Don't Be an Audit Model Cynic

by Edith Orenstein

Traditionally, the independent audit is looked by many as being primarily a 'cost' of doing business.

© StudioM1/istock/thinkstock

The benefits accrue mainly to investors, shareholders, owners or other users of the company's financial statements who desire a "Good Housekeeping Seal" in the form of the work performed by an independent audit firm.

Others are aware of the benefits auditors bring, indirectly, to management and the company board by their expert knowledge, training and very independence.

I would encourage both camps, including those who lean toward the more cynical side, to take full advantage of the fact that the PCAOB recently extended the comment deadline on its far-reaching proposal on the "Auditor's Reporting Model". I would strongly suggest that financial executives review the PCAOB's proposal, with the full benefit now of the panelist statements now available (as well as the archived webcast and full transcript of Day 1, full transcript of day 2) from the PCAOB's public roundtable held earlier this month on this very proposal. Reading the panelists' statements and/or viewing the archived webcast will give you a practical perspective on what the implications of the major areas of the PCAOB's proposal could be that will impact your auditors - and therefore - your audit, the cost of your audit, and the public disclosures made by your auditors and potentially related disclosures that your company's management will make as you consider the impact of any new auditor disclosures.

The PCAOB's proposal would, among other things, require:

  1. CAMs (Critical Audit Matters) to be identified by the auditor, and reported on by the auditor, in the Auditor's Report (NOTE: a similar proposal issued by the International Auditing and Assurance Standards Board (IAASB) in July, 2013 proposes disclosure by the Auditor of KAMs (Key Audit Matters), and
  2. Read and "evaluate" "other information" that is contained in documents that include the audited financial statements and the related auditor's report. (NOTE: The term "evaluate" would be an enhancement vs. the current term in auditing standards which is: read and "understand" such other information.) The IAASB issued a separate proposal last year pertaining to the auditor's responsibilties for "other information."

Why Should Preparers Care about Auditing Standards?

Some readers may assume that the world of financial accounting and reporting divides neatly into two hemispheres. The first are the company controllers, CFOs, Directors of Accounting Policy, VPs of External Reporting and such following the FASB and IASB and directing their comment letters only at FASB, IASB or other National accounting standard setting organizations (and with public companies following SEC rulemaking as well). The second are the audit firms directing their attention to the SEC and PCAOB, IAASB and other national auditing standards organizations.

But the world does not divide as neatly as that, and preparers need to be aware of the more significant auditing standards and proposed changes to those standards. Auditors work in those areas and related disclosures can have a major impact on the conduct of the audit, the related cost and hours, and related public disclosures made by the auditor and potentially by company management as well.

In testimony before the PCAOB roundtable, Prof. Arnold Schilder, chairman of the International Auditing and Assurance Standards Board (IAASB), noted pertinent comments of the preparer community on the his global organization's proposed KAMs (similar to the PCAOB's proposed CAMs) when he told the PCAOB's April roundtable:

Preparers and others who do not support the concept of KAM often cite concerns with the auditor providing “original information” – that is, information that is not otherwise required to be disclosed in the financial statements. And auditors have asked for more guidance on how to deal with circumstances that might result in the auditor communicating about sensitive matters. The Board is exploring how to find an appropriate balance between auditors providing useful information about the most significant matters in the audit that was performed, while at the same time respecting the important concepts of client confidentiality, as addressed in the auditor’s relevant ethical code or requirements, and law and regulation.

The information required by the PCAOB's proposal is currently generated by the major audit firms, according to former SEC Chief Accountant Lynn E. Turner, who told the roundtable (emphasis added),

...I believe that important information useful to investors is most often contained in what is commonly called “Critical Audit Matters” (CAMS) or “Matters for the Attention of the Partner” (“MAPS”). For as long as I have been associated with the auditing profession, significant issues that arise during the planning and/or fieldwork, and their resolution, have been documented in a summary memo that is typically signed by the audit partner, the concurring partner, manager and perhaps even the senior in charge of fieldwork. These summary memos’, which are almost always produced during discovery when litigation occurs, are well reasoned and thoughtfully constructed in a quality audit. Their purpose is to integrate key audit strategy decisions, the execution of that strategy by the audit team, and completion of the audit, all into one summary memo for consideration by the partner and other members of the audit team. I believe it will take small amounts of time and effort to turn the CAMs into disclosure in an SEC filing.

