THE NEW AUDIT

REPORT

NOW ON THE MUST-READ LIST

EXPERTS WITH IMPACT

 Securities and Exchange
Commission and Public Company
Accounting Oversight Board

O n October 23, 2017, the Securities and Exchange Commission (“SEC”)

approved the new auditor reporting standard, as proposed by the Public
Company Accounting Oversight Board (“PCAOB”). The final standard maintains the
pass/fail opinion of the existing auditor’s report, but makes a number of significant
changes including the introduction of critical audit matters (“CAM”).

Auditors will now be required to communicate in the auditor’s report any CAM
arising from its audit or state that there were no CAMs.

The determination of a CAM is principles based, and is defined as a matter that was
communicated or required to be communicated to the audit committee and that:

1. Relates to accounts or disclosures that are material to the financial

statements and;

2. Involves especially challenging, subjective, or complex auditor judgment

Beyond the introduction of the CAM, the new auditor’s report makes several other
changes including required statements concerning auditor tenure, independence,
the nature of the audit, and others.

FTI CONSULTING | The New Audit Report 2

The New Audit Report
Now on the Must-Read List
In adopting the standard, the PCAOB’s goal is to make the auditor’s report more
relevant to investors by requiring the inclusion of additional and specific details
about the audit.

W ith no significant changes to the standard

form of the audit report in over 70 years,
it is not a surprise that its form and content was
5 Potential Unintended Consequences
of New Auditor Reporting Standard
evaluated to see how it could be enhanced. Today,
auditor’s reports are generally boilerplate, and
follow strict standards over form and content.
In developing the new standard, the PCAOB 1 Disclosure or inference of information
not previously made public
solicited feedback on various drafts, receiving
over 400 comments from industry, accounting
firms, investors, analysts, and professional
Perception of heightened risk by
organizations. Although the feedback was mixed, 2 users of financial statements
there were some potentially significant concerns
raised by commenters, including disclosure of
previously unreleased information, increased
time and expense, and impacts to auditor and 3 Reduced communication
between audit committees and
issuer liability. external auditors

While the new auditor’s report is intended

to increase relevancy and transparency for 4 Disputes regarding significance
investors, commenters have raised concerns
the new requirements may result in a number
of unintended consequences.
5 Shift in auditors’ potential liability

FTI CONSULTING | The New Audit Report 3

1
Disclosure or inference of
information not previously
made public

Disclosure of information not previously

made public or which provides an inference
to circumstances not previously disclosed
which could adversely impact a company
from an operational perspective.

2
Perception of heightened
As an example, assume a public company
manufactures products for a large retailer and is
risk by users of financial
reliant on that retailer for a substantial portion statements
of its business. The company’s auditor spends a
significant amount of effort evaluating whether a CAMs may lead to the release of previously
going concern is present, ultimately concluding undisclosed facts and circumstances related
a going concern opinion was not merited; to an issuer’s financial reporting processes.
however, under the new requirements, the auditor This additional disclosure may lead to a
evaluates whether the assessment of the going perception of heightened risk, additional
concern should be documented as a CAM and
pressure on internal controls, or a need for
concludes given the particular circumstances that
additional oversight for CAMs.
it merits disclosure in the audit opinion. In fact, the
PCAOB release states, “the auditor’s evaluation
Assume an international manufacturing company
of the company’s ability to continue as a going
has significant operations across the globe. As
concern could also represent a critical audit
part of its close process for financial reporting,
matter depending on the circumstances of
the company undergoes a complex financial
a particular audit.”1
statement consolidation, whereby data is received
Now, consider a competitor using this information from numerous subsidiaries and is processed
to disadvantage the company’s future negotiations through a complex consolidation by the parent
with its largest customer by suggesting to the entity. Many of the subsidiaries operate on
retailer that the auditor’s opinion highlights unique or independent ERP systems. This is an
previously undisclosed risk and that the retailer outcome of a significant portion of the company’s
should consider alternative sources to reduce operations having been acquired over many years,
perceived supply risk. The previously undisclosed and operated on platforms that do not directly
information could directly impact the company’s interface with each other. As such, the financial
operations, by influencing its largest customer’s statement consolidation performed at the parent
decision making. is predominantly a manual process and lacks
meaningful automation or system-level controls.
Based on the preceding facts, the company’s
auditors have determined that the consolidation
process is a CAM, as it requires significantly more
1
PCAOB Release No. 2017-001 effort to audit this area, including the manual

