Critical audit matters: the most important change to audit reporting

In June 2017 the Public Company Accounting Oversight Board (PCAOB) issued perhaps the single most meaningful change to the auditor’s report since the 1940s. The new PCAOB auditing standard, dubbed AS 3101, includes the communication of critical audit matters (CAMs) in an audit report. This is a considerable change to the brief pass-fail auditor reports of the past several decades.

As of June 2019, the rule change has begun to take effect and it is vital to know what that entails.

What is a Critical Audit Matter (CAM)?

According to the PCAOB, a critical audit matter is defined as any matter that develops from the audit of financial statements and:

• Has been communicated or requires communication to the audit committee;
• Is related to accounts or disclosures that are material to the financial statements; and
• Involves especially challenging, subjective or complex auditor judgment.

CAMs are the responsibility of the auditor only, not the audit committee or company management. Furthermore, it is only necessary to identify critical audit matters in relation to the current period audit.

Challenging, Subjective or Complex Auditor Judgment

One of the most frequently asked questions regarding CAMs is about the requirement that the matter involve particularly challenging, subjective or complex judgment. So what does that mean? According to the PCAOB, the auditor should account for the following factors:

• The auditor’s assessment of the risks of material misstatement;
• The degree of auditor judgment related to areas in the financial statement that involved application of significant judgment or estimation by management, including the estimates with significant measurement uncertainty;
• The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions;
• The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures;
• The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter.

This list of factors is non-exclusive.

When do Critical Audit Matters go into effect?

For large accelerated filers, CAM requirements take effect for the fiscal years ending on or after June 30, 2019. Comparably, for audits of all other companies to which they apply, CAM requirements are effective for fiscal year ending on or after December 15, 2020.

Due to the Jumpstart Our Business Startups (JOBS) Act, the new audit standard does not apply to audits of emerging growth companies (EGCs). An emerging growth company has less than $1 billion in revenue and meets other certain qualifications. EGCs receive a number of regulatory breaks for five years after going public.

CAMs are also not required for audits of:

• Brokers and dealers reporting under Rule 17a-5 under the Securities Exchange Act of 1934;
• Registered investment companies other than business development companies; or
• Employee stock purchases, savings and similar plans.

Does reporting a Critical Audit Matters reflect negatively on my company?

CAMs do not indicate wrongdoings, deficiencies in internal controls or misstatements. In fact, they do not alter the auditor’s opinion on the financial statements.

Rather, CAMs provide information to stakeholders regarding issues that arose during the audit which required challenging, subjective or complex auditor judgment. Auditors must describe how the CAM was addressed and identify relevant financial statement accounts or disclosures related to the CAM.

The matters vary depending on the nature and complexity of the audit. Audits of companies in the same industry may feature different CAMs. Furthermore, auditors may encounter different CAMs for the same company from year to year.

For example, the implementation of new accounting standards may require a CAM report. However, over the following years there may be less complicated judgment requirements; thus, it is no longer a CAM.

What areas are likely to be Critical Audit Matters?

It is predicted that the more common critical audit matters will likely relate to areas involving substantial estimation. These areas include, but are not limited to, goodwill impairment, intangible assets, acquisitions, taxes and illiquid investments.

Another likely trigger is an area that is especially difficult or complex to audit, such as complicated contract terms (e.g. long-term contracts, severely modified contracts, or multiple performance obligations) when auditing revenue.

Additionally, industry specific matters may involve an elevated degree of estimation and are typically highly material. For example, a CAM may be considered for allowance for loan loss in the banking industry, or liability reserve within the insurance industry.

The PCAOB predicts that in most audits, at least one matter will meet the standards for a CAM.

How is a Critical Audit Matters described in an audit report?

As an auditor reports a CAM, they are expected to include specific introductory CAM language as prescribed by the PCAOB. These steps are:

1. Identify the CAM.
2. Describe the principal considerations that led the auditor to classify the matter as a CAM.
3. Describe how the CAM was addressed in the audit.
4. Refer to the relevant financial statement accounts and/or disclosures related to the CAM.

As with other auditing standards, the language and detailed descriptions must enable an experienced, separate auditor to comprehend the determinations.

How are auditors preparing for the implementation of Critical Audit Matters?

Public accounting firms are taking significant steps to prepare for the implementation of CAMs. Among these efforts, many are developing tools and guidance, as well as performing “dry runs” of the CAM requirements. Through dry runs, firms are assessing what matters are more likely to be CAMs, how they might be drafted and how to effectively communicate them to an audit committee and management.

The inclusion of CAMs is a substantial change and comprehensive preparation is vital. Firms acknowledge the benefits and lessons from dry runs include:

• Audit professionals gaining experience identifying CAMs.
• Determining whether a matter requires significant judgment and is specific to the circumstances of the audit. Therefore, understanding that a CAM on one audit may not be a CAM on another.
• It is difficult to clearly and concisely draft a CAM. Dry runs highlighted the need to start early.
• Sharing draft CAMs with audit committees and management allows everyone to come to a common understanding of the requirements, process and timing of a CAM. This also sets expectations.
• Communication with management and the audit committee is vital throughout the process of identifying and drafting a CAM.

Dry runs and the development of other essential tools has helped ease the anxiety and uncertainty related to reporting CAMs. This is labeled as one of the most significant changes to audit reporting in decades, and the severity should not be underestimated.

What other Critical Audit Matters resources are available?

With the changes beginning to take effect, the PCAOB and Center for Audit Quality (CAQ) recently published different guides and resources for investors, audit committees, and others. In fact, they hired Erin Dwyer as a direct point of contact for the implementation of critical audit matters.

The PCAOB initially presented a guide, “Implementation of Critical Audit Matters: The Basics" that outlines essential definitions and language requirements.

In July 2019, the PCAOB issued two separate guides to clarify the new rules. One guide is intended for investors, and the other is directed towards audit committees. Each provides a list of frequently asked questions regarding CAMs.

The CAQ has distributed a number of articles and research about CAMs. Among these resources is a publication Critical Audit Matters: Lessons Learned, Questions to Consider, and an Illustrative Example. The publication includes observations from dry runs and unique perspectives for audit committees, auditors and others affected by the rule change.

For more information on this topic or to learn how Baker Tilly specialists can help, contact our team.