Compliance Dates. In its initial phase, AS 3101 will require changes in the format and contents of audit reports issued on financial statements for fiscal years ending on or after December 15, 2017, and will therefore be required in audit reports contained in Form 10-K annual reports filed by calendar year-end companies that are subject to PCAOB audit standards, including emerging growth companies. These changes include new disclosure about auditor tenure and various other changes that are intended to clarify the disclosure in audit reports. The second phase will require auditors to discuss “critical audit matters” that arise during the audit. This alert discusses critical audit matters in greater detail below. This disclosure will apply to large accelerated filers beginning with fiscal years ending on or after June 30, 2019. Other filers must comply with this disclosure requirement beginning with fiscal years ending on or after December 15, 2020.
2018 Changes in Audit Reports
AS 3101 will require several changes in the format and contents of audit reports. The PCAOB guidance includes an annotated example of an audit report that shows the changes required by AS 3101. The PCAOB has stated that these changes are intended primarily to clarify the auditor’s role and responsibilities, provide additional information about the auditor, and make the audit report easier to read.
In light of the new requirement to disclose auditor tenure summarized below, some audit committees may wish to consider reviewing the proxy statement disclosure about their auditor selection and retention policies.
The principal changes required by AS 3101 include:
- Disclosure of auditor tenure, reflecting the entire relationship between the company and the auditor. This includes the tenure of predecessors of the company and predecessors of the audit firm, including periods before the company became subject to SEC reporting requirements. No specific location in the audit report is required for this disclosure. This requirement applies to investment companies based on the year the auditor began serving consecutively as the auditor of any investment company in a group of investment companies.
- Clarification of the nature and scope of the auditor’s responsibilities, including a new statement that the auditor is a public accounting firm registered with the PCAOB and is required to be independent under U.S. federal securities laws and SEC and PCAOB rules.
- Uniform standards concerning addressees of the audit report, requiring that the report be addressed to the company’s stockholders and board of directors or equivalent groups, but permitting the report to include additional addressees.
- Other enhancements in the audit report, including among others, identification of the financial statement notes and related schedules as part of the audited financial statements, and a statement clarifying the auditor’s responsibility to obtain reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud.
Critical Audit Matters
The most significant change in audit reports required by AS 3101 will be identification and discussion of any critical audit matter (CAM) that the auditor encountered in performing its audit. This disclosure requirement will apply to large accelerated filers beginning with fiscal years ending on or after June 30, 2019 (i.e., for companies with a calendar year-end, Form 10-K annual reports for calendar-year 2019 are due no later than March 22, 2020). Other filers must comply with this disclosure requirement beginning with fiscal years ending on or after December 15, 2020 (i.e., for companies with a calendar year-end, Form 10-K annual reports for 2020 are due no later than March 16, 2021, for accelerated filers, or March 31, 2021, for non-accelerated filers). Auditors may voluntarily include CAM disclosure before the applicable effective date, or for entities to which the CAM requirements do not apply.
The CAM disclosure requirement will apply to audit reports filed by foreign private issuers, but will not apply to audit reports filed by emerging growth companies, investment companies other than business development companies, employee stock purchase, savings and similar plans, or certain brokers and dealers.
In advance of implementation, companies and their management and audit committees may wish to discuss CAM disclosures with their auditor and, as the implementation date approaches, obtain discussion drafts of the auditor’s CAM disclosures. Companies should consider discussing with their auditors how the auditor will identify CAMs, which audit-related matters may be CAMs for the company, and the nature of any CAM disclosure that the auditor might include in its audit report.
CAM disclosure will require the auditor to communicate in its audit report any CAMs that arose during the current period’s audit of the financial statements. If the auditor concludes that there are no CAMs, the audit report must state that the auditor determined that there are no CAMs. AS 3101 defines a CAM as a matter that was communicated or required to be communicated to the audit committee and that:
- relates to accounts or disclosures that are material to the financial statements; and
- involved especially challenging, subjective or complex auditor judgment.
The PCAOB has stated that it believes that CAMs will likely be identified in areas that investors have indicated would be of particular interest to them, such as:
- significant management estimates and judgments made in preparing the financial statements;
- areas of high financial statement and audit risk;
- significant unusual transactions; and
- other significant changes in the financial statements.
In determining whether a matter involved especially challenging, subjective or complex auditor judgment, the auditor takes into account, alone or in combination, certain factors, including, but not limited to:
- 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.
The communication of each CAM must:
- identify the CAM;
- describe the principal considerations that led the auditor to determine the matter is a CAM;
- describe how the CAM was addressed in the audit; and
- refer to the relevant financial statement accounts or disclosures.