Thursday, March 17, 2011

PCAOB Investor Advisory Group Calls for Expanded Disclosure in Audit Report

The audit report on corporate financial statements is essentially a binary boilerplate document that leaves investors with too little information with which to make an informed investment decision. The status quo on audit reports is no longer either appropriate or sustainable. This was the conclusion of a report delivered at a recent meeting by a working group of the PCAOB’s Investor Advisory Group. The report found that investors want more information on, among other things, risks, unusual transactions, and the company’s accounting policies. IAG member Norman Harrison, Managing Director of Breeden Capital Management, noted a sentiment in the investment community that calling it an audit report glorifies the document when it is often no more than a transmittal letter. The IAG urged the PCAOB to methodically and aggressively examine the issues raised in the report.

PCAOB Chairman James Doty noted that investors clearly want more from the audit report. Moreover, embedded in the call for more information from the auditor is a call for auditors to better serve investors. In his view, most auditors do not see investors as their direct or even ultimate masters, unless they are dealing with a private investor, such as to conduct due diligence for a potential acquisition.
The IAG report found that investors also want the audit report to disclose more on quantitative and qualitative materiality thresholds. They also want more information on the work performed by other audit firms, both foreign and domestic, including non-US affiliates of the principal auditor. Auditors should also discuss significant estimates and judgments made by management, the auditor’s assessment of their accuracy, and how the auditor arrived at that assessment.

Similarly, the audit report should discuss the quality of the accounting policies employed by the company. The results of sensitivity analysis in significant areas of judgment should also be disclosed. The report should also disclose unusual transactions, restatements, significant changes in segment reporting and in the consolidation of entities. Investors also desire the auditor to disclose the key issues discussed in the summary audit memorandum and how those issues were resolved by the auditor.

The report found that investors want more risk disclosure. This is intuitive, noted Mr. Harrison, since risk is critical to investor decision making. If the auditor found a greater level of risk, he added, investors want to know that.

On the issue of an auditor’s fraud detection duties, investors believe that the audit report should state that the auditor has obtained reasonable assurance as to whether the financial statements contain a material misstatement. Investors also believe that there should be a separate Auditor’s Discussion & Analysis section in the Form 10-K, which should include a narrative summary of issues communicated to the company’s audit committee.

After thanking the IAG for its efforts, Chairman Doty said that he believes more information can be included in the audit report without enhancing auditor liability. Joseph Carcello, University of Tennessee Ernst & Young Professor of Accounting, said that it was not the intention of the IAG that including more and better information in the audit report would increase auditor liability.

PCAOB Member Lewis Ferguson noted that one advantage of the binary audit report in which a qualified opinion is or is not given is that it is easy to compose, while an analytical report would be more difficult to compose. Professor Carcello suggested keeping the binary report and adding an additional discussion and analysis section.

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