When the PCAOB originally floated the idea of an expanded audit report in 2011, the proposal fueled quite a controversy.  Supporters of the concept contended that the current form of the auditor’s report was just boilerplate that “tells investors little of substance about a company’s true condition,” while audit firms were concerned that one consequence of an expanded auditor’s report could be the possibility of increased auditors’ legal exposure. The PCAOB’s recent reproposal, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (see this Pubco post), which provides for inclusion in the auditor’s report of “critical audit matters,” attempts to address some of those concerns. While the reproposal has generally been viewed favorably by investors, among the groups still crying foul are audit firms and organizations (see this PubCo post).

In that light, it’s somewhat ironic to see the results of an academic study showing, among other things, that disclosure of CAMs could help protect auditors from legal exposure if a misstatement were subsequently discovered in the CAM area. More specifically, the study found that the “types of CAMs illustrated by the PCAOB are more likely to prompt a ‘disclaimer effect’ by warning users of the inherent subjectivity and complexity associated with auditing CAM areas. Specifically, we find that CAM disclosures lead to less confidence in the CAM area before a misstatement is revealed and less assessed auditor responsibility after a misstatement is revealed in the CAM area.”

Typically, as you know, auditors just give companies a pass/fail grade and provide no description of any issues or problems that occurred during the audit process; those problems are instead taken up with the audit committee.  While the PCAOB reproposal retains the pass/fail model (sort of), it provides for the inclusion in the auditor’s report of CAMs, disclosures of “matters arising from the audit that required especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters.”

The study, The Disclaimer Effect of Disclosing Critical Audit Matters in the Auditor’s Report, examined “the effects of CAMs on user confidence before a misstatement is revealed and on assessments of auditor responsibility after a misstatement is revealed.”  Using auditor’s reports that included a CAM patterned after the examples in the PCAOB proposal and a control auditor’s report that was patterned after current practice (i.e., without CAMs), the study authors asked participants first to read background information on multiple areas of financial statement risk, then to view an auditor’s report including a CAM related to one of the background risk areas. Participants were then asked to “indicate their confidence in the reliability and accuracy of the values reported in the CAM area and in an area not disclosed as a CAM.” After providing these assessments, participants learned of a material misstatement (that may or may not have been associated with the CAM) and then indicated their perceptions of the auditor’s responsibility and liability for the misstatement.  The same general process was undertaken with the control report.

Participants were plaintiff and defense attorneys, financial analysts and MBA students. Before participants were aware of any misstatement, all four groups reported significantly lower confidence in a CAM area than in a risk area that was not disclosed as a CAM, but did not indicate lower confidence in the report in general. In essence, they viewed the CAM as cautionary.

With regard to assessments of auditor responsibility for subsequently discovered misstatements, the authors found a general disclaimer effect, but noted differences among the participant groups. In particular, MBA students and financial analysts assessed lower auditor responsibility when auditors identified the “right” CAM (i.e., where the misstatement and CAM were in the same area as opposed to different areas), but, interestingly, their responsibility assessments did not significantly differ between a report with a CAM in the area of the misstatement and the control report with no CAM disclosure. The authors concluded that that result supported audit firms’ concern “that a misstatement in a non-CAM area could lead users to second-guess ‘that the cause of loss should have been identified as a critical audit matter’…. If so, a CAM regime could lead auditors to disclose excessive CAMs in an effort to guard against litigation.” By contrast, defense attorneys attributed significantly less auditor responsibility for misstatements that were previously disclosed as CAMs than when the same misstatement occurred in the context of a control report that had no CAM disclosure. However, defense attorneys did not distinguish in their assessments of responsibility between a CAM disclosure in the same area as the misstatement or in a different area, crediting the auditor for disclosing any CAM, relative to the control report with no CAMs. Not surprisingly perhaps, plaintiffs’ attorneys assessed a high level of auditor responsibility for a misstatement “irrespective of whether the auditor previously disclosed a related CAM, disclosed a different CAM, or disclosed nothing about CAMs. In short, class-action attorneys appear to believe that auditors must bear responsibility for material misstatements in financial reports, period.”  However, in subsequent questioning, even plaintiffs’ attorneys indicated that a “CAM disclosure in the misstatement area could potentially strengthen the auditor’s legal position,” consistent with the authors’ conclusion that there is an “overall disclaimer effect of CAM disclosures.”

The authors observe that prior studies have shown conflicting results and acknowledged that “other settings could generate different conclusions,” for example, where the CAM involved “categorical determinations that can be classified in hindsight as either correct or incorrect” as opposed to the CAMs used in this study, which involved “valuations with high measurement uncertainty.”  The study suggests that “when the underlying accounting standard appears to be relatively precise, a CAM disclosure will challenge the appearance of precision, highlighting the auditor’s awareness of increased risk and increasing ‘jurors’ assessments that the auditor could have foreseen the eventual negative outcome.’”

The authors concluded that implications of the study “are mixed. On one hand, auditors’ clients are unlikely to welcome disclosures that lower user confidence [in the area of the CAM]. Still, any disclosure in the auditor’s report that places an implied ‘asterisk’ on specific accounts could encounter client resistance. On the other hand, as long as auditors identify the ‘right’ CAMs (i.e., those related to any subsequently discovered problems), the audit profession may benefit if CAM disclosures partially protect the auditor from legal exposure in the event of a material misstatement, much as product warning labels can partially protect manufacturers….”

SideBar: The study does not address the potential impact of CAM disclosure on audit clients. However, some corporate entities commenting on the reproposal expressed the concern that CAM disclosure would provide roadmaps to baseless litigation against companies and  encouraged the PCAOB and the SEC  to  protect companies (and audit firms) through introduction of a safe harbor related to CAMs. Some commenters contended that CAMs are likely to be misinterpreted to have the effect of “qualifications” to otherwise unqualified audit opinions, weakening the value of the auditor’s opinion.  Others argued that CAM disclosure would be redundant of company disclosures regarding critical accounting policies and estimates and provide auditors with leverage to compel companies to include disclosure in the notes or MD&A that management may not view as necessary. (Some commenters suggested as an alternative that the report simply concur with management’s discussion of  critical accounting policies and estimates.)

In addition, concerns have been raised that, because the trigger for CAM consideration under the reproposal is whether a matter has been or is required to be communicated to the audit committee, the impact may be to chill communications between the audit firm and the audit committee.  In addition, to address concerns in the original CAM proposal regarding potential disclosure by the audit firm of confidential company information, the reproposal adds a note indicating that, when describing CAMs in the auditor’s report, the auditor “is not expected to provide information about the company that has not been made publicly available by the company unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit.” However, that exception may not be simple to apply, and some commenters contended that the exception effectively instructs the auditor to make the disclosure. Some commenters argued that the revised CAM definition continues to intrude on the responsibility of management and the board for the financial statements by making the auditor’s report a primary source of a company’s financial information. As discussed in this Bloomberg BNA article,  both the Center for Audit Quality and the Institute of Management Accountants suggested that the PCAOB  eliminate the exception because it “could lead to auditors having to report company information initially” and “blurs the line between whether management or auditors have primary responsibility for disclosures.”  (See this PubCo post.)

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