Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules on the Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and Departures From Unqualified Opinions and Other Reporting Circumstances, and Related Amendments to Auditing Standards, 35396-35433 [2017-15718]

Download as PDF 35396 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices SECURITIES AND EXCHANGE COMMISSION [Release No. 34–81187; File No. PCAOB– 2017–01] Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules on the Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and Departures From Unqualified Opinions and Other Reporting Circumstances, and Related Amendments to Auditing Standards July 21, 2017. Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the ‘‘Act’’ or ‘‘Sarbanes-Oxley Act’’), notice is hereby given that on July 19, 2017, the Public Company Accounting Oversight Board (the ‘‘Board’’ or ‘‘PCAOB’’) filed with the Securities and Exchange Commission (the ‘‘Commission’’ or ‘‘SEC’’) the proposed rules described in Items I and II below, which items have been prepared by the Board. The Commission is publishing this notice to solicit comments on the proposed rules from interested persons. asabaliauskas on DSKBBXCHB2PROD with NOTICES I. Board’s Statement of the Terms of Substance of the Proposed Rules On June 1, 2017, the Board adopted new rules and amendments to auditing standards (collectively, the ‘‘proposed rules’’) to make the auditor’s report more informative and relevant to investors and other financial statement users. The text of the proposed rules appears in Exhibit A to the SEC Filing Form 19b–4 and is available on the Board’s Web site at https://pcaobus.org/ Rulemaking/Pages/Docket034.aspx and at the Commission’s Public Reference Room. II. Board’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rules In its filing with the Commission, the Board included statements concerning the purpose of, and basis for, the proposed rules and discussed any comments it received on the proposed rules. The text of these statements may be examined at the places specified in Item IV below. The Board has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. In addition, the Board is requesting that the Commission approve the proposed rules and related amendments, with the exception of the requirements related to critical audit matters, pursuant to Section 103(a)(3)(C) of the SarbanesOxley Act, for application to audits of emerging growth companies (‘‘EGCs’’), VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 as that term is defined in Section 3(a)(80) of the Securities Exchange Act of 1934 (‘‘Exchange Act’’). The Board’s request is set forth in section D. A. Board’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rules (a) Purpose Summary The Board has adopted a new auditor reporting standard, AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion (the ‘‘final standard’’ or ‘‘AS 3101’’) and related amendments to its auditing standards that will require the auditor to provide new information about the audit and make the auditor’s report more informative and relevant to investors and other financial statement users. The final standard retains the pass/fail opinion of the existing auditor’s report but makes significant changes to the existing auditor’s report, including the following: • Communication of critical audit matters—matters communicated or required to be communicated to the audit committee and that: (1) Relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment; • Disclosure of auditor tenure—the year in which the auditor began serving consecutively as the company’s auditor; and • Other improvements to the auditor’s report—a number of other improvements to the auditor’s report to clarify the auditor’s role and responsibilities, and make the auditor’s report easier to read. The Board believes that adopting these requirements responds to the strong interest of investors for enhanced communication about the audit and is consistent with its mandate to ‘‘protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.’’ 1 The Board has adopted the final standard after more than six years of outreach and public comment, including comments from members of the Board’s Standing Advisory Group (‘‘SAG’’) and Investor Advisory Group (‘‘IAG’’). The Board has taken into consideration all comments and believes its approach responds to investor requests for additional 1 Section 101(a) of the Sarbanes-Oxley Act of 2002 (‘‘Sarbanes-Oxley’’), 15 U.S.C. 7211(a). PO 00000 Frm 00002 Fmt 4701 Sfmt 4703 information about the financial statement audit without imposing requirements beyond the auditor’s expertise or mandate. Investors are the beneficiaries of the audit and the auditor’s report is the primary means by which the auditor communicates with them. Currently, however, the auditor’s report conveys little of the information obtained and evaluated by the auditor as part of the audit. And while the auditor’s report has generally remained unchanged since the 1940s, companies’ operations have become more complex and global, and the financial reporting frameworks have evolved toward an increasing use of estimates, including fair value measurements. As part of the audit, auditors often perform procedures involving challenging, subjective, or complex judgments, but the auditor’s report does not communicate this information to investors. Stated differently, the auditor’s report does little to address the information asymmetry between investors and auditors,2 even though investors have consistently asked to hear more from the auditor, an independent third-party expert whose work is undertaken for their benefit.3 The Board believes that reducing the information asymmetry between investors and auditors should, in turn, reduce the information asymmetry between investors and management. Outside the United States, other regulators and standard setters have already adopted expanded auditor reporting. The communication of critical audit matters will inform investors and other financial statement users of matters arising from the audit that involved especially challenging, subjective, or complex auditor judgment, and how the auditor addressed these matters. The Board believes that these matters will 2 Economists often describe this imbalance, where one party has more or better information than another party, as ‘‘information asymmetry.’’ As part of the system of financial reporting, the audit of the financial statements helps reduce the information asymmetry investors face by providing an independent opinion about whether the financial statements are presented fairly in all material respects. 3 See PCAOB IAG survey, Improving the Auditor’s Report (Mar. 16, 2011) (‘‘IAG 2011 survey’’). See also CFA Institute’s Usefulness of the Independent Auditor’s Report Survey Results (May 4, 2011), Independent Auditor’s Report Survey Results (Mar. 31, 2010), and Independent Auditor’s Report Monthly Poll Results (Mar. 12, 2008) (‘‘CFA survey and poll results’’). See also Board public meeting transcripts and participant statements (Apr. 2–3, 2014), available on the Board’s Web site in Rulemaking Docket Matter No. 034, Proposed Auditing Standards on the Auditor’s Report and the Auditor’s Responsibilities Regarding Other Information and Related Amendments (‘‘Docket 034’’). E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices likely be identified in areas that investors have indicated would be of particular interest to them, such as significant management estimates and judgments made in preparing the financial statements; areas of high financial statement and audit risk; significant unusual transactions; and other significant changes in the financial statements. The final standard is designed to elicit more information about the audit directly from the auditor. The Board believes that the critical audit matter requirements will respond to requests from investors for more information from the auditor while appropriately addressing concerns raised by other commenters. Investors and investor advocates have suggested a variety of ways in which investors can use the information provided in critical audit matters. In the view of some investors, critical audit matters will add to the total mix of information, providing insights relevant in analyzing and pricing risks in capital valuation and allocation, and contributing to their ability to make investment decisions. Investors also stated that critical audit matters will focus their attention on key financial reporting areas and identify areas that deserve more attention, enhancing the efficiency of investors and others in the consumption of financial information. Some investors believe that critical audit matters will highlight areas that they may wish to emphasize in their engagement with the company and provide important information that they can use in making proxy voting decisions, including ratification of the appointment of auditors. The final standard also includes a new required statement in the auditor’s report disclosing the year in which the auditor began serving consecutively as the company’s auditor, as well as a number of other improvements to the auditor’s report, such as a statement regarding the requirement for the auditor to be independent. Requiring disclosure of auditor tenure in the auditor’s report will make this information readily accessible in a timely way for investors who find it useful. The other improvements to the auditor’s report are intended to enhance the user’s understanding of the auditor’s role and responsibilities related to the audit of the financial statements, make the auditor’s report easier to read, and provide a consistent format. The final standard will generally apply to audits conducted under PCAOB standards. However, communication of critical audit matters is not required for audits of brokers and dealers reporting under the Securities VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 Exchange Act of 1934 (the ‘‘Exchange Act’’) Rule 17a-5; investment companies other than business development companies; employee stock purchase, savings, and similar plans (‘‘benefit plans’’); and emerging growth companies (‘‘EGCs’’), as defined in Section 3(a)(80) of the Exchange Act. Auditors of these entities may choose to include critical audit matters in the auditor’s report voluntarily. The other requirements of the final standard will apply to these audits. Critical audit matters are determined using a principles-based framework and the Board anticipates that the level of auditor effort will depend on the nature and complexity of the audit. The Board has adopted a phased approach to the effective dates for the new requirements to provide accounting firms, companies, and audit committees more time to prepare for implementation of the critical audit matter requirements, which are expected to require more effort to implement than the additional improvements to the auditor’s report. Subject to approval by the Securities and Exchange Commission (‘‘SEC’’), the final standard and amendments will take effect as follows: • All provisions other than those related to critical audit matters will take effect for audits of fiscal years ending on or after December 15, 2017; and • Provisions related to critical audit matters will take effect for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply. Auditors may elect to comply before the effective date, at any point after SEC approval of the final standard. (b) Statutory Basis The statutory basis for the proposed rules is Title I of the Act. B. Board’s Statement on Burden on Competition Not applicable. C. Board’s Statement on Comments on the Proposed Rules Received From Members, Participants or Others The Board released the proposed rule amendment for public comment in Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements; and Related Amendments to PCAOB Standards, PCAOB Release No. 2011– 003 (June 21, 2011) (‘‘concept release’’), Proposed Auditing Standards—The Auditor’s Report on an Audit of Financial Statements When the Auditor PO 00000 Frm 00003 Fmt 4701 Sfmt 4703 35397 Expresses an Unqualified Opinion; The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report; and Related Amendments to PCAOB Standards, PCAOB Release No. 2013–005 (Aug. 13, 2013) (‘‘proposal’’), Proposed Auditing Standard—The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, PCAOB Release No. 2016– 003 (May 11, 2016) (‘‘reproposal’’). See Exhibit 2(a)(A). A copy of Release Nos. 2011–003, 2013–005, 2016–003 and the comment letters received in response to the PCAOB’s requests for comment are available on the PCAOB’s Web site at https://pcaobus.org/Rulemaking/Pages/ Docket034.aspx. The Board received 491 written comment letters. The Board’s response to the comments it received and the changes made to the rules in response to the comments received are discussed below. Discussion of the Final Standard Critical Audit Matters Under the final standard, the auditor will be required to communicate critical audit matters in the auditor’s report in order to provide more information about the audit and make the auditor’s report more informative and relevant to investors and other financial statement users. Investor, investor advocate, and analyst commenters generally supported the reproposed requirement to communicate critical audit matters. Some of them stated that the communication of critical audit matters would be relevant to investors and other financial statement users by informing them of issues identified in the audit that were significant to the auditor, focusing attention on issues that would be pertinent to understanding the financial statements, and enhancing investor confidence in the financial statements. The larger and some smaller accounting firms generally supported including critical audit matters in the auditor’s report with some modification of the reproposed requirements. Other commenters, including other smaller accounting firms, companies, and audit committee