By Amanda Maine, J.D.
In a letter to the PCAOB responding to the Board’s request for comments on the initial impact of the communication of critical audit matters (CAMs), the Council of Institutional Investors (CII) said that CAM communications have improved the ability of investors to analyze companies’ financial statements and make financial decisions and have, in general, improved the quality of financial reporting. However, CII believes that auditors need to do a better job at explaining the outcome and key observations related to the CAMs that are described in the audit report.
CAMs. In 2017, the PCAOB adopted a new audit reporting standard requiring the communication of CAMs in the annual auditor’s report. CAMs are defined as matters that are communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment. The SEC approved the new standard in October 2017, and it became effective for effective for audits of large accelerated filers for fiscal years ending on or after June 30, 2019 (and December 15, 2020, for audits of other issuers).
In April 2020, the PCAOB issued a document soliciting comments from stakeholders on the implementation of CAMs. The questions were aimed at different categories of stakeholders, including investors, analysts, and other financial statement users. For these users, the PCAOB inquired how CAM communications have changed the ability to analyze companies’ financial statements, if they have affected interactions with management, and whether some CAMs have been more useful than others.
CII comments. In its letter, CII stated that it has reviewed more than 190 audit reports that contain CAMs. While CII cautioned that at this stage, it does not have the benefit of examining changes resulting from the new standard that will become more evident after a period of years of data collecting, it believes that there is “ample evidence” that the communication of CAMs has already benefited investors and the capital markets. These benefits include investors adding CAM reviews to their due diligence process when making investment decisions, gaining a better understanding of the quality of a company’s financial statements, and facilitating more constructive conversations with management, according to CII.
CAM communications have also improved investor understanding of management disclosures by providing a contextualized presentation of the issues underlying the CAMs in the auditor’s report, CII said. CII cited in particular disclosures involving critical accounting estimates (CAEs), which, while different from CAMs, can be informative for investors who compare both measures. CAMs can also help investors better understand the complexities of GAAP, making them more inclined to support opportunities to improve, simplify, and reduce the costs of financial reporting, CII explained.
CII stated that CAM communications have improved the quality of financial reporting generally. For example, CII cited a research paper indicating that disclosure of a tax-related CAM appears to eliminate the use of tax expense as an earning management tool, which can benefit investors by increasing scrutiny by both management and auditors of matters underlying the CAMs, CII advised. In addition, communication of CAMs has led to an improvement in internal control over financial reporting, according to CII, noting that a corporate survey found that 62 percent of audit committees have used CAMs to identify ICFR issues and to consider changes to improve their ICFR.
While its initial review of CAM disclosure indicates that the standard has improved audits and financial reporting, there is room for more improvement, CII noted. For example, as CII General Counsel Jeff Mahoney pointed out in his remarks at February’s SEC Investor Advisory Committee, auditors are failing to provide more information about the outcome of audit procedures and key observations, which is required as part of the standard. Those kinds of explanations are exactly the type of disclosures that investors wanted to know about during the development of the standard, CII reiterated. Without these critical auditor insights, the quality of the CAMs will continue to be “uneven,” according to CII.