Over the course of the past year, a treasure trove of new disclosures about audits of U.S. public companies has started to become available to investors. And there is more to come.
These disclosures respond to investor demand and arm investors with new tools to evaluate the quality of an audit and, ultimately, through shareholder engagement, voting on audit committee members, and ratification of the auditor, the ability to promote reliable audits.
What are the new disclosures, and when and where can an investor find them?
New rules adopted by the Public Company Accounting Oversight Board require auditors to disclose the name of the engagement partner on every public company audit, as well as the names of any other firms that contributed 5% or more of the total hours spent on the audit. These disclosures must be filed with the PCAOB and may be found through the AuditorSearch tool on the PCAOB website.
Audit reports also provide new information. Within the past few weeks, audit reports:
- are better organized;
- provide investors with the tenure information they have asked for but could only obtain sporadically until now; and
- include an express statement about auditor independence beyond what is implied by the title of the report.
In addition, auditors are preparing for a paradigm shift. Beginning in late 2019, audit reports no longer will be boilerplate. They will continue to provide a pass or fail grade, but they also will be required to provide unique descriptions of critical audit matters identified and addressed in the audit.
Critical audit matters, or CAMs, are matters that are communicated — or required to be communicated — to the audit committee and that relate to accounts or disclosures that are material to the financial statements and involve especially challenging, subjective or complex auditor judgments. When well written, these disclosures will provide investors and analysts a road map to more deeply explore the financial statements and better evaluate the credibility and caliber of the audit work that stands behind those statements. Over time, CAMs will reveal a time series of changes in a company's audit and financial risks as well as a cross-section of insights for comparison with peer companies.
Here are the new disclosures, and when and where investors can find them:
How can investors use this new information and what impact can investors expect?
Audit disclosures have been effective tools for investors to express preferences for the role of the audit in investor protection. For example, at the turn of this century, the Securities and Exchange Commission began requiring companies to disclose the fees they paid to auditors for audit and non-audit services. Investors used the disclosures to express a preference for reducing non-audit services, as reflected in a 2003 Institutional Shareholder Services policy, by voting against audit committee members who approved excessive non-audit services. According to the data service Audit Analytics, in 2002, less than half of the fees that accelerated filers paid their audit firms were for the audit. By 2005, non-audit fees had fallen to 20% of total fees, making the investor protection that the audit provides the dominant service performed for such companies.
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.
Samantha Ross is founding chief of staff and former special counsel to James R. Doty, former chairman of the Public Company Accounting Oversight Board. This content represents the views of the author and does not necessarily reflect the views of the Public Company Accounting Oversight Board, Board members or staff of the PCAOB. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.