members, did not support the requirements. Some of these commenters asserted that critical audit matters would not provide relevant information to investors, may be duplicative of the company’s disclosure, may result in disclosing information not otherwise required to be disclosed, E:\FR\FM\28JYN2.SGM 28JYN2 35398 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices could increase cost, or could delay completion of the audit. Other commenters suggested that the Board align the definition of critical audit matters with the International Auditing and Assurance Standards Board’s (‘‘IAASB’’) definition of key audit matters to enhance overall consistency. Consistent with the Board’s statutory mandate under Section 101(a) of Sarbanes-Oxley and in response to the 2008 U.S. Department of the Treasury Advisory Committee on the Auditing Profession (‘‘ACAP’’) recommendation and continued investor support for expanded auditor reporting, the final standard includes the requirement to communicate critical audit matters substantially as reproposed. The Board has taken into consideration all comments, including concerns raised by some commenters, which are described in more detail below, and believes its approach responds to investor requests for additional information about the financial statement audit without imposing requirements beyond the auditor’s expertise or mandate. The communication of critical audit matters will inform investors and other financial statement users of matters arising from the audit that involved especially challenging, subjective, or complex auditor judgment, and how the auditor addressed those matters. Critical audit matters are determined using a principles-based framework and the Board anticipates that the level of auditor effort will depend on the nature and complexity of the audit. This would in turn depend on the complexity of the operations and accounting and control systems of the company. Determination of Critical Audit Matters asabaliauskas on DSKBBXCHB2PROD with NOTICES Definition of Critical Audit Matter The reproposed standard defined a critical audit matter as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective, or complex auditor judgment. For the reasons explained below, the Board is adopting the definition as reproposed. Communicated or Required To Be Communicated to the Audit Committee Most commenters agreed that matters communicated or required to be communicated to the audit committee would be the appropriate source for critical audit matters. These VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 commenters stated that matters communicated to the audit committee are the most meaningful to users of the financial statements and using them as the source of critical audit matters would assist the auditor in determining critical audit matters in the most efficient and effective manner. PCAOB standards require the auditor to communicate to the audit committee, among other things: • Significant risks identified by the auditor; • Certain matters regarding the company’s accounting policies, practices, and estimates; • Significant unusual transactions; • Certain matters regarding the auditor’s evaluation of the company’s relationships and transactions with related parties; and • Other matters arising from the audit that are significant to the oversight of the company’s financial reporting process. Several commenters suggested revising the source of critical audit matters. Some suggested narrowing the source of critical audit matters only to matters required to be communicated to the audit committee, on the basis that this would avoid chilling communications regarding non-required matters and reduce the burden of documentation. Other commenters suggested that the Board consider, as an alternative, selecting critical audit matters only from critical accounting policies and estimates disclosed by management, which some said would eliminate the potential for the auditor to become the original source of information, as well as the potential for conflicting disclosures between the auditor and management. Some commenters also recommended not specifying the source for critical audit matters and leaving it up to auditor judgment. Other commenters suggested broadening the source of critical audit matters to include matters documented in the engagement completion document, reviewed by the engagement quality reviewer, or communicated with management and other members of the board of directors, as the Board had originally proposed in 2013. The final standard retains the source of critical audit matters as reproposed. Critical audit matters will be drawn from matters required to be communicated to the audit committee (even if not actually communicated) and matters actually communicated (even if not required). The source will include auditor communication requirements under AS 1301, Communications with Audit Committees, other PCAOB rules PO 00000 Frm 00004 Fmt 4701 Sfmt 4703 and standards,4 and applicable law,5 as well as communications made to the audit committee that were not required. This approach scopes in the broadest population of audit committee communications and will not require the auditor to determine whether matters communicated to the audit committee were required to be communicated. However, it seems likely that matters that meet the definition of a critical audit matter will usually relate to areas that are required to be communicated to the audit committee, either under a specific communication requirement or the broad provisions of paragraph .24 of AS 1301, which requires communication of matters arising from the audit that are significant to audit committee oversight of the financial reporting process. Required communications to the audit committee generally include the areas in which investors have expressed particular interest in obtaining information in the auditor’s report, such as significant management estimates and judgments made in preparing the financial statements; areas of high financial statement and audit risk; significant unusual transactions; and other significant changes in the financial statements. The final standard does not limit the source of critical audit matters to critical accounting policies and estimates because the Board does not believe this would be an appropriate starting point in light of investor interest in a broader range of topics related to the audit. Additionally, the final standard does not broaden the source, as proposed in 2013, to also include matters documented in the engagement completion document and reviewed by the engagement quality reviewer because it is unlikely that a matter that is determined to be a critical audit matter would not have already been communicated to the audit committee. Some commenters suggested that using audit committee communications as the source for critical audit matters could impair the relationship between auditor, management, and the audit committee (e.g., chill communications, give rise to conflict, or cause auditors to communicate more than they otherwise would). However, other commenters argued that critical audit matters would 4 See Appendix B of AS 1301, which identifies other PCAOB rules and standards that require audit committee communication, such as AS 2410, Related Parties, and AS 2502, Auditing Fair Value Measurements and Disclosures. 5 See, e.g., Section 10A(k) of the Exchange Act, 15 U.S.C. 78j–1(k); Rule 2–07 of Regulation S–X, 17 CFR 210.2–07; and Exchange Act Rule 10A–3, 17 CFR 240.10A–3. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices enhance, not impair, communications between auditors, investors, and those charged with governance (including audit committees). For matters required to be communicated to the audit committee, the Board believes there should not be a chilling effect or reduced communications to the audit committee because the requirements for such communications are not changing. It would seem that any chilling effect would more likely relate to matters that are not explicitly required to be communicated to the audit committee, although given the broad requirements of AS 1301 (particularly paragraph .24), the Board believes that there may be few, if any, relevant communications affected by that possibility. Some commenters suggested excluding certain required audit committee communications from the source of critical audit matters, generally because these communications relate to sensitive areas and may result in the auditor communicating information not disclosed by management. Suggestions included: Corrected and uncorrected misstatements, qualitative aspects of significant accounting policies and practices, alternative treatments within generally accepted accounting principles (‘‘GAAP’’) for policies and practices related to material accounts, violations or possible violations of law or regulation, independence considerations, disagreements with management, other material written communications between the auditor and management, overall planned audit strategy, delays encountered in the audit, and competency issues of management. Other commenters argued that no audit committee communications should be specifically excluded from consideration as a source of potential critical audit matters. The final standard does not exclude any required audit committee communications from the source of critical audit matters. To the extent that any such communication met the critical audit matter definition (including that it (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment), the Board believes it will be an appropriate subject for an auditor to communicate as a critical audit matter. Relates to Accounts or Disclosures That Are Material to the Financial Statements The materiality component of the reproposed definition of critical audit matters—that the matter ‘‘relates to accounts or disclosures that are VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 material 6 to the financial statements’’— was intended to respond to investor requests for informative and relevant auditor’s reports while, at the same time, addressing other commenters’ concerns regarding auditor communication of immaterial information that management is not required to disclose under the applicable financial reporting framework and SEC reporting requirements. Some investor commenters suggested removing the materiality component of the reproposed definition of critical audit matters, arguing that it made the definition too narrow and would unnecessarily exclude relevant information. Some of these commenters observed that many cases of material accounting problems or fraud started as ‘‘immaterial’’ to the financial statements and built over time, and that such matters may not meet the reproposed definition of a critical audit matter because of the materiality component. Other commenters, primarily companies and accounting firms, argued that the reproposed definition was too broad and suggested modifying the materiality component such that a critical audit matter would itself have to be material to the financial statements as a whole, rather than relating to accounts or disclosures that are material to the financial statements. These commenters expressed concern that the phrase ‘‘relates to accounts or disclosures that are material to the financial statements’’ could apply to too many matters, resulting in the auditor disclosing immaterial matters that would not otherwise be disclosed by management, or give the impression of a piecemeal opinion. After consideration of comments, the Board has determined to adopt the materiality component in the final definition of critical audit matter as reproposed. In the Board’s view, the purpose of the standard—making the auditor’s report more useful and informative to investors—is better served by auditor communication of matters related to accounts or 6 The definition of materiality is established under the U.S. federal securities laws. In interpreting those laws, the U.S. Supreme Court has held that a fact is material if there is ‘‘a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’’ See TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224, 231–32 (1988). As the Supreme Court has further explained, determinations of materiality require ‘‘delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him . . .’’ TSC Industries, 426 U.S. at 450. PO 00000 Frm 00005 Fmt 4701 Sfmt 4703 35399 disclosures that are material to the financial statements. As one commenter noted, limiting the source of critical audit matters and adding a materiality component that directly relates to accounts and disclosures ‘‘would allow the auditor to emphasize the most important matters to users of the financial statements, and limit the inclusion of an overabundance of [critical audit matters] within the auditor’s report that could deemphasize their importance.’’ 