The Public Company Accounting Oversight Board unveiled far-reaching proposals this week for enhancing the auditor’s reporting model in what could be the biggest transformation of the audit report in over 70 years.
Whereas many audit reports nowadays are full of boilerplate language and essentially take a pass/fail kind of approach to opining on whether a company’s financial statements are in accordance with U.S. GAAP, the new auditor’s reporting model envisioned by the PCAOB could potentially provide much more useful information to investors (see PCAOB Proposes to Change Auditor’s Reporting Model). On the other hand, it would also place a much greater burden on the auditor and the auditing firm, perhaps exposing them even more than they already are to the threat of litigation from investors, not to mention the ire of their clients.
Among the changes in the proposal are the communication of critical audit matters as determined by the auditor and new elements in the auditor’s report related to auditor independence and auditor tenure. There are also enhancements to the existing language in the auditor’s report related to the auditor’s responsibilities for fraud and notes to the financial statements. In addition, there’s a proposal for an “other information” standard, in which the auditor would be required to evaluate information apart from the financial statements, such as the company’s annual report and management’s discussion and analysis.
For the first time, according to PCAOB chairman James Doty, the audit report would describe this evaluation and its results. “The standard form audit report was designed by the audit profession more than 70 years ago,” he said at Tuesday’s PCAOB meeting in which the members of the board voted to issue the proposal. “While it serves a critical purpose, many question whether it could do more.”
Doty and the rest of the members of his board are expecting to hear plenty of comments and criticism of the proposal. They’ve been hearing about it ever since 2011, when the PCAOB first issued a concept release about the notion of changing the auditor’s reporting model. The board took some of that feedback into account in the latest proposal and it plans to hold roundtable meetings to gauge reactions and elicit further feedback from auditors, investors, audit committee members and other interested parties.
Going Beyond Pass/Fail
There’s a lot of material for the accounting and auditing profession to digest just in reading through the nearly 300-page proposal. “This is a pretty big document,” said David Grumer, CPA, a partner at the accounting firm Citrin Cooperman in New York. “I do think that our profession ought to be working with the PCAOB to improve audit quality.”
However, Grumer believes the pass/fail model has worked pretty well, and the PCAOB proposal might be more than what is really needed to serve the public interest. “We do have quite a lot of disclosures that we make about risks and uncertainties in finances, and our profession is going to continue to do that,” he noted.
Grumer is heartened that the PCAOB is going to listen to more feedback before finalizing a new standard for the auditor’s reporting model, which probably would not take effect until at least 2015. “I really am confident that the audit profession can have a dialogue with the PCAOB to work with them to take steps to improve audit quality,” he said. “The PCAOB has put a lot of thought into this, so it certainly merits a lot of serious consideration, but I think our auditing profession should have a chance to speak a little more about it with the PCAOB.”
Grumer is certain there will be strong feelings expressed about the proposed changes in the audit reporting model, but the final outcome is difficult to predict. “It’s impossible to know what those changes are going to be coming down the pike,” he said. “I’m certain that there will be some changes that will come about. What they are, and what the final product is going to look like, remains to be seen.”
James DeLoach, Jr., managing director of the consulting firm Protiviti, thinks the audit profession is overdue for a change. “The current pass/fail model has been in place for 70 years, and the question arises as to whether it is the model that can sustain the profession for the next 70 years,” he said. “Investors want more from the audit process. The new reporting proposal is an attempt to respond to the needs of the investment community.”
He suspects that much of the auditing profession would be content to see the same audit reporting model in place for the next seven decades, but the PCAOB was looking beyond that. “I think this is a legacy kind of move by the board,” said DeLoach. “Long after you and I are gone, people will look back at this and realize this is a legacy-defining event for the PCAOB.”
DeLoach believes the PCAOB’s proposal will help the auditing profession, even if auditors themselves may initially balk at the extra requirements. “There’s been an expectation gap for decades,” he pointed out. “Because auditor reports are essentially pass/fail, investors don’t derive much insight from them. There are many soft areas in the financial reporting process that require difficult, subjective or complex auditor judgments; present situations in which there is limited evidence supporting management’s assertions; and present difficulties in formulating an opinion on the financial statements.”
DeLoach pointed out that there are loss contingencies of every kind, in addition to asset impairment issues, going concern issues, complex estimation requirements, variations in management aggressiveness in applying accounting principles, among other items. “As the auditor has a unique perspective on these issues, he/she often reports on these matters to management and to the audit committee,” he said. “The new reporting standard proposal will now give auditors the editorial license to communicate to investors their unique perspective in terms of the audit implications regarding these matters, including the degree of subjectivity involved in determining or applying audit procedures, the nature and extent of audit effort required to address specific matters, and the availability of relevant and reliable evidence—rather than simply select a ‘pass/fail’ grade.”
Despite the threat of potential litigation, DeLoach thinks the proposal will also give auditors the chance to provide important information in the reports. “While there is a question as to whether this proposed standard could alter the profession’s exposure to litigation, the proposal provides auditors an opportunity to provide a ‘storyline’ over time through annual audit reports regarding the quality of the audit client’s financial reporting,” he said. “By pointing out the difficulties in gathering audit evidence, the severity of control deficiencies (if any), the changes between years in audit risks, the nature of the ‘soft spots’ in preparing the financial statements, the audit profession has an opportunity to provide transparency that never existed before.”
