It’s been seven years in coming, but the new auditing standards are now official and will be in effect starting this year for some companies. The Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) approved the new Critical Audit Matters (CAM) rules, which will be implemented in phases, in 2017. Large, accelerated filers are required to comply with CAM rules effective for their fiscal years ending on or after June 30, 2019. The rules will apply to all other companies after 2020. Emerging growth companies, as well as investment companies that are not business development companies, are excluded from CAM requirements.

The new auditing standards require auditors to discuss CAM in auditor reports with the goal of making auditor reporting more understandable and more useful for shareholders.

What Is a Critical Audit Matter?

The new standards require auditors to disclose issues that managers communicate to audit committees that also meet two other criteria:

  1. Issues that “relate to accounts or disclosures that are material to the financial statements”; and that
  2. “involve especially challenging, subjective, or complex auditor judgment.”

Implementing CAM Requirements

The new auditing standards must include factors that led the auditors to classify issues as CAMs and how they addressed the CAMs in the audit. To be in compliance with the measure, auditors must do a more in-depth analysis of how they determined which issues are considered CAMs.

The PCAOB did some dry runs on CAMs with clients and used them to create guidance on CAM methodologies, along with feedback from U.S. audit firms and auditors. The PCAOB states that some recent company filings provide a sample of what they expect CAM disclosures to look like once the new requirements are fully in force.

In addition, the PCAOB released three sets of guidance for staff in relation to implementing the new CAM standards. The guidance documents include:

  1. An overview of the basics of the CAM requirements
  2. PCAOB staff observations from a review of audit firms’ CAM methodologies
  3. A deeper dive on the determination of CAMs, including PCAOB staff FAQs

Auditors that express an unqualified opinion must include a summary of the issues that they believe qualify as CAMs under the Critical Audit Matters heading in the audit report. In this section, auditor reporting is expected to identify each CAM, describe the main considerations that led them to believe it qualifies as a CAM, describe how they addressed each CAM in the audit, and refer to the appropriate financial statement accounts or disclosures that pertain to each CAM.

The guidance materials instruct auditors to take the following list of factors into consideration at a minimum:

  • The auditor’s evaluation of risks related to material misstatements, including significant risks.
  • The degree of judgment the auditor gave the sections of the financial statements in which they applied significant judgment or estimation by managers, including estimates that have a significant measure of uncertainty.
  • The nature and timing of transactions that are unusual and significant, and the amount of effort and judgment that were related to those transactions.
  • The degree of subjectivity that the auditor applied during audit procedures to address CAM matters and the degree of subjectivity related to the results of their procedures.
  • The nature and extent of the auditor’s effort that was necessary to address CAM matters, including the extent of expertise or knowledge the auditor needed, or the nature of consultations needed by third-party external experts and the nature of the audit evidence that the engagement team and others received regarding the matter.

To clarify things a bit further, the PCAOB noted that it expects auditor reporting to identify CAMs in areas in which investors may have a particular interest. The following are a few possible areas of interest:

  • Notable areas in which management made estimates and judgments in preparing the financial statements.
  • Areas with high financial statements and audit risks.
  • Transactions that are unusual and significant.
  • Other major changes within the financial statements.

Implications of the New Disclosures 

It’s important for companies to think through the implications of the new auditing standards. Even though the auditor has to provide information about the company elsewhere in the Form 10-K, auditors will also need to describe the reasons that led them to decide that the matter is a CAM and provide a summary of how they addressed the matter in the audit. Consider that the investors may have questions about the CAMs and companies should be prepared to explain their reasoning for categorizing them as especially challenging, subjective or calling for complex auditor judgment.

The process for determining CAMs and communicating them will vary substantially based on the company that’s being audited. Smaller companies may find that the additional work necessary for auditors and managers may be particularly heavy, as they usually work diligently up to the final deadline as it is.

Audit committees should think and plan ahead as to how the new CAM requirements will affect their existing audit processes. Companies may want to weigh in on the side of caution and make a decision to participate in a practice run where they would identify, document and communicate CAMs before the disclosures are actually due.

In addition, CAMs may result in increased scrutiny on the auditor’s report and related disclosures in the financial statement and MD&A (management discussion and analysis). Companies should consider whether the CAMs they disclosed in their auditor’s report compare with CAMs that other companies disclosed. In addition, companies may need to decide whether they will make a practice of having management review the CAMs that they disclose in the audit opinions of their competitor’s financial statements.

Perhaps the best strategy is to have a plan in place to avoid any unexpected surprises when communicating CAMs. One thing that’s certain is that auditors, management and audit committees will need to engage in frequent and ongoing discussions about how to effectively implement the new audit standards in the auditor reporting and how to handle resulting inquiries from all angles. The need for confidential communication between these parties calls for a board management software program that has state-of-the-art security measures built in. The company you can trust to assist with the new audit standards and all of your governance needs is Diligent Corporation, a modern governance company.