7 At the same time, in the Board’s view, limiting critical audit matters to those that are, in and of themselves, material to the financial statements as a whole would not serve the intended purpose of the standard. If the auditor were required to determine that a critical audit matter itself is material, rather than related to an account or disclosure that is material, it is likely that fewer matters would meet the definition of a critical audit matter and, thus, investors would likely receive less, and less auditspecific, information than under the standard as adopted. Accordingly, as in the reproposal, the final standard provides that each critical audit matter relates to accounts or disclosures that are material to the financial statements. Consistent with the reproposal, ‘‘relates to’’ clarifies that the critical audit matter could be a component of a material account or disclosure and does not necessarily need to correspond to the entire account or disclosure in the financial statements. For example, the auditor’s evaluation of the company’s goodwill impairment assessment could be a critical audit matter if goodwill was material to the financial statements, even if there was no impairment; it would relate to goodwill recorded on the balance sheet and the disclosure in the notes to the financial statements about the company’s impairment policy and goodwill. In addition, a critical audit matter may not necessarily relate to a single account or disclosure but could have a pervasive effect on the financial statements if it relates to many accounts or disclosures. For example, the auditor’s evaluation of the company’s ability to continue as a going concern could also represent a critical audit matter depending on the circumstances of a particular audit. On the other hand, a matter that does not relate to accounts or disclosures that are material to the financial statements 7 See letter from Dixon Hughes Goodman, LLP (Aug. 15, 2016) at 2, available on the Board’s Web site in Docket 034 (also noting that there is a continuing risk that the auditor could disclose information about the company that was not previously disclosed by the company). E:\FR\FM\28JYN2.SGM 28JYN2 35400 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES cannot be a critical audit matter. For example, a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a critical audit matter; it does not relate to an account or disclosure in the financial statements, even if it involved especially challenging auditor judgment. The same rationale would apply to a potential illegal act if an appropriate determination had been made that no disclosure of it was required in the financial statements; the matter would not relate to an account or disclosure that is material to the financial statements. For the same reason, the determination that there is a significant deficiency in internal control over financial reporting, in and of itself, cannot be a critical audit matter; such determination, in and of itself, does not relate to an account or disclosure that is material to the financial statements as no disclosure of the determination is required. A significant deficiency could, however, be among the principal considerations that led the auditor to determine that a matter is a critical audit matter.8 Involved Especially Challenging, Subjective, or Complex Auditor Judgment Many commenters supported including ‘‘matters that involved especially challenging, subjective, or complex auditor judgment’’ in the reproposed definition of a critical audit matter. Other commenters argued that the phrase ‘‘especially challenging, subjective, or complex auditor judgment’’ is broad and subjective and would lead to inconsistent application of the reproposed definition. For example, some commenters said that critical audit matters would vary based on the experience and competence of the auditor, even if the underlying facts and circumstances were the same. One commenter urged disclosure of the auditor’s perspective on material related party transactions. Another commenter suggested that the standard include a note stating that it is expected that in most audits, financial statement matters involving the application of significant judgment or estimation by management would involve especially challenging, subjective, or complex auditor judgment. 8 See below for additional considerations related to auditor disclosure of original information. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 Several commenters suggested using the IAASB’s definition of key audit matters, which includes those matters that were of most significance in the audit of the financial statements and that required significant auditor attention. One commenter argued that this would avoid reliance on the auditor’s determination of whether a matter involved especially challenging, subjective, or complex auditor judgment, which the commenter said would give auditors too much discretion. After consideration of comments, the Board is adopting this component of the definition of critical audit matter as reproposed, namely ‘‘matters that involved especially challenging, subjective, or complex auditor judgment.’’ This grounds the definition in the auditor’s expertise and judgment, which is directly responsive to investor requests for information from the auditor’s point of view. Thus, the Board believes that this definition will focus critical audit matters in areas where investors will particularly benefit from expanded reporting by the auditor. The determination of critical audit matters is principles-based and the final standard does not specify any items that would always constitute critical audit matters. For example, the standard does not provide that all matters determined to be ‘‘significant risks’’ under PCAOB standards would be critical audit matters.9 Some significant risks may be determined to be critical audit matters, but not every significant risk would involve especially challenging, subjective, or complex auditor judgment. To illustrate, improper revenue recognition is a presumed fraud risk and all fraud risks are significant risks; 10 however, if a matter related to revenue recognition does not involve especially challenging, subjective, or complex auditor judgment, it will not be a critical audit matter. Similarly, the final standard does not provide, as some commenters suggested, that material related party transactions or matters involving the application of significant judgment or estimation by management always constitute critical audit matters. The auditor must determine, in the context of the specific audit, that a matter involved especially challenging, subjective, or complex auditor judgment. In addition, focusing on auditor judgment should limit the extent to which expanded auditor 9 A significant risk is a ‘‘risk of material misstatement that requires special audit consideration.’’ Paragraph .A5 of AS 2110, Identifying and Assessing Risks of Material Misstatement. 10 See AS 2110.71. PO 00000 Frm 00006 Fmt 4701 Sfmt 4703 reporting could become duplicative of management’s reporting. To the extent that critical audit matters reflect differences in auditors’ experience and competence, this in itself should also be informative. Factors The reproposal included the following nonexclusive list of factors for the auditor to take into account, together with audit-specific factors, when determining whether a matter involved especially challenging, subjective, or complex auditor judgment: a. The auditor’s assessment of the risks of material misstatement, including significant risks; b. The degree of auditor subjectivity in determining or applying audit procedures to address the matter or in evaluating the results of those procedures; c. The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; d. The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty; e. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions; and f. The nature of audit evidence obtained regarding the matter. Commenters in general agreed that including such factors would assist the auditor in determining critical audit matters. Some commenters suggested changes to better align the factors with areas of complex management judgment, to reduce the risk that the auditor would be the source of original information, to clarify the linkage of procedures performed by the auditor and sufficient appropriate audit evidence obtained in performing those procedures, and to focus the auditor on the audit procedures executed to obtain sufficient and appropriate audit evidence rather than audit strategy decisions. Some commenters suggested harmonizing the factors with the IAASB’s factors for determining key audit matters. After considering the comments received, the Board has modified the factors by reordering them and revising the factor relating to the degree of auditor subjectivity (factor b above) to refer to the application (rather than determination) of audit procedures, which focuses it more clearly on the E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices performance of the audit rather than audit strategy. Some commenters suggested that the factor pertaining to the nature and extent of the audit effort (factor c) be revised to relate to the nature and extent of audit effort required to obtain sufficient appropriate audit evidence to address a matter and the factor pertaining to the nature of audit evidence (factor f) be deleted to clarify that obtaining audit evidence is a component of audit effort. The final standard does not change factor c as suggested because it would inappropriately narrow the factor exclusively to considerations related to obtaining audit evidence rather than the nature of the overall audit effort. Additionally, the Board determined to retain factor f as a stand-alone factor because, as stated in the reproposal, in the limited implementation trial conducted by several accounting firms, this factor appeared to be one of the most useful in determining critical audit matters.11 A commenter recommended including a factor based on the extent of interaction with the audit committee. The final standard does not include this factor because the extent of interaction might not be a meaningful indicator of the complexity or subjectivity of the matter and it could create incentives to limit communication between the auditor and the audit committee. One commenter did not agree with elimination of two proposed factors that related to the severity of control deficiencies and corrected and uncorrected misstatements. These factors were eliminated from the reproposal in response to comments that the factors would lead the auditor to determine matters as critical audit matters in areas where the company has no existing reporting obligation, or where the company has determined that the matters are not material and therefore do not require disclosure under the financial reporting framework. For these reasons, the final standard does not include these factors. Under the final standard, once the auditor identifies a matter communicated or required to be communicated to the audit committee that relates to accounts or disclosures that are material to the company’s financial statements, the auditor should take into account the following nonexclusive list of factors, as well as other audit-specific factors, when determining whether a matter involved 11 See letter from the Center for Audit Quality (June 19, 2014) at 5, available on the Board’s Web site in Docket 034. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 especially challenging, subjective, or complex auditor judgment: a. The auditor’s assessment of the risks of material misstatement, including significant risks; b. The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty; c. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to these transactions; d. The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures; e. The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter; and f. The nature of audit evidence obtained regarding the matter. The determination should be made in the context of the particular audit, with the aim of providing audit-specific information rather than a discussion of generic risks. The factors provide a principles-based framework for the auditor to use in assessing whether a matter involved especially challenging, subjective, or complex auditor judgment. Depending on the matter, the auditor’s determination that a matter is a critical audit matter might be based on one or more of these factors, other factors specific to the audit, or a combination. Audit Period Covered by Critical Audit Matters The reproposal would have required the auditor to communicate critical audit matters for the audit of the current period’s financial statements. Because the communication of critical audit matters for prior periods might also be useful to investors and other financial statement users in certain situations, the reproposed standard provided that the auditor may communicate critical audit matters relating to a prior period when: (1) The prior period’s financial statements are made public for the first time, such as in an initial public offering, or (2) issuing an auditor’s report on the prior period’s financial statements because the previously issued auditor’s report could no longer be relied upon. Some commenters generally supported communicating critical audit matters for only the current period’s financial statements or for all periods if audited financial statements have not PO 00000 Frm 00007 Fmt 4701 Sfmt 4703 35401 been made public previously. Other commenters supported communication of critical audit matters for all periods presented along with an explanation if prior year critical audit matters are not repeated in the current year. Yet another commenter stated that the auditor should be encouraged to use judgment as to whether to include critical audit matters for prior periods and not limit the consideration only to the circumstances described in the reproposal. The final standard retains the requirement to communicate critical audit matters only for the current audit period. While most companies’ financial statements are presented on a comparative basis, and thus most auditor’s reports cover a similar period, requiring auditors to communicate critical audit matters for the current period, rather than for all periods presented, will provide relevant information about the most recent audit and is intended to reflect a costsensitive approach to auditor reporting. In addition, investors and other financial statement users will be able to look at prior years’ filings to analyze critical audit matters over time. However, the auditor could choose to include critical audit matters for prior periods. The final standard clarifies that the two situations relating to a prior period are examples rather than the only situations in which a critical audit matter for a prior period may be communicated. As noted in the reproposal, if the auditor’s report is dual-dated, the auditor will determine whether the new information for which the auditor’s report is