Critical audit matters: weighing the benefits

The PCAOB’s latest proposal to require auditors to disclose more information in their annual reviews of corporate financial results has run into a wall of opposition from corporate finance executives and the audit profession. Even investors think the proposal to require enhanced audit reports has significant room for improvement.

Based on comment letters the PCAOB had received as of December 11, 2013, when the comment period closed, CFOs and other critics contend that the idea of requiring auditors to issue more than an effective pass/fail grade to companies’ results exceeds auditors’ responsibilities and will add significantly to audit costs without providing much benefit to investors. In fact, critics warn the additional information will lead to confusion. For their part, many investors think the idea as currently formulated will yield little worthwhile information and may simply make for lengthier reports.

‘We are concerned the new procedures necessary to comply with the proposed requirements have the potential to be a significant distraction from the primary focus on the audit, and consume valuable time and resources during the most critical phases,’ writes Stephen Cosgrove, corporate controller of Johnson & Johnson and chairman of Financial Executives International’s corporate reporting committee, in a comment letter to the PCAOB.

The most controversial part of the proposal calls for auditors to describe what the PCAOB calls ‘critical audit matters (CAMs)’. These refer to the issues involving a company’s results that the auditors have the most difficulty coming to terms with – or, as Jack Ciesielski, an investment adviser who publishes the Analyst’s Accounting Observer blog, puts it in a recent report, the ‘audit matters that keep them awake at night.’

An unpopular proposal

Indeed, the proposal for requiring auditors to publish CAMs is uniformly panned by CFOs and other preparers of financial statements. A letter to the PCAOB from the Institute for Management Accountants complains that the process for determining CAMs would require extensive negotiations between corporate managers and auditors. ‘It’s hard to understand how this can possibly be a productive use of senior audit executive time at the critical audit closing juncture,’ write the authors. Many comments from individual finance officers say much the same thing.

Some of the critics complain that the proposal would usurp the role of corporate audit committees. ‘The proposal seems to disregard the importance we place on [audit committee] reviews,’ complains Robert McCullough, audit committee chairman of Acuity Brands, in that company’s letter to the board.

‘We strongly believe our financial statements and related disclosures are solely the responsibility of management,’ adds Richard Reece, Acuity’s CFO.

By contrast, financial statement users, including investors such as BlackRock and credit analysts at Standard & Poor’s, point out that they would find a discussion of CAMs useful.

‘We will benefit from information beyond the assurance currently provided by the pass-fail auditor’s opinion,’ writes Standard & Poor’s, adding that expanded disclosure about CAMs will ‘enhance audit discipline’. BlackRock managing director Steven Buller notes that the company’s analysts would value disclosures surrounding ‘changes in principles’ or ‘areas involving significant judgment’ so they could be properly understood and incorporated into analyst models.

Voices of dissent

Even so, certain of these supporters have concerns. Buller, for instance, is worried the additional information such disclosures require might ‘overwhelm’ the report and give investors the impression the auditor’s approval of a company’s results is ‘piecemeal’. He recommends the PCAOB should stipulate that such disclosures be ‘infrequent’.

Still others worry the disclosures will be so formulaic as to amount to meaningless ‘boilerplate’. Rather than curtail such disclosures, however, they think the PCAOB should take the proposal further, if only to spell out what it thinks auditors should focus on.

Brandon Rees, acting director of the AFL-CIO’s office of investment, recommends that the auditor’s report be expanded to include a discussion of the auditor’s assessment of the estimates and judgments made by management in preparing the financial statements, and how the auditor arrived at the assessment; a discussion of areas of high financial statement and audit risk, and how the auditor addresses those risks; a discussion of unusual transactions (including those around the end of a quarter), restatements and other significant changes in the financial statements; and a discussion of the quality, not just the acceptability, of a company’s accounting practices and policies.

Even a supporter like Ciesielski concedes there’s a risk such disclosures will turn into a ‘telephone book’, as he puts it. But he observes in his report that the disclosure of CAMs would be very valuable to investors, as it ‘captures precisely the kind of insider insight that auditors should possess, and brings it into the open for investors.’ Still, he concedes in a comment letter that auditors will have to learn how to write differently, and the PCAOB will have to learn how to regulate differently, to make CAM disclosures work.

Cost-benefit analysis

The question for the PCAOB, as it decides whether to go ahead with, revise or jettison the rule, may ultimately come down to whether the benefits to investors outweigh the confusion over how to measure the new disclosures and the costs that preparers will have to pay to provide them. While many of the critics said the costs would be onerous, none ventured to quantify them – nor, for that matter, have any of the supporters quantified the benefits.

Ciesielski’s report estimates that the costs would be minimal. According to his analysis, the Big Four accounting firms could add another $2.4 billion to fees they charge companies in the S&P 500 before the fees would subtract more than a penny from S&P 500 firms’ average earnings per share. As Ciesielski put it, the added costs may not only be ‘tolerable’ by investors, they may not even be ‘noticeable’.

Ciesielski explains that the proposal doesn’t require auditors to do any audit work they don’t already do, though he concedes that ‘the auditor is expected to say more in the report, which means a foundation has to be built in order to support their statements – and that will lead to increased file-stuffing and memo-writing, at the very least.’

But Ciesielski’s study suggests the real reason auditors oppose the idea of CAM disclosure may be the difficult position it puts them in. ‘Presentation of CAMs could cast clients – who pay the auditor – in an unflattering light, and arouse short-selling activity as an unintended result of the auditor’s actions,’ Ciesielski writes. At the same time, he notes, ‘If they merely state there are no critical audit matters, or present safe, uninformative CAMs year after year, the auditor runs the risk of PCAOB admonishment.’