PCAOB Critical Audit Matters Disclosure
The phase-in of the Public Company Accounting Oversight Board’s requirements for auditors to communicate critical audit matters in the auditor’s report recently began for large accelerated filers with fiscal years ending on or after June 30, 2019. The second part of the phase-in will begin for all other companies, regardless of filer status, with fiscal years ending on or after December 15, 2020.
What is a critical audit matter (CAM)?
A CAM is defined as any matter arising from the audit of the financial statements 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) involved especially challenging, subjective or complex auditor judgment. The PCAOB has indicated that matters communicated or required to be communicated to the audit committee would be appropriate sources for CAMs because those matters are the most meaningful to investors reviewing the financial statements.
Accounting literature indicates that CAMs would be expected to be identified where a matter poses significant risks; where there is a significant uncertainty associated with an estimate; in situations requiring specialized skills or knowledge on the part of the company; and significant unusual transactions. As examples, a CAM would most likely be reported when a company has a material transaction, such as an asset acquisition; when it carries goodwill or derivatives on its balance sheet; if revenue recognition is involved as an accounting principal; if the company is involved in litigation; the company has an uncertain tax position; or for industry specific judgment matters such as loan loss reserves for financial institutions.
Materiality. Importantly, a CAM may relate to only a component of a material account or disclosure in the financial statements; it does not need to correspond to the entire account or disclosure. Further, a CAM may not relate to a single account or disclosure but could have a pervasive effect on the financial statements if it relates to many accounts or disclosures.
Auditor Judgment. The PCAOB has provided the following list of factors for an auditor to take into account when determining whether a matter is a CAM:
- The auditor’s assessment of the risks of material misstatement, including significant risks;
- The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including 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; and
- The nature of audit evidence obtained regarding the matter.
In addition, the auditor should take into account other factors specific to the audit.
How will a CAM be disclosed?
The auditor’s report must contain specific introductory language in a separate “Critical Audit Matters” section of the report. Following the introduction, each CAM must be identified and accompanied by a description of the principal considerations that led the auditor to determine that the matter is a CAM, along with a description of how the CAM was addressed in the audit. In addition, the disclosure must refer to the relevant financial statement accounts or disclosures that relate to the CAM. The disclosure regarding the CAM is to be clear and concise so that it is readily understandable to investors. Boilerplate or generic language is to be avoided; the language should be tailored to the company’s specific circumstances.
The CAM disclosure is not expected to contain material non-public information regarding the company. However, if non-public information is necessary to describe the matter and the considerations that led the auditor to determine that the matter is a CAM, disclosure will be necessary. Consequently, it will be vitally important for public companies to begin communications with the auditor as early in the audit as possible.
The CAM disclosure may not contain any mitigating language that tries to disclaim, qualify or otherwise limit the auditor’s responsibility for the CAM or its opinion on the financial statements.
The CAM disclosure is only required for the most recently completed fiscal year. However, when that year is compared to earlier years it might be appropriate for the disclosure to relate to those prior years. This may be particularly the case for first time filers.
Can there be a determination that there are no CAMs?
The existence of a CAM is based on the facts and circumstances of each audit. Therefore, it is possible that an auditor could determine that there are no CAMs to report. However, the PCAOB expects that in most audits the auditor will determine that there is at least one CAM.
Audit committee and management involvement.
The auditor must provide a draft of its report to the audit committee and discuss the draft with the committee. Prior to the distribution of the draft report, it is expected that any matter that is a CAM will have already have been discussed with the audit committee as well as management as part of the audit process.
What CAMs have been reported to date?
There has not yet been widespread filing of Forms 10-K in which CAMs are included in the auditor’s report due to most companies using a December 31 year end. However, a review of a portion of the Form 10-K filings for entities with June 30 or September 30 fiscal year ends reveals auditors reporting one or two CAMs with the following CAMs being reported:
- Revenue recognition, related to adjustments for variable consideration received by companies (such as sales discounts and trade promotions), and estimates of completion and payment for specified scopes of work involving long-term fixed price contracts, among others;
- Goodwill and indefinite-lived intangible assets (such as trade names) and related impairment assessments;
- Acquisitions and the related accounting treatment (primarily related to acquired goodwill);
- Allowance for loan and lease losses;
- Product liability reserves;
- Litigation matters;
- Uncertain tax matters; and
- Matters involving the conduct of the audit, for example the sufficiency of audit evidence for certain reporting such as worldwide sales.
Preparing for your CAM disclosure.
We recommend that internal discussions of matters known to management that likely would be CAMs or that pose potential CAM disclosure should be held in advance of the audit. These matters should then be discussed with the auditor as early in the audit process as possible. A determination as to the sensitivity of the information that could be expected to be disclosed should also be made.
Todd Eveson and Alexander Donaldson are members of the Capital Markets practice group of Wyrick Robbins, which represents clients across a broad range of industries in connection with their significant financing transactions. The Capital Markets group publishes Client Alerts periodically as a service to clients and friends. The purpose of this Client Alert is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.