dual-dated gives rise to any additional critical audit matters. In situations in which a predecessor auditor has been asked to reissue its auditor’s report, the communication of critical audit matters for the prior period need not be repeated because it is only required for the current year. However, the predecessor auditor could choose to include prior year critical audit matters in the reissued auditor’s report. Requirements of Other Regulators and Standard Setters IAASB. Under the IAASB’s standard, ‘‘key audit matters’’ are defined as those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Key audit matters are determined using a two-step process. First, the auditor identifies the matters communicated E:\FR\FM\28JYN2.SGM 28JYN2 35402 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices with those charged with governance 12 that required significant auditor attention in performing the audit, taking into account: • Areas of higher assessed risks of material misstatement, or significant risks; • Significant auditor judgments relating to areas in the financial statements that involved significant management judgment, including accounting estimates that have been identified as having high estimation uncertainty; and • The effect on the audit of significant events or transactions that occurred during the period.13 Second, of the matters that required significant auditor attention, the auditor identifies those of most significance in the audit as the key audit matters.14 The IAASB requires the communication of key audit matters for the current period only.15 European Union (‘‘EU’’). The EU requires the auditor to describe the most significant assessed risks of material misstatement, including assessed risks of material misstatement due to fraud.16 The EU does not specify the period for which these need to be described. Financial Reporting Council in the United Kingdom (‘‘FRC’’). The FRC requires the auditor to describe the risks of material misstatement that had the greatest effect on: (1) The overall audit strategy; (2) the allocation of resources in the audit; and (3) directing the efforts of the engagement team.17 The FRC does not specify the period for which these need to be described. Communication of Critical Audit Matters asabaliauskas on DSKBBXCHB2PROD with NOTICES Under the reproposal, the auditor would have been required to include introductory language in the auditor’s report preceding the communication of critical audit matters and to communicate critical audit matters by identifying each matter, describing the auditor’s principal considerations for determining that the matter was a critical audit matter, describing how the critical audit matter was addressed in the audit, and referring to the relevant financial statement accounts and disclosures. 12 See paragraph 8 of ISA 701. See also ISA 260, Communication with Those Charged with Governance, which provides requirements for auditor communications with those charged with governance. 13 See paragraph 9 of ISA 701. 14 See paragraph 10 of ISA 701. 15 See paragraphs 8 and 10 of ISA 701. 16 See requirements in 2(c) of Article 10, Audit Report, of Regulation (EU) No. 537/2014. 17 See paragraph 19A of UK ISA 700 (2013). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 Comments varied on the reproposed requirements for communication of critical audit matters and the level of detail the auditor should provide, including whether the auditor should be permitted to provide information about the company that has not been previously disclosed by the company (which commenters referred to as ‘‘original information’’). Commenters generally agreed with identifying each critical audit matter and referring to the relevant financial statement accounts and disclosures. One commenter suggested removing the requirements to describe the considerations for determining that a matter was a critical audit matter and how the critical audit matter was addressed in the audit. While some commenters stated that the proposed requirements regarding auditor’s communication of critical audit matters are sufficiently clear, many suggested improvements to some of the components of the communication requirements. After consideration of comments, the Board has made some enhancements to the communication requirements, as described below. Introductory Language The reproposed standard provided introductory language to be included in the ‘‘Critical Audit Matters’’ section of the auditor’s report indicating that critical audit matters did not alter the opinion on the financial statements and that the auditor was not providing a separate opinion on the critical audit matters. Some commenters supported the introductory language on the basis that it could minimize users’ potential misunderstanding of the critical audit matters. Some commenters suggested additions to the introductory language to emphasize that critical audit matters are subjective and may not represent the most important aspects of the financial statements, to clarify that the description of procedures should not be taken as indicative of results of any individual procedure, or to limit reliance on critical audit matters by adding language similar to that used in a report on an audit of internal control over financial reporting (‘‘ICFR’’).18 The 18 The auditor’s report on the audit of internal control over financial reporting requires a paragraph stating that, ‘‘because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements and that projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.’’ See paragraph .85j of AS 2201, An Audit of Internal PO 00000 Frm 00008 Fmt 4701 Sfmt 4703 introductory language in the final standard does not include the suggested additions because such language could be interpreted as disclaiming or inappropriately minimizing the communication of critical audit matters. Other commenters suggested minor revisions in the introductory language to refer to the ‘‘communication of critical audit matters’’ rather than the critical audit matters themselves. In response to this comment, the required introductory language in the final standard has been revised as follows (additions are in italic and deletions are in {brackets}): The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) Relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of {C}critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we {do} are not, by communicating the critical audit matters below, {provide} providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Communication Requirements The reproposal required that, for each critical audit matter, the auditor would: • Identify the critical audit matter; • Describe the principal considerations that led the auditor to determine that the matter is a critical audit matter; • Describe how the critical audit matter was addressed in the audit; and • Refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter. As discussed in more detail below, these requirements have been adopted substantially as reproposed.19 Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements. 19 The reproposing release included two illustrative examples of the communication of critical audit matters. See PCAOB Release No. 2016–003, Section IV.A.2.b. Given the principlesbased nature of the requirements for critical audit matters and the objective of providing tailored, audit-specific information, the examples were intended to function as illustrations of how critical audit matters could be communicated, and not as templates for how critical audit matters should be communicated. Comments received on these examples were taken into account in the Board’s consideration of the final standard. Illustrative examples do not appear in the adopting release because the Board believes auditors should provide tailored, audit-specific information when communicating critical audit matters in the auditor’s report. E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES Identify the Critical Audit Matter and Describe the Principal Considerations That Led the Auditor To Determine That the Matter Is a Critical Audit Matter Many commenters who addressed this topic supported the identification of the critical audit matter and limiting the description to ‘‘the principal considerations’’ that led the auditor to determine that the matter is a critical audit matter, and those aspects of the communication requirements are adopted as reproposed. The auditor’s description of the principal considerations should be specific to the circumstances and provide a clear, concise, and understandable discussion of why the matter involved especially challenging, subjective, or complex auditor judgment. It is expected that the communication will be tailored to the audit to avoid standardized language and to reflect the specific circumstances of the matter. Describe How the Critical Audit Matter Was Addressed in the Audit The reproposed standard included a new requirement for the auditor to describe how the critical audit matter was addressed in the audit. While the standard did not specify how this should be done, the reproposing release provided four examples of potential approaches to such descriptions: (1) The auditor’s response or approach that was most relevant to the matter; (2) a brief overview of the procedures performed; (3) an indication of the outcome of the auditor’s procedures; and (4) key observations with respect to the matter, or some combination of these elements.20 Many commenters were supportive of a requirement to describe how each critical audit matter was addressed in the audit. Some commenters asserted that a description of how a critical audit matter was addressed would benefit investors by providing insights on how and on what basis the auditor developed the opinion or the rigor that underlies the audit procedures performed. For example, one investor commenter stated that including audit procedures in the description of a critical audit matter would make the auditor’s report more informative and useful. Several investors suggested that the auditor should be required or encouraged to provide informative, company-specific findings when describing how the critical audit matter was addressed in 20 These elements are similar to the IAASB’s elements described in paragraph A46 of ISA 701. The EU also requires that the auditor describe key observations with respect to the most significant assessed risks of material misstatement. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 the audit, such as whether management’s significant accounting estimates and judgments were balanced, mildly optimistic, or mildly pessimistic. One commenter suggested that the description of how the critical audit matter was addressed in the audit should be optional. Several commenters objected to the auditor including audit procedures in the description of critical audit matters because it would not provide any incremental value or actionable information to investors, investors may not have the expertise or context to understand audit procedures, or the description of audit procedures would become boilerplate. One commenter suggested adding a note to clarify that the purpose of describing audit procedures is to provide information about the audit but not specific details that would compromise the effectiveness of audit procedures. Other commenters suggested that only the principal audit procedures should be provided. The final standard includes the requirement for the auditor to describe how the critical audit matter was addressed in the audit because it is consistent with the Board’s objective of providing more information about the audit and, if developed with an appropriate focus on the intended audience, should be of interest to users. Similar to the reproposal, the final standard does not prescribe a specific way to meet this requirement. Several commenters suggested that the four examples provided in the reproposing release be included in the standard because they provide helpful guidance on how the requirement could be met. The final standard includes a note incorporating these examples, which should clarify the Board’s expectations while providing flexibility in describing how a critical audit matter was addressed in the audit. While the description of how the critical audit matter was addressed in the audit will require judgment, the auditor should bear in mind that the intent of communicating critical audit matters is to provide information about the audit of the company’s financial statements that will be useful to investors. A brief overview of the audit procedures performed is one of the alternatives for describing how the critical audit matter was addressed. If the auditor chooses to describe audit procedures, the descriptions are expected to be at a level that investors and other financial statement users would understand. In addition, as the four examples should make clear, the objective is to provide a useful summary, not to detail every aspect of PO 00000 Frm 00009 Fmt 4701 Sfmt 4703 35403 how the matter was addressed in the audit. Limiting the use of highly technical accounting and auditing terms in the description of critical audit matters, particularly if the auditor chooses to describe audit procedures, may help financial statement users better understand these matters in relation to the audit of the financial statements. In its comment letter, a working group of the IAG stressed the importance to investors of auditor findings, which they described as ‘‘the one item that [they] believe would provide the greatest value to investors.’’ 