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Changes to Proposed Auditing Standards: The Impact to Middle-Market Companies


Key Takeaways

  • Enhancing the audit report may provide benefits to the readers of financial statements of public companies, but care should be taken to implement these changes in a manner that considers the risks and unintended consequences to the middle market
  • Insights provided by the external auditor through the audit report would be most beneficial when they can be interpreted correctly in the context of the unqualified audit opinion
  • We encourage companies to share their views on the proposed Auditor Reporting Model with the PCAOB, and to talk to their auditor about how the changes to the audit report might affect them

2/18/14

On August 13, 2013 the Public Company Accounting Oversights Board (PCAOB) issued a proposal that would change the auditor’s reporting model. The release proposed new auditing standards for unqualified audit opinions and the auditor’s responsibilities for “other information” included in public company annual reports that are filed with the SEC.

The auditor’s report has changed very little over the last half century. The current report uses a “pass/fail” model that provides clear indication of whether the financial statements are fairly presented. In recent years, however, investor groups and others have indicated that they would benefit from information provided by the auditor’s unique insight.

The PCAOB proposal seeks to retain the “pass/fail” model while enhancing the insight provided by the auditor’s report. It would expand the auditor’s responsibilities for providing information about the audit itself. Auditors would be required to communicate specific information about each audit based on the audit procedures performed. In December, CohnReznick issued a comment letter in response to the PCAOB proposal. While we support the PCAOB’s goal of providing more useful information to investors and other users of financial statements, we have concerns as to how some of the measures would impact the middle market.

What Does the Middle Market Need to Know About the Proposed Standards?

Critical Audit Matters

The proposal calls for the addition of a new section in the auditor’s report where critical audit matters specific to an audit would be communicated. Effectively implemented, CohnReznick believes this section could enhance the value the audit provides to key stakeholders, and result in a more transparent audit process.

In order for the standard to achieve its stated goal, CohnReznick believes that auditor communications in the audit report should be closely aligned with the communications that auditors are required to make to the audit committee. The proposed standard requires the auditor to communicate details regarding the specific audit procedures performed and to disclose any difficulties the auditor faced in forming its opinion. We believe that the new section should avoid communicating matters that would be difficult for a reader to properly understand without more context than the audit opinion is designed to provide. We do not believe that a discussion of “audit difficulties,” for example, should be included in the audit report because such discussion may lead less informed users of financial statements to draw inappropriate inferences. For instance, would a less informed user infer that fraud is occurring despite the auditor procedures indicating that material fraud is not occurring? If the auditor indicates that it spent additional time evaluating the impairment analysis for a particular reporting unit, the possibility exists that someone might conclude impairment is likely, in spite of an unqualified opinion. Our concern is that misperceptions about procedures undertaken by the auditor could negatively impact an entity’s ability to attract capital. 

We are also concerned that the section, as described in the proposal, would create an environment that would inhibit discussions between management and the auditor because of reluctance to have the auditor disclose related information in the audit report. Management should be incented to discuss issues such as contingent liabilities and fraud monitoring activities with their auditor. Avoidance of these issues would hinder the effectiveness of the external audit process.

The Proposed Model May Raise Costs Disproportionately for the Middle Market

The PCAOB recognizes that the new standards will likely result in some increased audit costs, as the audit report will be more extensive and require additional communications with audit committees and others. Though not yet proven, CohnReznick believes that the middle market may bear a disproportional cost increase for the following reasons:

  1. It is likely that middle-market companies will report a higher number of critical audit matters due to a less robust infrastructure for financial reporting than that of larger registrants. This inverse relationship between entity size and the number of critical audit matters may put smaller companies at a competitive disadvantage in attracting capital.
  2. Generally speaking, the audit resources required to effectively create the required communications in the new standards will be higher level resources. Middle-market audits have smaller engagement teams than those of Fortune 1000 companies, with fewer higher-level resources assigned to “absorb” the hours to create these communications.
  3. The risk profile of serving middle market companies will change as the new communications expose accounting firms to additional litigation risk from investors. We believe both the effort and increased risk will increase costs in a way that will put pressure on fees.
     

Proposed Audit Standards in Practice: Field Study Results

In order to better analyze the implications of the proposed audit standards for the middle market, CohnReznick conducted a study of critical audit matters based on limited number of select audits we previously performed. We recognize that the PCAOB’s proposal is not final, further analysis will be necessary on subsequent revisions, and additional studies will be conducted. However, the results were telling, and they provided evidence supporting CohnReznick’s positions in our comment letter to the PCAOB.

Not surprisingly, given the broad definition, every entity analyzed had multiple critical audit matters that would have been reported, with an average number per client of four. Of the critical audit matters identified through the study, 85% were matters previously discussed with the audit committee, underscoring the fact that as written, the ARM proposal does not consistently align with the requirements of PCAOB Auditing Standard No. 16. More significantly, 40% of the identified critical audit matters were considered “sensitive” in nature, and 10% had no corresponding company disclosure. It is very likely that, prior to disclosure, these audit matters would be scrutinized heavily by in house legal counsels, leading to further dialogue with the auditors around the exact wording of the critical audit matters.

The field study estimated the amount of effort that would be required by auditors to comply with the newly proposed standards as an increase of 10% over the current audit standards. Estimates did not indicate that the increased effort would taper off over time. Our analysis shows that the additional effort was tied directly to the identification of “new” critical audit matters. Because the PCAOB seeks to keep critical audit matters from becoming “boilerplate,” we expect there to be a consistent stream of new critical audit matters.

As it is more likely than not that registrants will examine their disclosures related to critical audit matters, we anticipate communications with the auditor about critical audit matters will begin taking place at least quarterly, in order for management to ensure consistency between their quarterly and annual filings.

In Closing

The proposed new audit standards may provide a much needed overhaul of the auditor’s report to increase transparency to investors and other stakeholders. As currently proposed, however, the standards threaten to unduly and negatively impact the middle market and its relationship with its auditors. To learn more about the proposed audit standards and CohnReznick’s perspective, read our comment letter to the PCAOB.

What Does CohnReznick Think?
CohnReznick believes the PCAOB should take under strong consideration the comments made by CohnReznick and other top accounting firms to implement revisions to the proposed auditing standards that accomplish its primary goal while lessening the burden to the middle market.

Contact

For more information, contact Mark Spelker, Partner and National Director of SEC Services, at 973-618-6275.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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