Wednesday, October 25, 2017

Commission approves PCAOB’s revised audit report standards, CAMs

By Mark S. Nelson, J.D.

The Commission approved a set of changes proposed by the Public Company Accounting Oversight Board to make the auditor’s report more accessible to investors and other consumers of firms’ financial statements. The amended PCAOB standards replace some existing provisions and create new ones, while also explaining their application to emerging growth companies. Portions of the new standards unrelated to critical audit matters (CAMs) would be effective for companies with fiscal years ending December 15, 2017. Implementation of provisions dealing with CAMs would be phased: large accelerated filers with fiscal years ending June 30, 2019; all other companies with fiscal years ending December 15, 2020.

CAMs. Under the new standards, the auditor’s report would have to either communicate any CAMs in the current period audit or state that there were no CAMs. An item is a CAM if it arose from an audit of a company’s financials and was communicated (or was required to be communicated) to the company’s audit committee and the item is material and involves subject matter that is “especially challenging” to document. Auditors would use their judgement about CAMs, but in conjunction with other factors which require an auditor to explain “why” and “how” something became a CAM.

The revised standards also require disclosure of the year in which an auditor began consecutively working for a company. Auditors must include a statement that they are subject to the requirements about independence. The audit report also must be addressed to a company’s shareholders and directors.

SEC Chairman Jay Clayton said he “strongly support[s]” the goals of the PCAOB’s new standards, but he also warned of the potential for boilerplate communications and litigation. “I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships—with Main Street investors ending up in a worse position than they were before,” said Clayton.

Commissioner Kara Stein emphasized the benefits to investors. “The new auditor’s report should provide investors with more meaningful information about the audit, including significant estimates and judgments, significant unusual transactions, and other areas of risk at a company,” said Stein. Commissioner Michael Piwowar praised the SEC staff for its work in completing the approval, but also observed that “[i]t is of the utmost importance that such communications be well tailored and effective.”

Public comments. During the approval process, the Commission received 50 comment letters in which investors and large accounting firms generally supported the PCAOB’s proposal, although with some reservations. Those who opposed the CAM proposal said auditors could become a source of original information about a company and they worried about potential litigation.

The PCAOB’s re-proposal had addressed some of these concerns by weaving materiality into the CAMs, narrowing the definition of a CAM, and pledging to monitor developments as the CAMs requirement is implemented. The Commission agreed with the PCAOB that state legal and professional obligations should not prevent the communication of CAMs with respect to comments that raised possible conflicts between an auditor’s need to occasionally provide original information and state laws on auditors’ confidentiality obligations.

The Commission also agreed with the PCAOB that auditor-audit committee communications would not be chilled by CAMs because existing standards make it unlikely that an item could be a CAM yet not have to be communicated to the audit committee. Moreover, the Commission said the benefits of the CAMs were sufficient to take on the risk of increased litigation; the Commission also noted that CAMs might be used equally to commence or defend against litigation.

Emerging growth companies. The Commission’s approval would require that all of the proposed changes, except for the CAM requirements, apply to emerging growth companies (EGCs). In some instances, the proposed changes fall outside the scope of changes to the Sarbanes-Oxley Act made by the Jumpstart Our Business Startups (JOBS) Act regarding EGCs, but in other instances the changes do fall within the JOBS Act provisions and the Commission determined that the new standards should apply to EGCs. The Commission emphasized ease of use of the auditor’s report as one reason for extending these provisions to EGCs, while also noting that the cost to implement the changes should be a comparatively small, one-time expense for EGCs.

Likewise, the communication of CAMs in an audit report would not be required for some other types of entities. For one, broker-dealers who report under Exchange Act Rule 17a-5 are not subject to the requirement, except to the extent they may be issuers. Moreover, the communication of CAMs would not be required for investment companies that are not business development companies, nor would the CAMs requirement apply to employee savings plans.

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