21 Acknowledging the difficulty of mandating reporting of findings, the working group recommended that the Board encourage auditors to include them voluntarily. Under the final standard, communication of the auditor’s findings is not required; however, in describing the audit response, the auditor may choose to include findings as an indication of the outcome of audit procedures or key observations about a matter. The Board shares the working group’s view that the inclusion of informative, companyspecific audit findings related to critical audit matters may, in appropriate circumstances, be valuable to investors and encourages auditors to consider including such findings in their auditor’s reports. However, in describing findings, the language used should not imply that the auditor is providing a separate opinion on the critical audit matter or on the accounts or disclosures to which they relate. Refer to the Relevant Financial Statement Accounts or Disclosures That Relate to the Critical Audit Matter The reproposed standard would have required the auditor to refer to the relevant financial statement accounts and disclosures that relate to the critical audit matter. There were few comments on this requirement. One commenter suggested that, to avoid duplication, reference should be made only to the disclosures and not the financial statement accounts. In response to this suggestion, the final standard clarifies that the auditor could refer to either the relevant account or disclosure, rather than both, to avoid potential duplication. The reproposal also solicited comment on whether, in addition to referring to the relevant financial 21 Letter from the IAG’s auditor’s report working group (Aug. 15, 2016) at 1, available on the Board’s Web site in Docket 034. The working group made a presentation regarding its comment letter at the IAG meeting in October 2016, available on the Board’s Web site. E:\FR\FM\28JYN2.SGM 28JYN2 35404 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices statement accounts and disclosures, the auditor should refer to relevant disclosures outside the financial statements. Commenters that addressed this question generally opposed the auditor referencing disclosures outside the financial statements when describing a critical audit matter because it may incorrectly suggest that such information is audited or cause readers to misinterpret the auditor’s role in relation to such information. The final standard only requires the auditor to refer to the relevant financial statement accounts or disclosures. Additional Considerations Related to the Communication Requirements asabaliauskas on DSKBBXCHB2PROD with NOTICES Auditor Disclosure of ‘‘Original Information’’ About the Company The reproposed standard included a note to indicate that, when describing critical audit matters in the auditor’s report, the auditor is not expected to provide original information unless it 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. Investor commenters, including the auditor’s report working group of the IAG, argued that there should not be any limitation on the auditor providing original information and that the reproposal went too far in constraining the auditor from providing original information in response to concerns expressed by other commenters (which were primarily companies and accounting firms). Other commenters expressed the view that auditors should not provide original information about the company or should be limited to providing information about the audit and not the company. These commenters stated that the auditor providing original information about the company would be inconsistent with the traditional U.S. regulatory framework, whereby management provides information about the company and the auditor attests to compliance with the applicable financial reporting framework. However, one investor commenter noted that auditor reporting should not be limited by ‘‘original information,’’ a term that is undefined in auditing literature. No PCAOB standard, SEC rule, or other financial reporting requirement prohibits auditor reporting of information that management has not previously disclosed. Rather, there are areas under current law and auditing standards that require auditor reporting that goes beyond attesting to the VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 compliance of management disclosures (e.g., substantial doubt about a company’s ability to continue as a going concern 22 or illegal acts 23). As discussed in more detail below, auditors may have professional or state law obligations to maintain client confidentiality, but these obligations should not apply to, or should be preempted by, reporting obligations arising under federal law and regulations, including under PCAOB standards. Accordingly, the requirement to communicate critical audit matters is not, as some commenters have suggested, inconsistent with the existing U.S. financial reporting framework and auditors’ other obligations. Commenters also said that the role of the audit committee or management would be undermined by requiring the auditor to disclose information about the company’s financial statements, since in their view it is solely management’s responsibility to determine what disclosure is appropriate. Several commenters stated that the communication of critical audit matters would give auditors leverage to encourage disclosure of information by management, and that management would likely modify its disclosure in response to the communication of critical audit matters in the auditor’s report so the auditor would not be a source of original information. While some commenters said that this would improve management disclosures, others said it would be an inappropriate expansion of the auditor’s role or would add significant costs. Other commenters stated that companies could be harmed by the disclosure of confidential or competitively sensitive information. Another commenter expressed concern that investors could be confused or misled if auditor reporting lacked context or appeared to conflict with management disclosures. One commenter suggested that the auditor should disclose original information only if a disclosure matter continues to 22 See AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern. The auditor is required to include a going concern explanatory paragraph if the auditor concludes that substantial doubt exists about the entity’s ability to continue as a going concern for a reasonable period of time (see AS 2415.12). If management’s disclosure with respect to the company’s ability to continue as a going concern is inadequate, the auditor’s reporting responsibility regarding going concern remains and the report includes either a qualified or an adverse opinion (see AS 2415.14). 23 Auditors may be required, under certain circumstances, pursuant to the Private Securities Litigation Reform Act of 1995 (codified in Section 10A(b)1 of the Exchange Act), to make a report to the SEC relating to an illegal act that has a material effect on the financial statements. PO 00000 Frm 00010 Fmt 4701 Sfmt 4703 be unresolved after discussion with management and the audit committee. The Board acknowledges these concerns and, in developing the auditor’s communication requirements, has sought to strike an appropriate balance between investor demands for expanded auditor reporting and the costs and potential unintended consequences associated with providing it. While auditor reporting of original information is not prohibited, it is limited to areas uniquely within the perspective of the auditor: Describing the principal considerations that led the auditor to determine that the matter is a critical audit matter and how the matter was addressed in the audit. The objective of critical audit matters— helping investors to focus on identified areas of the audit and understand how the auditor addressed them—may not be accomplished if the auditor is prohibited from providing such information. Moreover, prohibiting the auditor from providing such information could make critical audit matter communications incomplete in a way that could be confusing to or misunderstood by investors. It seems likely, as one commenter observed, that auditors will generally not have incentives to provide information about the company that the company has not already made public. Another commenter noted that, in current practice, disclosure is already guided by an iterative process between management and the auditor, and expected that a similar process would occur for critical audit matters, reducing the likelihood that the auditor would be a source of original information since critical audit matters would likely overlap with increased management disclosure.24 To the extent that an auditor’s decision to communicate a critical audit matter incents the company to expand or supplement its own disclosure, the Board believes this may improve the quality of public disclosures, which would be an indirect benefit of the standard. However, if the company does not provide additional disclosure, and the information is necessary to describe the principal considerations that led the auditor to determine that the matter is a critical audit matter or how it was addressed in the audit, the Board believes it is in the public interest for the auditor to include that information in the auditor’s report. The final standard therefore retains the note from the reproposal explaining that 24 It should be noted, however, that critical audit matters are not a substitute for disclosures required of the company under the applicable financial reporting framework. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices 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. Of course, any matter that will be communicated as a critical audit matter will already have been discussed with the audit committee, and the auditor will be required to provide a draft of the auditor’s report to the audit committee and discuss the draft with them.25 In addition, as the auditor determines how best to comply with the communication requirements, the auditor could discuss with management and the audit committee the treatment of any sensitive information. Some commenters also stated that, in areas where there are specific reporting obligations under the applicable financial reporting framework or SEC reporting requirements but the matter falls below the disclosure threshold (for example, a significant deficiency), auditor communication could, in effect, impose a lower disclosure threshold. With regard to such areas, it is likely that the nature of a critical audit matter and its description would be broader than, for instance, focusing on a significant deficiency. In addition, while the auditor is required to describe the principal considerations that led the auditor to determine that the matter is a critical audit matter, (which may include, if relevant, information about the company’s processes and controls) and how the overall matter was addressed, it is not necessary for the auditor’s description to use the terminology of the other auditing standard, such as ‘‘significant deficiency’’ within the broader context of a critical audit matter. For example, if a significant deficiency was among the principal considerations in determining that revenue recognition was a critical audit matter, the auditor would describe the relevant controlrelated issues over revenue recognition in the broader context of the critical audit matter without using the term ‘‘significant deficiency.’’ 26 Some commenters suggested that any expanded disclosure requirements should come from the SEC and the Financial Accounting Standards Board (‘‘FASB’’), in the form of additional AS 1301.21, as amended. should be noted that the determination that a matter was a significant deficiency in internal control over financial reporting, on its own, could not be a critical audit matter. management disclosures, rather than from the Board expanding requirements for auditor reporting. However, investors have consistently asked to hear more from the auditor, an independent third-party expert whose work is undertaken for the investor’s benefit. As one commenter noted, the auditor is best suited to provide insights on how and on what basis the auditor developed its opinion. The final standard is designed to elicit information about the audit directly from the auditor’s perspective. If auditors can adequately convey to investors the principal considerations and how the auditor addressed the matter without including previously undisclosed information, it is expected that they will. However, the standard provides that even when management has not disclosed information, the auditor is not constrained from providing such information if it 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. The Board intends to monitor implementation of the critical audit matter requirements to determine if additional guidance is needed in this area. Potential Compliance Issues Related to Critical Audit Matters Some commenters suggested that the reporting of critical audit matters could create compliance challenges for companies. Two commenters expressed concern that companies’ SEC filings may have to be amended because of changes in the description or reporting of critical audit matters. In principle, auditors should approach errors and misstatements in the communication of critical audit matters in the same way they would approach any other error or misstatement in the auditor’s report that does not affect the auditor’s opinion or the ability of market participants to rely on the opinion.27 It appears that under current practice, SEC filings have been amended solely to correct errors in auditor’s reports, such as incorrect auditor’s report dates or missing explanatory paragraphs. Another commenter expressed concern that management may be asked to respond to investor questions regarding issues described in critical audit matters and may not be in a 25 See 26 It VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 27 The final standard indicates that the auditor’s communication of critical audit matters does not alter in any way the auditor’s opinion on the financial statements, taken as a whole. PO 00000 Frm 00011 Fmt 4701 Sfmt 4703 35405 position to do so, particularly in light of their responsibilities under Regulation FD. Given the auditor’s responsibility to communicate with the audit committee, and the likelihood of extensive discussions between auditors and management regarding critical audit matters, it seems likely that management will be prepared to respond appropriately and in compliance with their legal obligations (including Regulation FD), as they would with regard to any other question about information included in an SEC filing. Ability To Communicate No Critical Audit Matters The reproposal provided that the auditor could determine there were no critical audit matters and provide a statement to that effect in the auditor’s report. Commenters generally supported the auditor’s ability to determine that there are no critical audit matters. Two commenters suggested that the auditor should not have to make a statement in the auditor’s report that there were no critical audit matters because the absence of a critical audit matter should be sufficient without the definitive statement, similar to an emphasis paragraph. The final standard includes the possibility that the auditor could determine, and state in the auditor’s report, that there are no critical audit matters.28 The statement that there are no critical audit matters is required because unlike an emphasis paragraph, critical audit matters are a required element of the auditor’s report. The determination of critical audit matters is based on the facts and circumstances of each audit. The Board expects that, in most audits to which the requirement to communicate critical audit matters applies, the auditor will determine that at least one matter involved especially challenging, subjective, or complex auditor judgment. There may be critical audit matters even in an audit of a company with limited operations or activities. However, there may be circumstances in which the auditor determines there are no matters that meet the definition of a critical audit matter and, in those circumstances, the auditor will communicate that there were no critical audit matters. 