Earlier this month, after seven years of threats, the PCAOB adopted rules to drastically change the standard auditor’s report. In adopting the rules, the PCAOB noted that the standard auditor’s report had largely remained unchanged since the 1940s. I believe there was good reason for this: the current auditor’s report works well (or at least well enough). It is simple and, therefore, easy to interpret. Either a company receives an unqualified opinion or it doesn’t. The current report is generally referred to as a pass/fail model. But, the simple and straightforward approach is about to change.
Enter the CAMs
The PCAOB has introduced a new acronym for us to learn, CAM, which stands for Critical Audit Matter. Under the new rules, a CAM is any matter communicated or required to be communicated to the audit committee that: (i) relates to material accounts or disclosures that are material to the financial statements and (ii) involves especially challenging, subjective, or complex auditor judgment. Each and every CAM, as determined by an issuer’s auditor, will then be identified and described in the audit report and the auditor will explain how the CAMs were addressed in the audit. Simple enough, right? Don’t worry, if you are confused – the rules contain a flow chart!
The whole idea behind the CAMs concept is that it is designed to reduce the information asymmetry that exists between investors and auditors. The PCAOB is concerned that investors are unable to adequately assess the risk that underlies the estimates and judgments made by management in preparing the financial statements. That’s probably a fair assessment, but changing the auditor’s report won’t address information asymmetry. And here’s why:
First, critical audit matters are already identified in the MD&A and the financial statements. The PCAOB claims that the auditor should not be limited to discussing the estimates that management discloses. While that may be a good point, most sophisticated users of financial statements should be able to identify the significant estimates an issuer would make. Generally, these estimates are consistent from company to company based on their industry. Is it a revelation that a commercial bank’s most significant estimate is its allowance for loan losses? Or that the valuation of inventory would be important to an issuer with a large inventory balance (especially if the inventory can quickly become obsolete)?
Second, the PCAOB notes that if there aren’t any identified CAMs then the auditor will need to state that fact. What’s the likelihood that any of the larger accounting firms will go on record to state that there was very little judgment used in compiling a set of financial statements? I think the likelihood is next to zero. Also, what is the likelihood that each auditor will craft a custom disclosure each year for each client on each CAM? I would imagine that issuers will hope that answer is also zero, as the increased cost of the CAMs preparation will be passed on to the client. More likely, each firm will have its standard “Goodwill CAM”, “Pension CAM,” “Revenue Recognition CAM,” and so forth. As I argued in 2013, CAMs will become boilerplate disclosure intended to protect an auditor, will increase audit fees, and will not reduce the information asymmetry.
New risks facing issuers as a result of CAMs
CAMs cause at least a couple of new risks for issuers and auditors alike. The first risk is that an auditor will potentially be the original source of information regarding the issuer and may “force” the issuer to disclose information, possibly in its financial statements, that it otherwise would not disclose. For example, if an auditor expects to report a CAM on a matter that would not have otherwise been discussed by the issuer, the issuer will likely want to revise its disclosure to include a discussion of the matter in question. In other words, it may call into question the traditional notion that financial statements are prepared by the company rather than the auditor and thus may eviscerate the authority and discretion of management and the audit committee regarding disclosure. This also strengthens the hand of the auditor and may cause friction between an auditor and the issuer. While some may argue that strengthening the position of the auditor may be a good thing, I would argue that having disclosure dictated by an outsider rather than the issuer itself will lead to poor disclosure. The PCAOB gave short shrift to the concern by remarking that an “auditor is not expected to provide original information unless it is necessary…”
The second risk is that the presence (or absence) of CAMs fundamentally changes the pass/fail model of the audit report. If an issuer has more than a “normal” number of CAMs, then is that a good thing or a bad thing? Does an issuer with one CAM essentially receive a grade of “A” while an issuer with five CAMs receives a grade of “C”? The new standard audit report attempts to address that concern by containing a disclaimer that disputes any notion that the CAMs discussion alters in any way the opinion on the financial statements. But it’s anyone’s guess whether users of the financial statements (the same users who couldn’t assess the CAMs for themselves) will understand the importance or lack of importance of the existence of a CAM. Unfortunately, the PCAOB seems willing to just see how it pans out rather than actually addressing the issue upfront.
Long Termism: If you have been around awhile, we should assume you are not objective
The new auditor’s report will also need to disclose the year in which the auditor first started serving consecutively as the issuer’s auditor. This is a clearly less controversial than the mandatory audit firm rotation concept release issued in 2011. As I complained in 2011, mandatory audit firm rotation is just a bad idea. Audit firms, while certainly far from perfect, already do a pretty good job in maintaining quality control over their audits. Mandatory audit partner rotation, second partner review, PCAOB inspections, as well as the audit firms’ fear of reputation and/or monetary loss though litigation, restated financial statements, and Department of Justice proceedings are sufficient to maintain audit firms’ objectivity.
Fortunately, mandatory audit firm rotation met its demise in 2014 when the PCAOB encountered stiff resistance from Congress and the business community. But that hasn’t stopped the PCAOB from proposing the requirement to disclose audit tenure. By requiring audit tenure to be disclosed it implies that there is significance to the disclosure. And, really, the only implication that can follow is that a long-tenured auditor must be too cozy with its client and, therefore, not objective. In fact, that is exactly the concern PCAOB Member Jeanette M. Franzel, expressed as she voted to adopt the new rules. She further noted that there is insufficient evidence to draw that conclusion, but she would “encourage academic research about the impact and usefulness” of the disclosure. That, of course, is remarkable. To paraphrase: let’s adopt a rule that we don’t know what the impact will be (but it may be bad) and figure it all out later!
Issuers should be concerned that the increased availability of their auditor’s tenure will pressure an audit committee to make a change for change’s sake. Proxy advisory firms such as ISS and certain institutional investors may develop policies that will implement a de facto audit firm rotation policy. In the end, it’s the owners of companies that get hurt through increased audit cost and the higher likelihood of a failed audit.
When does this all become effective?
There is still hope – the rules can’t go into effect unless the rules are approved by the SEC, so maybe never. But, I wouldn’t hold your breath on that happening. Assuming the rules are adopted by the SEC, all provisions other than CAMs would go into effect for audits for fiscal years ending on or after December 15, 2017. CAMs would be included in audit reports for large accelerated filers for audits for fiscal years ending on or after June 30, 2019 and for all other filers for audits for fiscal years ending on or after December 15, 2020.
Some lucky companies won’t be subject to the new CAMs disclosure. The new standard won’t apply to audits of broker-dealers, investment companies other than business development companies, employee stock purchase, savings, and similar employee benefit plans, and emerging growth companies.