FTI CONSULTING | The New Audit Report 4

tracking and adjustments for intercompany describe the principal considerations that led the
and foreign exchange impacts. The extent of auditor to determine that a matter is a critical audit
these efforts necessitated a discussion with the matter or how the matter was addressed in the
audit committee. audit.”21Management may also receive questions
from financial statement users on matters that are
While the above scenario is not an uncommon disclosed by auditors as CAMs, especially if their
situation for both management and auditors, peers do not have similar CAMs.
it would be unusual for such facts and
circumstances to be publicly disclosed.

The disclosure of this previously undisclosed COMMENT LETTER EXCERPT

information could possibly lead to questions, Large Financial Services Provider 3
including:

• Is the company’s process inherently flawed or

“Although the auditor is not expected to
deficient? provide information about the company
that has not been made publicly available
• A view that consolidations in general represent by the company, such information may
a bookkeeping exercise, so exactly what be provided by the auditor if necessary to
warranted disclosure as a CAM? describe the principal considerations used
to determine that a matter is a CAM or
• Why don’t other industry peers have a
how the CAM was addressed in the audit
similar CAM disclosure? Is this indicative of a
(e.g., information regarding information
competitive disadvantage?
technology controls, or other information
• Could this imply the company may undergo not currently required by GAAP or typically
effort to standardize systems or implement included in the financial statements). In
additional internal controls to refine its the absence of appropriate context and
process? two-way communication, we believe that
such information potentially would be
• Is the company not integrating the bookkeeping
misleading, incomplete, and would not
among separate operations because it is
enhance the overall understanding of
contemplating divestures in the future?
the readers of the auditor’s report and
• Do analysts discount the company’s stock financial statements.”
value due to the perception that its information
systems and capabilities may be less robust
than its competitors?

While many of these are not questions you would

typically expect to hear on an investor call, this
is also possibly not information that has been
previously available or disclosed to investors. The
PCAOB release indicates “the standard provides
that even when management has not disclosed
information, the auditor is not constrained from
2
PCAOB Release No. 2017-001
providing such information if it is necessary to 3
Comment Letter #46 for PCAOB Docket 034

FTI CONSULTING | The New Audit Report 5

3
Reduced communication
between audit committees COMMENT LETTER EXCERPT
and external auditors Audit Firm 5

The determination of CAMs may “Without limiting the source of potential

unintentionally result in reduced CAMs to the communication requirements
communication between audit in AS 1301, a standard [The New Audit
committees and the external auditors. Report] risks creating a need for auditors
to consider and document every
With all matters communicated to the audit communication with the audit committee,
committee now serving as a population of potential which we believe could result in less
CAMs, the lines of communication between dialogue with the audit committee, which
audit committee and auditors may change. Audit would not be in investors’ interests.”
committee members may be more reserved in
the specific matters they discuss with auditors
and defer to communicating with management
on uncertain topics, so as not to unintentionally
increase this population of potential CAMs and
distract the auditor from the underlying audit
that is of the utmost importance to most audit
committees. The SEC has also acknowledged that,
“there exists a risk that communications between
the auditor and the audit committee could be
chilled, if the auditor were to avoid raising certain
issues to the audit committee’s attention so as to
not trigger the requirement to determine whether

4
such issues are CAMs.”41
Disputes regarding
There may also be a shift to audit committees significance
preferring to interact indirectly with auditors,
outside of required communications. Audit
committees may begin to engage with Reaching agreement on what accounts and
management and internal audit first to ensure their financial statement captions are material
communications with their auditors are reserved and judgmental will take on new importance
to only critical audit matters. As a result, internal among management and their auditors.
audit may also be assigned additional responsibility
in acting as a liaison between the audit committee Defining CAMs is likely to become a source of some
and auditor for informative and less critical tension between management and auditors, given
communications, redirecting internal audit from its the implications and impacts discussed above.
other important activities.
Auditors and management will inevitably have
time-consuming debates over which accounts or
disclosures should be considered “material.” The
4
SEC Release No. 34-81916
5
Comment Letter #54 for PCAOB Docket 034