28 Since communication of critical audit matters will not be required for the audits of EGCs, brokers and dealers reporting under Exchange Act Rule 17a–5, 17 CFR 240.17a–5, investment companies other than business development companies, and benefit plans, the auditor’s report for the audits of these entities will not be required to include the statement that there are no critical audit matters. E:\FR\FM\28JYN2.SGM 28JYN2 35406 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES Requirements of Other Regulators and Standard Setters IAASB. For each key audit matter, the IAASB requires the auditor to reference the related disclosures, if any, in the financial statements and address: (1) Why the matter was considered to be one of most significance in the audit and therefore determined to be a key audit matter and (2) how the matter was addressed in the audit.29 The IAASB allows the auditor to determine that there are no key audit matters to communicate in the auditor’s report and, if so, requires a statement to this effect.30 EU. The EU requires the auditor to include in the auditor’s report: (1) A description of the most significant assessed risks of material misstatement, including assessed risks of material misstatement due to fraud; (2) a summary of the auditor’s response to the risks; and (3) where relevant, key observations arising with respect to the risks.31 FRC. The FRC requires the auditor, among other things, to: (1) Describe those assessed risks of material misstatement that were identified by the auditor and (2) provide an overview of the scope of the audit, including an explanation of how the scope addressed the assessed risks of material misstatement.32 The explanations of the matters set out in the auditor’s report should be described in a way that: (1) Enables a user to understand their significance in the context of the audit of the financial statements as a whole and not as discrete opinions on separate elements of the financial statements; (2) enables the matters to be related directly to the specific circumstances of the audited entity and are not therefore generic or abstract matters expressed in standardized language; and (3) complements the description of significant issues required to be made by the audit committee.33 Documentation of Critical Audit Matters The reproposed standard required documentation of the basis for the auditor’s determination whether each matter that both: (1) Was communicated or required to be communicated to the audit committee and (2) relates to accounts or disclosures that are material to the financial statements, involved or did not involve especially challenging, subjective, or complex auditor 29 See paragraph 13 of ISA 701. paragraphs 14 and 16 of ISA 701. 31 See requirements in 2(c) of Article 10, Audit Report, of Regulation (EU) No. 537/2014. 32 See paragraph 19A of UK ISA 700 (2013). 33 See paragraph 19B of UK ISA 700 (2013). 30 See VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 judgment. Some commenters supported a documentation requirement only for matters that were determined to be critical audit matters. Some of these commenters asserted that documentation about matters determined not to be critical audit matters would add costs and primarily benefit PCAOB inspections rather than audit quality. Others stated that the requirement is not aligned with the IAASB’s documentation requirement, which, in their view, focuses on rationale for inclusion as a key audit matter rather than exclusion. However, another commenter argued that the determination that a matter was not a critical audit matter would seem to be an important audit judgment that ought to be documented for review by the engagement quality reviewer. This commenter suggested that documentation be required only for matters required to be communicated to the audit committee (which would already have been documented) and not for those that are communicated otherwise. One auditor argued that the reproposed requirement would lead auditors to document all audit committee communications even if not required, and that this would disproportionately affect smaller companies whose audit committees more commonly request information not required to be communicated under PCAOB standards. The final standard substantially retains the approach from the reproposal of requiring the auditor to document the basis for determining critical audit matters.34 The objective of the requirement is to document how the determination of critical audit matters (or the determination that there are no critical audit matters) was made from among the matters communicated or required to be communicated to the audit committee that relate to accounts or disclosures that are material to the financial statements. The documentation requirement will also facilitate review by the engagement quality reviewer.35 The amount of documentation required could vary with the circumstances. For example, the auditor’s basis for the determination 34 The language of the documentation requirements has been redrafted to improve clarity, based on a commenter’s suggestion. 35 Under the existing audit documentation requirements, audit documentation facilitates the planning, performance, and supervision of the engagement, and is the basis for the review of the quality of the work because it provides the reviewer with written documentation of the evidence supporting the auditor’s significant conclusions. See paragraph .02 of AS 1215, Audit Documentation. PO 00000 Frm 00012 Fmt 4701 Sfmt 4703 may be so clear for some matters that a single sentence will be sufficient. This situation may arise, for instance, when the auditor’s documentation prepared in the course of the audit includes sufficient detail about whether or not the matter involved especially challenging, subjective, or complex auditor judgment. Other matters may require more extensive documentation. As noted in the reproposing release, for matters determined to be critical audit matters, the description in the auditor’s report (which, among other things, must describe the principal considerations that led the auditor to determine that it was a critical audit matter) will generally suffice as documentation. The auditor could comply with the documentation requirement in a variety of different ways. For example, the auditor could start with the communications to the audit committee, which are already documented, identify which of those matters relate to accounts or disclosures that are material to the financial statements, and then document the basis for the auditor’s determination of whether or not each matter involved especially challenging, subjective, or complex auditor judgment. In documenting the basis for the determination, the auditor may include the factors the auditor took into account. This documentation may be prepared as an extension to the audit committee documentation or the auditor may prepare separate documentation. Requirements of Other Regulators and Standard Setters The IAASB requires the auditor to document the matters that required significant auditor attention and the rationale for the auditor’s determination as to whether or not each of these matters is a key audit matter.36 The EU does not include documentation requirements for expanded auditor reporting. The FRC does not include specific documentation requirements related to expanded auditor reporting.37 Liability Considerations Related to Critical Audit Matters In both the proposal and the reproposal, the Board acknowledged that including critical audit matters would change the auditor’s report in ways that could affect auditors’ potential liability. As discussed in those releases, liability may be imposed on auditors under a number of different legal theories depending on the specific 36 See paragraph 18(a) of ISA 701. documentation requirements appear in ISA (UK and Ireland) 230, Audit Documentation. 37 General E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices facts and circumstances of a particular case, including pursuant to Section 11 of the Securities Act of 1933, Section 10(b) of the Exchange Act, and various state law causes of action. The critical audit matters would themselves be new statements that could be the basis for asserted claims. In addition, information provided regarding critical audit matters could affect other aspects of securities fraud claims against either the issuer, the auditor, or both (for example, by being described in pleadings in an effort to plead fraud with particularity or as a basis to seek to undercut a claim of reliance). The Board specifically sought comment on what effect the communication of critical audit matters would have on private liability and whether there were any steps the Board could or should take to address any likelihood of an increase in potential liability in private litigation. A number of companies and accountants responded to this request for comment. While several of these commenters noted that changes from the proposal had addressed certain of their liability concerns, most continued to express varying degrees of concern about the potential for increased liability, either for auditors or for both auditors and companies. In particular, commenters expressed concern that investors who suffer a financial loss could assert legal claims against the auditor based on statements made in identifying and describing critical audit matters. As with the proposal, commenters expressed general concerns that communication of critical audit matters would encourage baseless litigation, would likely lead to increased audit fees, raise the settlement value of spurious claims, or potentially undermine the stringent pleading standards of the Private Securities Litigation Reform Act of 1995, which were intended to curtail nonmeritorious claims against auditors and avoid the costs and burdens associated with them. Some commenters argued that auditors, to avoid being secondguessed, would have the incentive to communicate matters to the audit committee that were not otherwise required or to identify too many critical audit matters in an effort to protect themselves from liability. Several commenters expressed concern that communicating critical audit matters might compromise their ability to argue that the statements in the audit report are opinions which, one commenter argued, were ‘‘less vulnerable to challenges that they are false or VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 misleading.’’ 