I don’t know very much about the federal budget process, but I do know that any budget proposed by the White House – regardless of its occupant – isn’t worth spending time on, and that by the time the budget is passed, it often looks
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 …
Continue Reading The CAMs are coming and other enlightened enhancements courtesy of the PCAOB
Over the years, the PCAOB has developed a reputation for pursuing zombie proposals – proposals that appear to be dead due to widespread opposition and even congressional action. Remember mandatory auditor rotation? It practically took a stake through the heart to kill that one off, and I’m informed that even after it was presumed to be long gone some PCAOB spokespersons were telling European regulators that it might yet be adopted.
Well, here we go again. The latest zombie proposal (OK, reproposal) would modify the standard audit report in a number of respects, the most significant of which would be to require disclosure of “critical audit matters”. The headline of the PCAOB’s announcement of the reproposal says that it would “enhance” the auditor’s report; not clarify, just “enhance”. And, as is customary whenever the PCAOB proposes to change the fundamental nature of the audit report, the proposal starts out by sayng that’s not the intention at all: “The reproposal would retain the pass/fail model of the existing auditor’s report,” it says. It seems to me to lead to the opposite result – the introduction of critical audit matter (“CAM”) disclosure could easily lead to qualitative audit reports; one CAM would be viewed as a “high pass”, two would be ranked as a medium pass, and so on, possibly even resulting in numerical “grades” based upon the number of CAMs in the audit report. And let’s not fool ourselves into thinking that any audit firm would ever issue a clean – i.e., CAM-free – opinion. I just can’t envision that happening, ever.
For those who think nothing ever gets done in Washington, last week must have been a challenge. From outward appearances, both the SEC and the PCAOB seem to be working overtime, possibly in order to ruin our holiday weekend or at least lay some guilt on us for not spending the weekend reading what they’ve put out.
First, on July 1 the SEC published rule proposals on the last of the so-called Dodd-Frank “four horsemen” (or, as the SEC Staffers called them, the “Gang of Four”) compensation and governance provisions – specifically, clawbacks. It’s too soon for even nerds like me to have gone over the proposed rules in any detail, but at first blush they disappoint in a few respects. Among other things, they appear to call for mandatory recoupment of performance-based compensation whenever the financials are restated, without regard to fault or misconduct; even a “mere” mistake will trigger the clawback. Moreover, neither the board, nor the audit committee, nor the compensation committee will have any discretion or any ability to consider mitigating circumstances. Last (for now), they do not seem to provide any exemptions or relief for small companies, emerging growth companies or the like. Interestingly, equity awards that are solely time-vested will not be considered performance-based compensation for purposes of the proposed rules. Of course, these are only proposed rules, and they will eventually take the form of exchange listing standards rather than SEC rules, but the basic approach is absolute and draconian, and it’s difficult to envision them changing very much.
The SEC has approved new PCAOB auditing standards relating to related party transactions, significant unusual transactions, and financial relationships and transactions between a company and its executives, including executive compensation. You can find the SEC’s release on the new standards here.
When the PCAOB first proposed these standards, a number of us were concerned…
The PCAOB’s recently proposed auditing standards aim to “provide investors and other financial statement users with potentially valuable information that investors have expressed interest in receiving but have not had access to in the past” by changing the standard auditor’s report and increasing the auditor’s responsibilities. Sounds like a lofty goal, except that the information that they are proposing to require auditors to provide is either (i) self-evident; (ii) an infringement on the judgment of the issuer’s audit committee; or (iii) just plain not helpful. What the proposed auditing standards do accomplish, however, is to add more costs to being a public company just like their last proposal on mandatory auditor rotation.
Critical Audit Matters. Under the proposed auditing standards, an auditor will be required to include a discussion in its auditor’s report about the issuer’s “critical audit matters.” Difficult, subjective, or complex judgments, items that posed the most difficulty in obtaining sufficient evidence, and items that posed the most difficulty in forming the opinion on the financial statements are deemed to be “critical audit matters.” While this requirement may seem straightforward at first, the reality is that this “new” information should be self-evident by anyone who knows how to read a financial statement. Revenue recognition, estimates for allowances, pension assumptions, etc. are typically deemed to be “critical audit matters” by an auditor when planning audit procedures. These critical accounting policies are already discussed in issuers’ MD&A and in their financial statements. Further, any investor who actually is looking at the fundamentals of an issuer’s business and historical results should already be highly focused on estimates that, if wrong, could materially impact the financial statements. Auditors will end up being overly inclusive on what is deemed “critical” for fear of having …
Continue Reading PCAOB proposal piling on more costs for public companies (again)
On August 16, 2011, the PCAOB issued a concept release seeking comments on ways that auditor independence, objectivity, and professional skepticism could be enhanced. While the PCAOB seeks advice on any approach, the concept is focused on mandatory audit firm rotation. Consequently, the release could lead to companies having to change their auditors every few…