, to the audit committee of the company;
relates to accounts or disclosures that are material to the financial statements; and
involved especially challenging, subjective, or complex auditor judgment.
Any matter that is deemed a CAM must be identified in the audit report under the heading “Critical Audit Matter.” If there are none, a statement to that effect must be included in the report. The auditor must also describe the principal considerations that led to the determination that the matter was a CAM and how the CAM was addressed in the audit. The report must also specify the relevant financial statement accounts or disclosures that relate to the CAM.
What was missing from both the PCAOB release and the SEC release approving the PCAOB proposed changes were any examples of what might constitute a CAM. All that was described is what is not a CAM. For example, a significant deficiency in internal control over financial reporting, in and of itself, is not a CAM. Critical accounting policies and CAMs are also not necessarily the same. In addition, the disclosure is not to replace any qualifications to the audit opinion.
What we do know is that a CAM may be an immaterial matter that relates to a material account. While commenters on the PCAOB proposal suggested that the materiality standard be applied to the matter, not the accounts or disclosures that are material to the financial statements, the PCAOB declined to do so. As such, for financial institutions and their holding companies, one likely source of CAMs is the adequacy of the allowance for loan losses. Another potential CAM is acquisition accounting, particularly fair value estimates of the assets acquired and any related credit marks. Goodwill and servicing rights could also potentially require disclosure as a CAM if they are material to the balance sheet of the audited company.