38 However, at least one of these commenters noted that the revised definition of a critical audit matter in the reproposal mitigated their concern on that point. Other commenters argued that the information communicated in describing critical audit matters could potentially be used to attack the audit by challenging the procedures performed or the adequacy of audit evidence obtained by the auditor. On the other hand, one commenter noted that the communication of critical audit matters is about disclosure of risks and challenges and expressed the belief that non-communication of such matters would be more problematic from a litigation point of view. Some commenters argued that the risk of liability would be heightened if the auditor were providing original information about the company. In particular, several commenters contended that doing so would conflict with accountants’ professional obligation to maintain client information in confidence, which could give rise to claims by the company against the auditor under state law. Some commenters argued that critical audit matters could increase litigation risk for companies as well as the auditor because the new statements required of the auditor could form a basis for new legal claims, could be misinterpreted as acts of negligence on the part of the company, or could be used by plaintiffs as a ‘‘road map’’ for litigation against the company. One commenter argued that, because the underlying work papers are subject to discovery, critical audit matters would be used as a source for potential litigation against both auditors and companies. Some of the commenters that expressed concerns about the potential for increased auditor liability also suggested changes to the reproposal that they maintained would reduce the liability impact of determining and communicating critical audit matters. For example, as previously discussed, several commenters suggested substantially similar changes to modify the materiality component of the definition of critical audit matters and to prohibit or discourage auditor communication of original information. The Board has carefully considered commenters’ concerns about potential liability throughout this standard-setting process, including the comments received on the reproposal. While mandating disclosure of critical audit matters will, by design, entail new 38 Letter from PricewaterhouseCoopers LLP (Aug. 15, 2016) at 7, available on the Board’s Web site in Docket 034. PO 00000 Frm 00013 Fmt 4701 Sfmt 4703 35407 statements in the auditor’s report, the Board notes that any claim based on these new statements would have to establish all of the elements of the relevant cause of action (for example, when applicable, loss causation and reliance). Critical audit matters will not replace or alter the fundamental requirement that the auditor’s report include the auditor’s opinion that the financial statements are fairly presented in accordance with the applicable financial reporting framework, which has been, and the Board expects will continue to be, the primary statement at issue in most private securities litigation under federal law involving auditors. Throughout this standard-setting process, the Board has carefully considered commenters’ suggestions to alter the terms of its proposal to mitigate their concerns about potential liability for omitting a critical audit matter. As discussed in the reproposal, the Board limited and clarified the process for determining critical audit matters, including by narrowing the source of critical audit matters to matters communicated or required to be communicated to the audit committee, adding a materiality component to the critical audit matter definition, and refining the factors used to determine critical audit matters. Those changes, as well as the critical audit matter definition’s focus on the auditor’s judgment, should mitigate concerns about potential liability for omitting a critical audit matter. With respect to suggestions to further narrow the definition of critical audit matters and the related communication requirements, it is not clear, and commenters did not explain, how those changes would mitigate liability concerns other than by reducing the number and content of required communications of critical audit matters. As described above, the Board has determined not to incorporate those suggested changes because they appear likely to significantly reduce the number of potential critical audit matters and the informativeness of auditor communication of critical audit matters. With respect to potential state law claims by companies against their auditors for disclosing original information, the Board notes that, as discussed above, it does not expect that, in general, critical audit matters will provide sensitive information that has not been disclosed by the company. With respect to the potential for a claim based on a situation in which the auditor found such disclosure necessary, the Board notes that auditors already have preexisting duties to E:\FR\FM\28JYN2.SGM 28JYN2 35408 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES disclose original information in certain circumstances.39 Commenters did not cite any specific examples in which these requirements have resulted in unwarranted claims against auditors for disclosing client confidences. Because the auditor’s obligations under PCAOB standards arise under federal law and regulations, professional or state law duties of client confidentiality should not apply to,40 or should be preempted by,41 the obligation to communicate critical audit matters.42 While the Board takes seriously the prospect of potential increases in auditors’ or companies’ liability, the Board believes it has appropriately addressed commenters’ concerns regarding liability in a manner compatible with the objectives of this rulemaking, and in view of the rulemaking’s anticipated benefits. Indeed, the Board notes that at least one of the commenters that expressed concern about potential liability, noted that those concerns ‘‘should not stand in the way of moving forward’’ on the reproposed standard.43 At the same time, the Board acknowledges that a 39 For example, for at least the last 20 years, auditors have had duties to disclose in their auditor’s reports when they have substantial doubt about the company’s ability to continue as a going concern. See Section 10A of the Exchange Act and AS 2415. In addition, when in an audit of internal control over financial reporting, the auditor identifies a material weakness that has not been included in management’s assessment, the auditor must modify its report to, among other things, ‘‘include a description of the material weakness, which should provide the users of the audit report with specific information about the nature of the material weakness and its actual and potential effect on the presentation of the company’s financial statements . . .’’. See Note to paragraph .91 of AS 2201; cf. Statement of Gaylen R. Hansen, CPA, at the PCAOB public meeting (Apr. 2, 2014) (‘‘Client confidentiality has a long-standing and important place in the accountancy profession. However, it doesn’t serve investors well when it is parlayed to obfuscate the important obligation to call things as they are seen.’’). 40 For example, the relevant AICPA rule provides that auditors ‘‘shall not disclose any confidential client information without the specific consent of the client,’’ but further provides that the confidentiality obligation shall not be construed ‘‘to prohibit . . . compliance with applicable laws and government regulations.’’ See paragraphs .01 and .02 of 1.700.001 Confidential Client Information Rule of the AICPA Code of Professional Conduct (as of Dec. 15, 2014). 41 See Crosby v. Nat’l Foreign Trade Council, 530 U.S. 363, 372–73 (2000); New York v. FCC, 486 U.S. 57, 64 (1988). 42 Some commenters suggested that safe harbor rules be created to protect auditors and companies from liability for statements about critical audit matters. While, as noted above, the Board will monitor the effects of critical audit matters should the requirements be approved by the SEC, the Board is not convinced at this time that any such safe harbor is necessary and, in any event, such a safe harbor is beyond the Board’s authority. 43 See letter from Deloitte & Touche LLP (Aug. 12, 2016) at 5, available on the Board’s Web site in Docket 034. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 variety of claims can be raised related to the statements in the audit report and that litigation is inherently uncertain. If the final standard is approved by the SEC, the Board will monitor the standard after implementation for any unintended consequences. Additional Improvements to the Auditor’s Report The reproposal provided a list of basic elements to be included in every auditor’s report. Some of these basic elements, such as auditor tenure, would be new elements in the auditor’s report. Other basic elements, such as the auditor’s opinion, identification of the financial statements audited, and management’s and auditor’s responsibilities, were drawn from the existing auditor reporting standard.44 Yet other basic elements, such as the name of the company under audit and the date of the financial statements, were incorporated from existing illustrative auditor’s reports. Auditor Tenure The reproposal included a required statement in the auditor’s report of the year the auditor began serving consecutively as the company’s auditor. The Board also sought comment on whether auditor tenure should be disclosed in Form AP, Auditor Reporting of Certain Audit Participants (‘‘Form AP’’), rather than in the auditor’s report.45 Disclosure of Tenure Investor commenters stated that information regarding auditor tenure would be useful to financial statement users, for example, in deciding whether to vote to ratify the appointment of the auditor. Investors that expressed a preference supported tenure disclosure in the auditor’s report, some on the basis of reducing investor search costs by ensuring a consistent location for the disclosure. One commenter representing a group of investors asserted that since the auditor’s report is the primary means by which the auditor communicates with investors, it is appropriate for auditor tenure to be included in the auditor’s report. This commenter further stated that disclosure of auditor tenure on Form AP would be existing AS 3101.06–.08. December 2015, the Board adopted Form AP, which provides investors and other financial statement users with information about engagement partners and other accounting firms that participate in audits of issuers. See Improving the Transparency of Audits: Rules to Require Disclosure of Certain Audit Participants on a New PCAOB Form and Related Amendments to Auditing Standards, PCAOB Release No. 2015–008 (Dec. 15, 2015). PO 00000 44 See 45 In Frm 00014 Fmt 4701 Sfmt 4703 an acceptable alternative to disclosure in the auditor’s report only if the timeliness, accessibility, searchability, and overall functionality of the information disclosed on Form AP were at least equivalent to having the information disclosed in the auditor’s report. Another commenter suggested that, if disclosure were required in the auditor’s report, a specific location should be designated. Currently, information about auditor tenure is not required to be communicated to investors by the auditor, management, or the audit committee.46 However, there is a growing trend toward voluntary disclosure of auditor tenure. Recent analysis of corporate proxy statements for annual meetings of shareholders has found that a growing number of companies are disclosing auditor tenure,47 presumably due to interest from investors. However, voluntary disclosure is not provided for a significant number of audits subject to the Board’s jurisdiction. Additionally, if disclosed, such information may not be provided in the same location in the proxy statement; for instance, some disclosures are in the audit committee report while others are in another section of the proxy.48 Further, the proxy rules do not apply to all companies required to be audited under PCAOB standards; for example, foreign private issuers, many companies whose 46 In certain instances, investors may be able to manually calculate tenure by reviewing company filings on the SEC’s Electronic Data Gathering, Analysis and Retrieval system (‘‘EDGAR’’) to determine when a company changed auditors. However, the information is not available prior to 1994 and may not be available for certain entities, such as investment companies and brokers and dealers, that are not required to file Form 8–K. See 17 CFR 249.308, Item 4.01 Changes in Registrant’s Certifying Accountant. Accordingly, currently available information is neither complete nor a readily accessible alternative to auditor tenure disclosure. 47 The Center for Audit Quality, together with Audit Analytics, reviewed corporate proxies filed through the end of June 2016, 2015, and 2014 of 1,500 Standard and Poor’s (‘‘S&P’’) Composite companies. Their analysis identified that in 2016, 2015, and 2014 auditor tenure was disclosed in the annual proxy statements of 59, 54, and 47 percent of the S&P 500 large-cap companies, respectively, 45, 44, and 42 percent of the S&P MidCap 400 companies, respectively, and 48, 46, and 50 percent of the S&P SmallCap 600 companies, respectively. See Center for Audit Quality and Audit Analytics, 2016 Audit Committee Transparency Barometer (Nov. 2016). Separately, during their review of proxy statements of Fortune 100 companies, Ernst & Young identified that 63 percent of the companies reviewed voluntarily disclosed auditor tenure in 2016 compared to 62 percent in 2015, 51 percent in 2014, 29 percent in 2013, and 24 percent in 2012. See Ernst & Young, Audit Committee Reporting to Shareholders in 2016 (Sept. 2016). 48 See Center for Audit Quality and Audit Analytics, 2016 Audit Committee Transparency Barometer (Nov. 2016). E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES securities are not listed on a national securities exchange, and most investment companies are not required to prepare proxy statements. Some commenters, primarily companies, did not support disclosure of auditor tenure in the auditor’s report on the basis that such disclosure would not provide value to investors. Other companies and accounting firms raised a concern that tenure disclosure could result in inferences that, in their view, would be inappropriate about correlations between auditor tenure and audit quality, or between auditor tenure and auditor independence. Some commenters also suggested that auditor tenure is a corporate governance matter and that disclosure should be provided by management or the audit committee rather than the auditor. A few commenters suggested that tenure disclosure should be addressed by SEC rulemaking or provided only voluntarily. Some commenters, many of whom generally opposed auditor tenure disclosure, suggested that Form AP would be a preferable location for disclosing tenure if the Board proceeded with requiring the disclosure. The SEC’s Investor Advocate stated that he ‘‘strongly support[s] requirements for public disclosure of auditor tenure,’’ recognizing that there were different opinions about the best party and location to make that disclosure.49 Noting that the SEC had issued a concept release asking whether auditor tenure should be disclosed in the audit committee report,50 the SEC’s Investor Advocate stated that he believed the SEC should ultimately decide these questions. In light of these considerations, the SEC’s Investor Advocate recommended that the PCAOB act to require disclosure of auditor tenure (either in the auditor’s report or in Form AP), but also consider including a contingent sunset clause such that the auditor disclosure requirement would expire if and when the SEC imposed any form of a company disclosure requirement. The Board believes that public disclosure of auditor tenure is important and in the public interest, and that it is 49 See letter from Rick A. Fleming, Investor Advocate, SEC (Aug. 15, 2016) at 4, available on the Board’s Web site in Docket 034. The letter noted that the views of the Investor Advocate do not necessarily reflect the views of the SEC, the Commissioners, or staff of the SEC, and the SEC disclaims responsibility for the letter and all analyses, findings, and conclusions contained therein. Additional information about the Office of the Investor Advocate is available on the SEC’s Web site. 50 See SEC, Possible Revisions to Audit Committee Disclosures, Exchange Act Release No. 75344 (July 1, 2015), 80 FR 38995 (July 8, 2015). