Investors Endorse Proposed Audit Report Expansion

Aug 15, 2013

Investors responded positively—albeit cautiously—to the PCAOB’s plan to expand the auditor’s report in public company regulatory filings.

The audit regulator says it wants to give investors more useful information about a company’s financial condition.

The audit report hasn’t changed substantially for more than 70 years and no longer meets the demands of investors who want more than what’s available in the current pass-fail model.

“We, therefore, applaud the PCAOB board and staff for issuing a proposal as a positive step forward to considering improvements to the usefulness of the standard form auditor’s report,” said Jeff Mahoney, general counsel for the Council of Institutional Investors.

Investors complained that the current report is of only modest utility and said they wanted to know more about what auditors thought in scrutinizing a company’s financials.  Some investors and public officials have also said that the 2008 financial crisis brought to light the shortcomings of the existing auditor report, because some companies were given clean audit reports just months or weeks before they failed or needed the government’s assistance to survive.

In response, the PCAOB initiated the revamp in June 2011 by publishing Concept Release No. 2011-003, Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards.

On August 13, 2013, the board issued a proposal in Release No. 2013-005, Proposed Auditing Standards on the Auditor’s Report and the Auditor’s Responsibilities Regarding Other Information and Related Amendments.

If the plan is adopted, auditors would be required to communicate what they determined to be critical audit matters, such as the issues they believed were the most difficult and complex during the audit, a main feature of the release.

The Board isn’t asking for what had been characterized as an auditor’s discussion and analysis and compared to the sometimes lengthy narratives in SEC filings.  Investors sought long and detailed narratives, but audit firms and companies resisted, arguing that it would create conflicts between auditors and their clients.

In their view, a more limited approach would be appropriate.

The proposed standard has a list of factors that will help auditors determine the matters that should be considered critical.  In the proposed audit report, auditors would first need to identify the critical matters and describe the consideration that went into determining how the matters where classified as critical.

The board wants the statements to be communicated clearly to investors, tailored to the audit, and avoid the use of boilerplate language.  If no critical matters arose during the review of the client’s financial report, an auditor would state that.

Joe Carcello, a professor of accounting at the University of Tennessee and a member of the PCAOB’s Investor Advisory Group, who’s been strongly pushing for a more useful audit report, said the proposal “didn’t go as far as I hoped it would.”

In his view, the board tried to strike a middle ground between what investors want and what companies and auditors are willing to provide.

“Clearly, they are going to provide a lot more information than they have in the past,“ he said.  However, “What we have is so limited, almost anything would be an improvement.”

Investors have always wanted to get more information about certain aspects of financial statements from the auditor’s perspective, but auditors have resisted for a number of reasons.

“Their clients don’t want that,” Carcello said.

“We hope that what ultimately comes out from the PCAOB won’t be sandbagged by big audit firms and corporations and be of very little use,” said Vineeta Anand, the chief research analyst in the AFL-CIO’s Office of Investment.

The PCAOB staff said the critical matters should be issues that kept auditors awake at night.

“Our concern is that auditors don’t seem to have been kept awake at night very much because we saw companies for which they gave [unqualified] opinions collapse during the financial crisis,” she said.  “They don’t seem to be awake at night sufficiently, and that’s a concern.  What is or isn’t a critical audit matter, there need to be a more objective standard.”

Another concern, in the view of James Cox, a member of the PCAOB’s Standing Advisory Group, is that an audit firm’s engagement team that works directly with a client will get wrapped up in extended debates with the firm’s national office, which interprets regulations and accounting standards for the entire firm.

The firms will be trying to balance its fear of angering a client that generates millions of dollars in fees against the risk of running afoul of SEC and PCAOB regulations.

“The real question is none of these norms have any significance unless we have a substantial enforcement effort behind them,” Cox said.  “That means not just the PCAOB but also the SEC.”