FTI CONSULTING | The New Audit Report 6

determination of materiality can be a subjective and Liability may be imposed on auditors under a
evolving exercise. How an auditor and management number of different legal theories depending on
define account level detail can differ and evolve, the specific facts and circumstances of a case,
and the new CAM disclosures by the auditor will including pursuant to the Securities Act of 1933,
likely place more importance on management and the Securities Exchange Act of 1934 and various
their auditors developing an upfront understanding state laws. Further, some believe investors who
on materiality to prevent surprises and disputes suffer a financial loss could assert legal claims
regarding the ultimate CAM disclosures. against the auditor based on statements made in
identifying and describing CAMs, or based on the
Similarly, the distinction of how complex, judgmental lack of such statements. In their comment letters
or challenging an account or disclosure is may regarding the new audit opinion requirements,
depend on whether it is seen through the lens of certain respondents raised concerns that
management or the auditor. Management may additional disclosures may lead plaintiffs to view
disagree with the auditor on the complexity of the audit opinion as an additional source of support
an account, and may even take issue with the for litigation. The SEC has also acknowledged the
manner in which the auditor is testing the account. possibility of such an outcome, reflecting that,
Management may ask the following question of “we recognize reporting of CAMs likely will create
its auditor: is the account inherently complex an incremental risk of litigation and potential
and challenging, or is it possible that the design of liability.”61The addition of CAMs introduces more
the audit procedures can be improved to reduce information to the audit opinion that may serve as
perceived risks? ammunition to bring unsubstantiated actions.

COMMENT LETTER EXCERPT

Audit Firm 7

“[A]uditor liability concerns should be

recognized as the Board moves forward
with finalizing the standard. As discussed
in our previous comment letter, the
reproposed new auditor statements —
with respect to CAMs — could lead to
new claims under Section 10(b) of the

5
Exchange Act, Section 11 of the Securities
Shift in auditors’ potential
Act of 1933, and various state laws.”
liability

The inclusion of CAMs may change

auditors’ potential liability under securities
law, imposing additional liability not
previously observed.
6
SEC Release No. 34-81916
7
Comment Letter #41 for PCAOB Docket 034

FTI CONSULTING | The New Audit Report 7

T he preceding concerns appear to be shared by a broad group of professionals and practitioners,
including the SEC, which has highlighted that the implementation of this new requirement needs
to be carefully monitored by all. Specifically, SEC Chairman Jay Clayton summarized:

“I would be disappointed if the new audit reporting

standard, which has the potential to provide investors with
meaningful incremental information, instead resulted in
frivolous litigation costs, defensive, lawyer-driven auditor
communications, or antagonistic auditor-audit committee
relationships — with Main Street investors ending up in a
worse position than they were before.

I therefore urge all involved in the implementation of the

revised auditing standards, including the Commission and
the PCAOB, to pay close attention to these issues going
forward, including carefully reading the guidance provided
in the approval order and the PCAOB’s adopting release.

In this vein, I am also pleased the PCAOB intends to monitor

the results of implementation, including consideration of
any unintended consequences.”8
– Jay Clayton, SEC Chairman

8
October 23, 2017 Statement on SEC Approval of the PCAOB’s
New Auditor’s Reporting Standard

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 Other Potential Considerations

The potential impacts of CAMs on the PCAOB inspection and SEC review processes.

The auditor may take a “catch-all” or “shotgun” approach in determining CAMs in an effort to
reduce potential auditor liability.

CAMs may represent a regurgitation of risk factors and critical accounting policies already
disclosed by management, resulting in boilerplate language and adding further duplicity to
the Form 10K.

The disclosure of audit tenure may result in a perceived correlation between audit tenure
and audit quality.

Conclusion
T he PCAOB’s goal to increase relevancy and transparency for financial statement users via
revisions to the auditor’s report is an honorable endeavor with potential positive benefits.
However, as with other new rules, there are potential unintended consequences. Ultimately, time will
tell as to whether the new audit report in its current form fosters or dampens its usefulness to the
public markets.

The information in this publication does not constitute professional advice on facts and circumstances specific to
any person or entity. FTI is not, by means of this publication, rendering accounting, business, financial, investment,
legal, tax, or other professional advice or services. FTI Consulting, Inc., including its subsidiaries and affiliates, is a
consulting firm and is not a certified public accounting firm or a law firm.

FTI CONSULTING | The New Audit Report 9

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