Statement on Reproposed Auditing Standard on the Auditor's Report

Date May 11, 2016
Speaker Lewis H. Ferguson, Board Member
Event PCAOB Open Board Meeting
Location Washington

This reproposal is the culmination of several years of work by the Board and its staff to reconsider both the form and content of the standard auditor's report. I support the reproposed standard because I believe it is important to modernize the auditor's report to expand the information it contains to make it more useful and relevant to investors by narrowing the information gap between investors and auditors that in recent years has steadily been increasing. Auditors possess more information about the companies they audit than anyone except company management itself. The traditional pass/fail format of the auditor's report, while useful, gives almost no clue to either the auditor's work on the audit or the extent of the auditor's knowledge about its client's business. The informational asymmetry between auditors and investors, not to mention investors and company management, has of late grown due to growing complexity in financial reporting, particularly the increased use of estimates, fair value measurements and the use of a myriad of new financial instruments and financing techniques, including derivatives. I believe the reproposed standard will serve to shrink the information gap; better clarify and more sensibly organize the auditor's report, and include standardized information concerning auditor tenure that, while previously derivable from public sources and in some cases voluntarily disclosed, was not routinized, and which some investors may find useful to consider and assess in the geography of the expanded report.

The reproposed standard will also ensure that U.S. financial reporting both keeps pace with and leverages insights gained from the expanded auditor reports that are being put in place globally by other regulators and standard setters, including the International Auditing and Assurance Standards Board (IAASB), the European Union (EU), and the Financial Reporting Council in the United Kingdom (FRC). The PCAOB staff had discussions with representatives of all these organizations in developing the reproposal, a cooperative strategy that had been urged by commenters, and the staff has thoughtfully compared and contrasted the various regulatory approaches. Although the regulatory frameworks of these other jurisdictions are not the same as in the U.S., and the details of the non-U.S. initiatives vary, they each ultimately have pursued a goal of communicating more information about audit-specific matters in the auditor's report itself, and departed from the traditional binary pass/fail model previously in use in those jurisdictions. To this same end, the reproposed standard is meant to better arm investors with insight previously available to, and considered by the auditors, but not ultimately evident in the auditor's report.

One of the things the Board and staff have been most careful with in the preparation of this standard is to make sure that management remains the primary, if not sole source of original information about the company. Company information, both financial and otherwise, and its disclosure is the responsibility of management, not the auditor. To blur that responsibility by putting part of it on the auditor could only lead to confusion and mischief. For this reason, the Board did not adopt the suggestion of some commenters that any new standard should require an "auditor's discussion and analysis" where the auditor would give its views of the company's financial information beyond whether it was fairly stated. The Board has been careful in this new standard to make sure that the auditor's basic assertion about the fair presentation of the financial information remains unchanged and that additional information is confined to what the auditor did in the audit and the principal reasoning behind key facets of the audit—all activities within the exclusive purview of the auditor.

In particular, the reproposal will strengthen the value of the auditor's report to investors by requiring a description of "critical audit matters" (CAMs), which would provide audit-specific information about especially challenging, subjective, or complex aspects of the audit, along with references to the relevant financial statement accounts and disclosures. This would include a description, for identified CAMs, of the principal considerations that led the auditor to determine that the matter is a CAM, an account of how it was addressed in the audit, with reference to the relevant financial statement accounts and disclosures. This is perhaps the most significant change to the existing auditor's report in decades, and a considerable expansion of the binary model. One concern with this approach is that audit firms, particularly larger audit firms, may, in an attempt to assure uniformity in practice and quality control, reduce the language included in the audit report relating to CAMs to repetitive boilerplate that communicates little or no useful information. The reproposal attempts to avoid that problem by tying the disclosures to specific aspects of audits that the auditor found particularly challenging and requiring the disclosures to be fact-specific, which should make it at least somewhat more difficult to reduce the disclosures to boilerplate. The CAM disclosure must also refer to the relevant financial statements and disclosures that were the subject of the audit work in question where applicable.

The reproposed standard also clarifies existing auditor responsibilities to enhance certain language in the auditor's report concerning obtaining reasonable assurance about whether the financial statements are free of material misstatements "whether due to error or fraud;" requires additional language about auditor independence; and mandates information concerning auditor tenure so as to provide consistent and easily accessible information concerning the duration of the auditor's relationship with the company. Finally, the reproposal dictates a more sensible report format, moving the "Opinion on the Financial Statements," upfront, and requiring section titles to make it easier for readers to follow.

One may argue about whether investors will in practice use, or care about, every single component of the additional information contained in the expanded report, but I continue to believe, as I have stated with respect to prior iterations of the proposed standard, that investors and other financial statement users, in general, operate under several implicit premises: (1) that investors desire more rather than less information about audited financial statements, so long as the information is accurate and relevant to their potential use of it, and they believe that auditors possess such relevant information; (2) that the efficiency of financial and other markets is directly correlated with the quality and quantity of information available to the markets; and (3) that auditors, in the ordinary course of their audit work, do gain some information that, if made more widely available, would be useful to investors and financial statement users, but that the auditor's knowledge of the entities they audit is both limited and specialized.

Few would argue with the proposition that the auditor's knowledge is uniquely influenced by his or her unique vantage point in relation to the company and by his or her highly specialized need to focus on tasks and facts that will enable the auditor to express an opinion on the fair presentation of the financial statements. Thus, areas that were particularly challenging in the audit are matters that financial statement users would likely find to be of interest. Ultimately, at the end of the day, if the auditor is able to issue a clean opinion, it is implicit that the auditor was ultimately satisfied that the financial statements were fairly stated. Nonetheless, investors will undoubtedly benefit from knowing those areas of the audit on which the auditor found challenging, subjective, or complex, and the principal considerations that led the auditor to make CAM determinations; how they were addressed, and the relevant financial statement accounts and disclosures that led to that challenging, subjective or complex audit work. That is not information that is currently made publicly available by the auditor, but would be addressed for identified CAMs under the reproposed standard. In the end, financial statement users will make their own decisions about whether the information is useful to them, but as a general matter financial statement users are well served by receiving as much information as possible that is even arguably relevant and useful about the relationship between an issuer and its auditor.

On balance, I believe the reproposal advances the usefulness of the auditor's report to investors, but strikes a careful and correct balance between meeting the desire of investors for more information from auditors while retaining the primary role of management in the financial reporting process, and keeping in mind the costs and potential unintended consequences of the reproposed standard. I would like to thank the staff of the PCAOB for their hard work in developing this proposal. In particular, Marty Baumann, Jennifer Rand, Jessica Watts, Karen Wiedemann, Elena Bozhkova, and Ekaterina Dizna in the Office of the Chief Auditor; Andres Vinelli, Morris Mitler, Marcelo Pinheiro and Nicole Funari in the Center for Economic Analysis; and Gordon Seymour and Jennifer Williams in the Office of General Counsel. We are also indebted to the staff of the Securities and Exchange Commission for their thorough and thoughtful review of this reproposal as it was developed. I support today's reproposal and I look forward to reviewing the comments we receive in response. I especially hope that we will receive helpful input on our economic analysis and thoughts on the benefits and costs of the proposed standard.