Late last month, the SEC approved the new auditing standards adopted by the PCAOB back in June, which substantially modify the content of the auditor’s report. They also raise various concerns that public companies and the SEC will need to closely monitor going forward.
Critical audit matters disclosure.
By far the biggest and most controversial change to the old standards is the requirement that the auditors include in a separate section of their report “critical audit matters” applicable to the current period covered by the report. CAMs are defined as:
“any matter … that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective, or complex auditor judgment.”
The auditor must identify the CAM, describe the principal considerations that led the auditor to determine it was a CAM, describe how the CAM was addressed in the audit, and reference the accounts or disclosures related to the CAM. In the unlikely event that a report contains no CAMs, it must affirmatively so state.
Though the determination of a CAM is supposed to be principles-based, the new rules provide a nonexclusive list of factors for the auditor to consider in its determination. Even so, the standards emphasize that disclosure must be tailored to the particular company and audit, meaning that it should not be boilerplate.
Emerging growth companies and employee stock purchase plans, savings plans and similar plans are excluded from the CAM disclosure requirements.
The modified auditor’s report also must:
- State the year the auditor began serving as the company’s auditor,
- Provide an enhanced description of the auditor’s role, responsibilities and independence, and
- Satisfy certain format requirements designed to enhance readability.
All changes to the report except for communication of CAMs are effective for audits of fiscal years ending on or after December 15, 2017.
Communication of CAMs becomes effective for large accelerated filers for fiscal years ending on or after June 30, 2019, and, for all other companies, for fiscal years ending on or after December 15, 2020.
Auditors may, however, elect to comply with the new standards prior to the applicable effective date.
Things to watch for.
The SEC’s approval order and remarks by SEC Chairman Jay Clayton acknowledge a number of issues raised during the comment process:
- The new standards could “chill” communication among the company’s audit committee, management and the auditors. The SEC and PCAOB believe that it would be unusual for a matter to qualify as a CAM and not already be otherwise required by existing audit standards to be communicated to the audit committee, i.e., nothing has really changed regarding required communications. But given the subjectivity inherent in the CAM concept, as well as its newness, it seems somewhat naïve to think that audit committees and management won’t be prescreening communications with an eye toward whether and how it may appear in the audit report.
- A related concern is whether the CAM reporting obligations may result in the auditors unilaterally disclosing information not elsewhere disclosed by the company, meaning that the auditors could be in the position of making original disclosures. Again, the SEC and PCAOB believe that this is unlikely due to the materiality qualifier in the definition of a CAM. Nevertheless, one can envision tense conversations between the company and the auditors as auditors seek to comply with their new affirmative duty to report.
- It will be interesting to see if the CAM disclosures turn into a long “risk factor” style of disclosures where anything that might conceivably be deemed a CAM gets communicated to ensure that nothing is overlooked (thereby minimizing liability exposure). In this manner, CAM disclosure could quickly turn into meaningless boilerplate, which would substantially add to the company’s disclosure burden and cost without actually enhancing investor understanding.
- Speaking of liability exposure, it seems inevitable that the standards create a new category of disclosure risk that plaintiffs’ attorneys will be quick to exploit. While Chairman Clayton stated that he will be “disappointed” if the new standards result in “frivolous litigation costs,” I doubt that the threat if his disappointment will be much of a deterrent to plaintiffs.
Even though CAM disclosures are still about two years away for calendar-year-end large accelerated filers (and three years for other filers), it is not too soon to begin a dialogue around the types of matters expected to be CAMs in the future and how the auditor will engage with management to identify and describe CAMs in the report.
As I’ve said before, lawyers should:
- Be sure that the audit committee (a) is informed of the new standard, (b) is kept apprised of relevant discussions as they arise and (c) understands that all future communications with auditors may impact whether an issue is treated as a CAM and, therefore, may affect the company’s other public disclosures.
- Consider how CAM determinations and disclosures might impact such bigger picture issues as materiality analyses, MD&A disclosures and critical accounting policy disclosures.
- Inform the disclosure committee and other responsible personnel about this new development and its potential impact.
- Guard against CAM disclosure creep (similar to risk factor creep) as auditors include more and more disclosure over time to minimize liability risk.
- Understand how CAM disclosure processes will impact the timing of the audit and, therefore, the audit committee review, earnings release and SEC filing schedules.
- Anticipate increased audit costs related to CAM disclosures.
- If the company’s auditors have a long tenure, consider whether to include disclosure in the proxy statement (perhaps in the Audit Committee Report) describing the corresponding benefits to the company.