The U.S. Securities and Exchange Commission (SEC) announced Monday that it will now require publicly traded companies to disclose remarks or inquiries made by independent auditors regarding critical audit matters.

Through this new rule, the SEC approved new standards for independent auditors set by the Public Company Accounting Oversight Board (PCAOB). The changes, which investor advocates argue will help investors better understand potential risk, will alter the PCAOB's auditing standards for independent auditors' reports in several ways:

  • Independent auditors' reports must provide additional information on "critical audit matters" (CAMs).

  • Independent auditors' reports must include the length of tenure of the auditor.

  • Independent auditors' reports must include a statement about their independence.

  • Independent auditors must follow a new standardized reporting form.

The most substantial change is the CAM reporting requirement. To determine whether a matter qualifies as a CAM, auditors must consider whether: (1) the matter concerns a required communication from the independent auditors to the audit committee; (2) the matter is material to the financial statements; (3) the matter involves "especially challenging, subjective, or complex auditor judgment;" and (4) other factors, such as the amount of judgment, subjectivity, and specialized knowledge used in an audit conclusion, the risks of misstatement, the nature of the evidence, and the existence of unusual transactions, support CAM classification.

Some examples of a CAM include a critical accounting practice or estimate, a significant unusual transaction, or significant risks found during the audit process. In support of the change, the PCAOB stated: "[a]s part of the audit, auditors often perform procedures involving challenging, subjective, or complex judgments, but the auditor's report does not communicate this information to investors."

If the independent auditor determines that there are no CAMs, the auditor must state that conclusion in the report. If, however, the independent auditor determines a CAM exists, he or she must:

  • identify the CAM;

  • describe why the matter was identified as critical;

  • describe how the CAM was addressed in the audit; and

  • refer to the relevant financial statements or disclosures that underlie the CAM.

The CAM reporting requirement will affect public companies, their boards' audit committees, their auditors, and their investors in several ways. First, the CAM reporting requirement may lead to more litigation instead of more informed investors—any time new statements are added to an auditing report, the risk of litigation increases. The subjective decision points involved in CAM reporting increase this threat substantially. Not only must auditors determine—based on subjective factors—whether a matter is critical, they must also determine what information to include, how to phrase their opinions, and what documents are relevant. Although the PCAOB has agreed to provide advice to auditors on a case-by-case basis, it has refused to publish any guidance.

Second, this reporting requirement may not lead to more or better information for investors because many CAM disclosures might merely mirror management disclosures. Additionally, with the looming threat of litigation, auditors may be incentivized to identify non-critical matters as critical. This could turn CAMs into a series of boilerplate disclosures instead of selected useful information.

Third, these new standards might strain relations among independent auditors, audit committees, and management. The CAM reporting requirement arises only if the matter is (or must be) communicated by the auditors to the audit committee. To avoid the CAM requirement, auditors may choose to avoid communicating certain issues to the audit committee. Chilling speech between auditors and audit committees would undoubtedly affect the accuracy and effectiveness of the independent audit process.

The CAM rule will be effective for large, accelerated filers for all audits ending June 30, 2019, and for all other filers for audits ending on December 15, 2020. The other changes mentioned will go into effect starting with audits ending on December 15, 2017. Although these new requirements will apply to all, the CAM requirement will not apply to emerging-growth companies, broker-dealers reporting under Exchange Rule 17a-5, some investment companies, and employee stock purchase or savings plans.

A public statement on the new auditing standards by SEC Chairman Jay Clayton can be found here.

The PCAOB's final standard, approved by the SEC, can be found in Appendix 1 of this document. The old standards still appear on the PCAOB's website here.

The SEC's order approving the new auditing standards and addressing the concerns raised in this alert can be found here.

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