In some ways, the expanded audit report could provide some defense against litigation, according to DeLoach. “If the audit client becomes a litigation issue, the auditor can point to the storyline and the signals it provided regarding the quality of financial reporting, rather than just ‘pass/fail.’ To be sure this is a significant adjustment and no doubt the plaintiff bar will attempt to exploit it,” he said. “However, years from now, it also could prove to be the most important step the PCAOB took to strengthen the relevancy of the audit process to the investment community.”
Mark Plichta, CPA, a partner in the Transactional & Securities practice of the Milwaukee law firm Foley & Lardner, believes that some of the disclosures proposed by the PCAOB might ultimately turn out be redundant as they would typically be included in the management discussion and analysis section of a company’s reports, but he admits that other parts would be new. “Disclosures about areas that pose the most difficulty to the auditor in obtaining sufficient appropriate evidence are certainly not covered currently,” he said. “That may or may not be ultimately useful to investors. I think it probably will cause some heartburn for both the accountants and the companies as they try to put their hands around what that disclosure should look like and how it might be interpreted.”
Another area that may be helpful, depending on the user, is a proposal that the firm disclose its tenure as the auditor for the company. “That’s something that some in the investor community are looking for,” said Plichta. “I’m not sure that’s particularly useful information, and there’s been a lot of discussion and study about that. I think some of the board members may have even commented on whether that’s particularly relevant or significant when evaluating an auditor. I’m not sure that would necessarily be helpful, but on the other hand some people think it might be.”
In a way, the proposal for disclosing auditor tenure may be a kind of consolation prize for those who had pushed for the PCAOB to require mandatory audit firm rotation. The chances of the PCAOB imposing mandatory firm rotation are looking shakier these days, especially after the House of Representatives voted overwhelmingly last month on a bill prohibiting the board from forcing public companies to rotate their auditing firms (see House Approves Bill Banning Mandatory Audit Firm Rotation). “Long tenure means different things to different people,” said Plichta. “There’s kind of a spectrum of what a long tenure is. Is anything over 10 years a long tenure? Is it 20 years? Is it 100 years? Companies and their auditors fall under various places along that spectrum.”
Plichta is also not sure about the idea of requiring auditor reports to include a disclosure on independence. “That’s just stating something factual that is already out there,” he said. “I don’t think it’s going to change any practices.”
He also has his reservations about the “other information” disclosures. “The requirements now say the auditor must read and evaluate the other financial information in the annual report,” said Plichta. “Going beyond that, the standard has specific procedures and processes that the auditor should undertake to define what the evaluation is and then disclose if they find discrepancies that aren’t resolved. Currently for most audits that I see and auditors that I deal with, they’re already doing those types of procedures, and if they find discrepancies they wouldn’t allow an audit report to be issued in an annual report that had those kinds of discrepancies. For most companies, I don’t think that would help the investors because it’s really just codifying what’s already being done. I wouldn’t expect that anyone is going to be disclosing unreconciled differences, or there would be any unreconciled differences, because the auditor just wouldn’t allow that.”
Plichta wasn’t surprised to see the PCAOB dropping the idea of including an auditor’s discussion and analysis in the proposal. “That was very controversial and it was dropped,” he said. “It would have changed the responsibilities for reporting in a large way. Instead of management and the company being the primary source of information, and the auditors blessing it, it would have been a situation where the auditor becomes another primary source of information and they’re making their own disclosures. There also would have been a great deal of tension between the auditors and the company and management and the audit committee, to make sure that there’s consistency of message, and then you run into a situation where there are concerns that you might usurp the authority of the audit committee by effectively giving that authority to the auditors. That was one of the concerns. It was dropped and it is no longer an issue on the table.”
Opining on GAAP Compliance
Trevor Harris, a professor at Columbia Business School who teaches about accounting and finance, does not believe the proposal will be helpful for many investors. “I think the intention is fine, but the result will be of little use to investors,” he said. “There are two different proposals in a sense. The first is to talk about critical audit issues in the context of the audit report. The primary problem in my mind is that as long as the focus of the audit is compliance with U.S. GAAP, they’re not going to provide the incremental information about what’s really going on in the business. I view auditors as potentially having significant insight as to what’s going on in the business, at least in principle, and what we have seen is the profession converging to more of a statutory role in terms of the compliance with whatever the accounting principles or practices are. If all they’re doing is opining on that, they’re not going to actually address the specific issues. I think the unintended consequence is that there may be less dialogue between the auditors and the companies because of some concern that it would raise questions about whether they should have put something into the report.”
Harris pointed out that auditors can have discussions with their client that can be very informative, but then they would need to get into a debate about what to disclose or not disclose, with an eye toward the regulators. “I think the profession has become somewhat gunshy about the lookback of regulators who are looking for all sorts of compliance checks on the audit itself, and so the focus becomes ‘have I complied, have I complied?’ Is this really reflecting the information about the business? I think the intent is fine, but I think that the fundamentals have to be changed if they really want to make the audit report more meaningful,” he said. “The change that should happen is that they should get rid of the words ‘in compliance with Generally Accepted Accounting Principles.’ If they just said it was ‘a fair presentation of the financial position and performance of the business,’ and the auditors had to opine on that, we would have a much more interesting profession, we would attract better people in the profession, and investors would get more of the real information that they’re looking for.”