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Financial Reporting and the Law

The PCAOB has announced it will schedule a public meeting in the first half of 2014 to discuss its proposal to expand auditors’ reports. If adopted, the proposal would require the reports to, among other things, describe critical audit matters and the results of evaluations of information outside the financial statements and identify the year when the company’s auditor first began serving that role. We believe that companies should consider participating in the meeting.

In addition to increasing the time pressures to meet filing deadlines for annual reports, the changes could create investor confusion as to the meaning of the auditor’s report. The expanded auditor’s report also could expose companies and their auditors to additional risk of litigation, result in questions relating to auditors’ tenure, and raise various other issues, including those discussed below. Although the proposal was designed to address investor requests for information regarding auditors’ insights about companies obtained as a result of their audits, some investors have submitted comment letters that express concerns about the proposal.

Among other issues with the PCAOB’s proposal to expand the report to discuss critical audit matters is the possibility that the auditor’s report would provide information not otherwise required to be disclosed by a company. For example, the auditor’s report may need to explain the auditor’s difficulties in ultimately agreeing with a company that no accrual or disclosure about a lawsuit was required, which could result in prejudicial disclosures about the lawsuit. In addition, the report might need to explain that the auditor took additional audit steps given a significant deficiency in internal control over financial reporting, possibly raising investor concerns as to the effectiveness of the company’s controls.

The expansion of the auditor’s report also would require a discussion about the auditor’s responsibility to review and evaluate whether information that is outside the financial statements—but that is included in or incorporated by reference into an annual report filed under the Securities Exchange Act of 1934—contains a material inconsistency with amounts or information in the audited financial statements or a material misstatement of fact. This requirement would expand the scope of the audit because “evaluating” such information would necessitate additional audit steps as the current standards mandate only “review and consideration” of information outside the financial statements. In addition, the need to evaluate information incorporated by reference would require an auditor to review a company’s proxy statement filed after the annual report on Form 10-K was filed. Finally, the disclosure required by this aspect of the proposal could confuse investors because it would not identify precisely the information covered by the auditor’s evaluation or the nature of the auditor’s expertise for such information.

The Financial Reporting Council, the United Kingdom’s independent financial regulator, has already adopted changes to the auditor’s report, and similar expansions of the report are being considered by the International Auditing and Assurance Standards Board and the European Commission (EC). Most recently, the European Parliament and the EU member states reached a preliminary agreement on auditor reform. According to Michel Barnier, EC Commissioner for Internal Market and Services, the reform includes “new rules [that] will require auditors to produce more detailed and informative audit reports, with a required focus on relevant information to investors.”