Nick Land, Chairman of the Audit and Assurance Council of the U.K.'s Financial Reporting Council (FRC) in testimony at the PCAOB's April roundtable, described how the U.K. FRC originally wanted to have auditors disclose certain information arising from its proposal directly to the audit committee, and review the information disclosed by the audit committee under the U.K.'s recently amended corporate governance code;  then if the auditor was not satisfied with the audit committee's disclosures to the public, the auditor could make additional disclosures as a result.

However, Land added,

In making the above changes the FRC considered that audit committees may be reluctant to describe matters concerning the conduct of the audit in their report. The FRC, therefore, amended the auditor reporting standard to require the auditor’s report to:

  • Describe those assessed risks of material misstatement that were identified by the auditor and which had the greatest effect on the overall audit strategy; the allocation of resources in the audit; and directing the efforts of the engagement team.
  • Provide an explanation of how the auditor applied the concept of materiality in planning and performing the audit; and
  • Provide a summary of the audit scope, including an explanation of how the scope was responsive to the assessed risks of material misstatement and the auditor’s application of the concept of materiality, as disclosed in the auditor’s report.

Land continued,

"The above requirements are set at a high level. The only prescriptive requirement is that the discussion of materiality must specify the threshold used by the auditor as being materiality for the financial statements as a whole."

My two-cents: The U.K. FRC approach described by Land, above, excerpted from his testimony at the PCAOB's April roundtable appears to be one way to devise a 'principles-based' approach to disclosure by the auditor.

 Proposals of the PCAOB, FRC and IAASB, Commonalities/Convergence?

Aside from the fact that one could make a nice rhyme, if one had the time, out of PCAOB, FRC and I - double - A - S - B, will their proposals ultimately converge? Have you commented on some/all of them? Have we convinced you to at least consider commenting on the PCAOB's proposal by their May 2 comment deadline? (See comment letters previously filed, including the comment letter filed by FEI’s Committee on Corporate Reporting (CCR) on Dec. 11, 2013.  Some of the highlights in CCR’s letter include (reformatted to bullets for emphasis):
  •  CCR believes that the proposals in the Release have the potential to produce profound changes in the conduct and effectiveness of the audit
  •  We do not agree with the PCAOB’s proposal for auditors to provide disclosures of Critical Audit Matters (“CAMs”).
  • …, we believe that the change in terminology [related to the auditor’s responsibilities for “other information”] from consider to evaluate could, in practice, lead to significant additional work.
  •  CCR believes that this level of assurance [with respect to ‘other information’] is different and higher than what is provided today under the requirement to read and consider. We are concerned this level of assurance will, of necessity, expand the scope of audit work performed and potentially lead to many challenging situations for the auditor, particularly with regard to qualitative statements and non-financial information.
  • We do not believe information related to the tenure of the auditor contributes to [an investor’s understanding of the audit scope and process] and is more suitably placed in the proxy statement, as it is more directly relevant to investor decisions on whether the independent auditor should be reappointed.

May 8 Event in London Sponsored by FEI and the CAQ on The Auditor's Reporting Model

Readers are invited to attend (and please forward this to a friend who may wish to attend) an event being sponsored by FEI and the Center for Audit Quality at the Park Lane Hotel in London on May 8, 2014 entitled, "Enhancing the Auditor's Reporting Model: What Can We Expect?"  Please forward this column to colleagues who you believe may be interested in attending the event. Featured speakers include Gary Kabureck, Board Member, IASB, Marie Hollein President and CEO, FEI, and Cindy Fornelli, Executive Director, The CAQ.