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Financial Reporting and the Law

On May 11, 2016, the Public Company Accounting Oversight Board (PCAOB) issued a reproposal of its auditor reporting standard. This action follows more than five years of active PCAOB consideration of whether the auditor’s audit report could be made more useful to investors and other users of financial statements. The reproposal retains the binary pass/fail opinion on financial statements, but proposes new disclosures about critical audit matters (CAMs), auditor tenure and independence, and the auditor’s responsibility to consider errors and fraud in the audit and revisions to the format of the auditor’s report.

The PCAOB believes that the reproposal addresses the comments received in response to its 2013 proposal. Notably, the proposed definition of a “critical audit matter” would narrow the scope of CAMs to those matters that auditors communicated or were required to communicate to the audit committee and that involve especially challenging, subjective or complex auditor judgments and relate to accounts or disclosures that are material to the financial statements. As a result, some matters that would have been considered CAMs under the 2013 proposal would not be considered CAMs under the reproposal, such as, although probably rare, a loss contingency that the auditor communicates to the audit committee but determines to be remote, “even if it involved especially challenging auditor judgment.” The reproposal lists six nonexclusive factors that auditors should take into account in identifying CAMs, and the PCAOB’s release describing the reproposal includes examples of disclosures about CAMs. The example disclosures are not intended or expected to result in boilerplate disclosures since the expanded auditor’s report is intended to be fact-specific. The PCAOB believes that the narrowed scope of the definition of a CAM addresses auditors’ concerns that the 2013 proposal would require extensive auditor documentation.

The reproposed expanded auditor’s reporting requirements retain the communication requirements of the 2013 proposal, which would require disclosure of any specific CAMs and information about how the CAMs were identified and to which financial statement accounts or disclosures the CAMs relate. In addition, it would require the auditor’s report to describe how the auditor addressed each of the CAMs (such as through additional audit procedures or other relevant descriptions.) If the auditor had not identified any CAMs, the auditor’s report would so state.

The PCAOB believes that the reproposed standard addresses the concern of some commenters that the 2013 proposal would have required the auditor to disclose in the auditor’s report matters that a company itself was not required to disclose. Examples given by those commenters were certain loss contingencies and internal control deficiencies that are not material weaknesses. Although a note to the reproposed standard states that the auditor is not expected to provide information about the company that the company has not disclosed publicly, the effect of that note is uncertain since the auditor may need to make such disclosures to comply with the requirement that the report describe the reason the auditor identified the matter as a CAM.

Two of the Board members expressed skepticism about the benefits of the proposed requirement for the auditor’s report to disclose the auditor’s tenure and concern that the disclosure would give credence to the argument that tenure adversely affects audit quality. Given investor requests for such information, unless the SEC revises its rules to require such disclosure, we believe that the final PCAOB auditor’s reporting requirements will require disclosure of auditor tenure. Such disclosure would likely cause companies to disclose in their proxy statements why, notwithstanding the auditor’s long tenure, the audit committee believes that the auditor should continue to be the issuer’s auditor.

The reproposal would apply to auditors’ reports on the financial statements of emerging growth companies, but would exclude auditors’ reports on the financial statements of broker-dealers, investment companies (other than business development companies), and benefit plans.

Several Board members noted that the reproposal is consistent with and fulfills the mandate in Section 101 of the Sarbanes-Oxley Act of 2002 that the PCAOB be established to “protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for public investors.” The PCAOB staff noted that the proposed expanded auditor’s report would be similar to the expanded reports required for auditors’ reports issued in other countries.

The comment period on the reproposed auditor reporting standard ends on August 15, 2016. Absent compelling and new negative comments against such expansion, which we don’t expect, we believe that the PCAOB will adopt expanded auditor reporting requirements. The international changes in auditors’ reporting have received widespread favorable acceptance, particularly in the United Kingdom, where auditors have been issuing such expanded reports since 2014. In addition, the PCAOB chair’s statement at the open meeting on May 11, 2016 suggests that the SEC chair and chief accountant support the PCAOB’s proposal.