Against the backdrop of this experience, there is ample reason to expect investors will be able to use the new disclosures to encourage further improvements in how well the audit serves their needs. Here are some of the changes investors can expect:
1. Investors will be able to reward companies that select engagement partners that establish track records for investor protection and provide relevant, specific and insightful communications to investors. The new disclosures will allow investors and analysts to discern which engagement partners are associated with enhanced investor benefits, such as by reporting material weaknesses in clients' internal control over financial reporting that warn of potential risks to financial reporting before a material misstatement occurs. Once the requirement to disclose CAMs in audit reports becomes effective in late 2019, investors and analysts will be able to tie engagement partners to the informativeness of their descriptions of CAMs and how they addressed them. The disclosures will give auditors a chance to show how effective they can be, and they will give investors the information needed to reward companies that hire the best auditors.
2. Audit committee oversight and disclosures should become more robust and relevant to the specific circumstances of the audit and the company. The new disclosures will provide investors significantly more context to be able to compare and contrast the ways different audit committees oversee audits. Since the new disclosures on other firms involved in audits began to come out last summer, they already have revealed interesting information to investors:
In some companies' audits, numerous other firms each contributed 5% or more of the hours. In at least one case, more than 20 firms contributed. In some cases, other firms performed more than 80% of the hours on the audit, and in one audit, other firms' hours totaled 97%. In several cases, the other participants were not registered with the PCAOB and therefore not subject to regular PCAOB inspection. As a result, neither the PCAOB nor investors have insight into these firms' audit quality.
When significant portions of the audit were conducted by other firms, investors can expect audit committees to do more to explain why the audit team was assembled as it was and how the audit committee ensured sufficient communication and coordination among dispersed participants in the engagement.
3. Similarly, investors can use the new disclosures on auditor tenure to judge audit committees' management of risks to auditor preparedness and independence. There are risks associated with both first-year audits as well as long-tenured engagements, but they are different risks and they must be managed differently. A new auditor will need the resources, access and skill to develop a deep understanding of the company's financial reporting process and financial and other risks. On the other hand, a long-tenured engagement runs the risk that the auditor has become overconfident and complacent about risk or, worse, that the auditor feels inherent pressure to please management so as not to jeopardize a sustained income stream. Investors will look for evidence that the audit committee understands and has appropriately addressed the specific risks that investors would be worried about. And, when investors fear that the risks cannot be addressed without a change, the new disclosures give investors the context they will need to participate in informed and thoughtful engagement with the company's board and other representatives.
4. Company disclosures should provide investors relevant and satisfactory explanations of how circumstances that give rise to CAMs are resolved. When an auditor's report includes a paragraph expressing substantial doubt about the company's ability to continue as a going concern, investors can bet the company will provide a discussion of management's plans to obtain the financing needed to survive. In the same way, CAMs will drive companies to provide investors adequate explanations and context to appreciate the issue, such as the impact of subtle judgments, and, ultimately, a stronger basis for confidence in the reliability of the financial statements. Indeed, there is a hidden, but in some cases significant, cost to companies when investors lack confidence in fair value judgments and other management estimates embedded in the financial statements. When an auditor calls out such judgments as having received special attention, and then management in turn demonstrates earnest consideration of the circumstances, investors can judge the persuasiveness of management's and the auditor's work and where warranted reward the company with an enhanced level of confidence.
The new disclosures provide investors with a wealth of actionable information. But, more fundamentally, they establish a new paradigm for the auditor's relationship with investors. No longer is the value of the audit locked inside outdated boilerplate. The disclosures reinforce the channel of communication between the auditor to investors, and it is not just a one-way path. As we have seen with previous auditor disclosure initiatives, information is a tool that investors can use, through shareholder engagement and voting, to communicate preferences for audits that are most relevant and reliable.