Is it Time to Expand the Auditor's Report?
The auditor’s report is the primary way an external auditor communicates to investors and other users of financial statement information. For the first time in decades, the Public Company Accounting Oversight Board (PCAOB) wants to move beyond the pass-fail format of this report.
Investors call the proposal one of the most important and useful changes the PCAOB can implement. But it’s unpopular among external auditors, managers and audit committee members, who worry that any changes could result in confusion and blur the lines regarding the roles of auditors, financial statement preparers and audit committees.
A closer look at the auditor’s report
Typically appearing as a four-paragraph cover letter to the company’s audited financial statements, the standard auditor’s report serves three main purposes:
- To identify the financial statements that were audited,
- To describe the nature of the audit, and
- To present the auditor’s opinion as to whether the financial statements “present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in conformity with the applicable financial reporting framework.”
It’s commonly described as a pass-fail model because the auditor decides on whether the financial statements are fairly presented (pass) or not (fail).
Investors call for change
The PCAOB started the project to expand the audit report about four years ago, after investors complained that the report’s pass-fail model is of little use. Investors told the board that they wanted to know more about what auditors thought when they scrutinized a company’s financial statements. Through the audit process, external auditors gain extensive knowledge of the company and its industry. Moreover, they’re independent third parties who bring a fresh perspective to the financial reporting process.
Investors cite the recent financial crisis as an example of a situation in which expanded auditor reporting, such as a discussion of off-balance sheet contingencies or the sensitivity of loan loss estimates, might have provided early warning signals of potential issues.
PCAOB issues proposal
In August 2013, the PCAOB issued Release No. 2013-005, Proposed Auditing Standards on the Auditor’s Report and the Auditor’s Responsibilities Regarding Other Information and Related Amendments. Under the proposal, the auditor’s report would retain the pass-fail model. But it would also ask auditors to communicate what they determined to be critical audit matters (CAMs), which are the most difficult, subjective and complex issues that arose during the audit.
In many ways, the CAM requirements are similar to the Securities and Exchange Commission’s (SEC’s) requirements for the management’s discussion and analysis section of quarterly and annual reports. For many companies, the introduction of this section has become a valuable resource for investors — and it has improved the relationship between management and investors at many companies. The PCAOB hopes its expanded auditor’s report will someday achieve similar results.
Some investors want to expand the auditor’s report beyond CAMs, however. One idea that’s gaining support among investors is to require the auditor’s report to describe significant accounting judgments and estimates made by management. These descriptions would include subjective assessments, such as the degree of aggressiveness or conservatism of management’s estimates and whether the related reported amounts appear “reasonable.”
Managers and auditors resistant
Public companies and auditors have been resisting the PCAOB’s plan to expand the auditor’s report, in part because they worry that the proposed changes may cause auditors to reveal matters the company hasn’t disclosed, which is not the job of auditors but of management. They believe such a fundamental shift in regulatory reporting could result in negative consequences.
For example, disclosures could include confidential or privileged information, material that would be harmful or detrimental to the company’s operations, and information the SEC’s reporting requirements don’t address. They could also result in perceived weaknesses in the auditing process, management’s abilities or the effectiveness of the company’s internal control environment.
Work in progress
The PCAOB is currently considering how to proceed with its project to expand the auditor's report. A re-proposal is a probable next step. In the meantime, the PCAOB continues to solicit public comments on its current proposal. Stay tuned for more developments.