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 appropriate to require disclosure in the auditor’s report because it is the primary means by which auditors communicate with investors. This will ensure that the disclosure is in a readily accessible and consistent location—the auditor’s report—for all companies. It will make auditor tenure information immediately available to investors upon filing with the SEC of a document containing the auditor’s report. Disclosure of auditor tenure in the auditor’s report will also reduce search costs for investors who are interested in auditor tenure, relative to the current environment of voluntary reporting. Disclosure of auditor tenure in the auditor’s report may also be more likely to encourage further discussion of auditor tenure by management and the audit committee and potential disclosure in company filings. The Board is not persuaded by commenters’ concerns that disclosure of auditor tenure in the auditor’s report necessarily suggests a specific correlation between auditor tenure and audit quality, or between auditor tenure and auditor independence. In the Board’s view, auditor tenure is another data point about the auditor, in addition to the firm name and the office issuing the auditor’s report, for which there is demonstrable investor demand. The standard does not specify a required location within the auditor’s report for the statement on auditor tenure; auditors that are concerned about the inferences readers may draw based on the placement of the disclosure in the auditor’s report have discretion to present auditor tenure in the part of the auditor’s report they consider appropriate. Consistent with the reproposal, the illustrative auditor’s report in the final standard includes the statement on auditor tenure at the end of the report. The Board considered disclosure of auditor tenure in Form AP, which requires disclosure of the name of the engagement partner and of the names and percentage of participation of other accounting firms in the audit for all issuer audits. Form AP was developed primarily to respond to commenter concerns about the potential liability consequences of naming persons in the auditor’s report, the potential need to obtain consents from those named persons in connection with registered securities offerings, and the additional time needed to compile information about the other accounting firms. The Board’s determination to require disclosure in Form AP, rather than in the auditor’s report, was a means to address these concerns. Disclosure of auditor tenure does not have the same potential liability or other consequences PO 00000 Frm 00015 Fmt 4701 Sfmt 4703 35409 as disclosure of the name of the engagement partner or other accounting firms, so such an approach is unnecessary in this case. The Board acknowledges that the SEC, given its broader authority and responsibility for the financial reporting process, could in the future determine that auditor tenure should be disclosed by some other party or in some other location, in addition to or instead of in the auditor’s report. Accordingly, the Board is adopting its requirement for tenure disclosure in the auditor’s report today. The Board anticipates that, if the SEC undertook rulemaking for disclosure of auditor tenure, the Board would work with the SEC to ensure that PCAOB standards coordinate appropriately with any new SEC requirements.51 Determination of Tenure The reproposal contemplated that tenure would be calculated taking into account firm or company mergers, acquisitions, or changes in ownership structure, and it included a note providing that if the auditor is uncertain as to the year the auditor became the company’s auditor, the auditor should so state and provide the earliest year of which the auditor has knowledge. Some commenters objected to this approach, saying that it could confuse investors and its relevance is unclear. The Board believes that the disclosure of tenure should reflect the entire relationship between the company and the auditor, including the tenure of predecessor accounting firms and engagement by predecessors of the company under audit. No changes have been made to the note in the final standard. Additionally, if a company went public and maintained the same auditor, auditor tenure will include the years the auditor served as the company’s auditor both before and after the company became subject to SEC reporting requirements. Because of the unique structure of investment companies, which typically includes common accounting, internal control, and oversight functions at the group level, the reproposed standard required that, for an investment company that is part of a group of investment companies,52 the auditor’s 51 Of course, the SEC also has authority to abrogate or modify PCAOB rules at any time, to, among other things, further the purposes of the securities laws. Section 107(b)(5) of SarbanesOxley, 15 U.S.C. 7217(b)(5). 52 A group of investment companies, as defined by Section 12(d)(1)(G)(ii) of the Investment Company Act of 1940 (‘‘Investment Company Act’’), means any two or more registered investment companies that hold themselves out to investors as E:\FR\FM\28JYN2.SGM Continued 28JYN2 35410 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices statement regarding tenure will contain the year the auditor began serving consecutively as the auditor of any investment company in the group of investment companies.53 For example, if Firm A has been auditing investment companies in XYZ group of investment companies since 1980, the current auditor’s report for XYZ fixed income fund, whose inception date was in 2010, will state that Firm A has served as the auditor of one or more XYZ investment companies since 1980. A commenter asserted that measuring auditor tenure from the first year of service to the group of investment companies might confuse or even mislead the reader of the auditor’s report for a new fund, especially if the auditor has served the group for several years. Another commenter supported the reproposed methodology for measuring tenure for investment companies stating that it is appropriate given the common accounting system, system of internal control over financial reporting, and board oversight for a group of investment companies. After considering the comments received, the Board is adopting the requirement regarding auditor tenure for an investment company that is part of a group of investment companies as reproposed. The Board believes that the length of an auditor’s relationship with the group is more relevant than the relationship with an individual fund, since funds can be started and merged over time but the auditor’s relationship with the group continues. Requirements of Other Regulators and Standard Setters The EU requires a statement in the auditor’s report that indicates the total uninterrupted engagement period, including previous renewals and reappointments of the statutory auditors or the audit firms.54 The IAASB and the FRC do not include a similar requirement. asabaliauskas on DSKBBXCHB2PROD with NOTICES Clarification of Existing Auditor’s Responsibilities The reproposed standard included requirements that would enhance standardized language of the auditor’s report by clarifying the nature and scope of the auditor’s existing responsibilities, related companies for purposes of investment and investor services. For purposes of determining auditor tenure, any tenure with other entities that may be part of an investment company complex, such as investment advisers or private investment companies, is not included. 53 The following is an example of such statement: ‘‘We have served as the auditor of one or more [Group Name] investment companies since [year].’’ 54 See requirements in 2(b) of Article 10, Audit Report, of Regulation (EU) No 537/2014. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 such as a new statement regarding auditor independence and the addition of the phrase ‘‘whether due to error or fraud,’’ when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements. In addition, the reproposed standard included a requirement intended to promote uniformity with respect to the addressee of the report. Auditor Independence The reproposed standard included a required statement in the auditor’s report that the auditor is a public accounting firm registered with the PCAOB and is required to be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC 55 and the PCAOB.56 Commenters generally supported the required statement regarding auditor independence. Some said that the statement would reinforce financial statement users’ understanding of the auditor’s existing obligations to be independent and serve as a reminder to auditors of these obligations. Some commenters preferred a more definitive statement, such as stating that the auditor is in fact independent and in compliance with applicable independence rules. A few commenters questioned whether the statement will improve an investors’ understanding of the auditor’s independence responsibilities, yield any incremental benefits or insight to investors, or have any impact on auditor behavior. Some of these commenters pointed out that independence is already included in the title of the auditor’s report and including an additional statement in the auditor’s report is redundant and unnecessary. After consideration of comments, the statement regarding auditor independence is adopted as reproposed. The Board believes that the independence statement in the auditor’s report will both enhance investors’ and other financial statement users’ understanding of the auditor’s existing obligations to be independent, and serve as a reminder to auditors of these obligations. The statement regarding auditor independence is not intended to, and will not, affect auditor independence requirements under the securities laws, SEC rules, or PCAOB rules. 55 See Regulation S–X Rule 2–01, 17 CFR 210.2– 01. PO 00000 56 See PCAOB Rule 3520, et seq. Frm 00016 Fmt 4701 Sfmt 4703 Requirements of Other Regulators and Standard Setters The IAASB requires that the auditor’s report include a statement that the auditor is independent of the entity in accordance with the relevant ethical requirements relating to the audit and has fulfilled the auditor’s other ethical responsibilities in accordance with these requirements.57 The EU requires a statement in the auditor’s report that the auditor remained independent of the audited entity in conducting the audit.58 The FRC requires the auditor to state that the auditor is required to comply with the United Kingdom’s ethical standards for auditors, which include requirements regarding auditor independence.59 Addressee Under the existing standard, the auditor’s report may be addressed to the company whose financial statements are being audited, its board of directors, or stockholders.60 Under current practice, the auditor’s report is generally addressed to one or more of the following: (1) The board of directors and stockholders/shareholders, or their equivalent for issuers that are not organized as corporations; (2) the plan administrator or plan participants for benefit plans; and (3) the directors or equity owners for brokers or dealers.61 To promote consistency in addressing the auditor’s report to the company’s investors, the reproposed standard included a requirement for the auditor’s report to be addressed to the shareholders and the board of directors, or equivalents for companies not organized as corporations. The reproposed standard stated that the auditor’s report may include additional addressees. Commenters generally supported the addressee requirement as reproposed stating that it is appropriate and will create consistency in practice. A commenter suggested limiting the required addressees to the shareowners of corporations or equivalents for companies not organized as corporations because investors are the key customers of the auditor’s report. A few commenters stated that the auditor’s report is intended for general use and the requirement for the auditor’s report to be addressed to a specific party is not 57 See paragraph 28(c) of ISA 700. requirements in 2(f) of Article 10, Audit Report, of Regulation (EU) No 537/2014. 59 See paragraph 15 of UK ISA 700 (2013). 60 See existing AS 3101.09. 61 This information is based on a review by PCAOB staff of a random sample of 2014 fiscal yearend auditor’s reports for issuers and brokers and dealers. 58 See E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices necessary. A commenter expressed concern that retaining the option for the auditor’s report to be addressed to third parties could inadvertently result in increased auditor liability and cost. In response to comments, and to promote greater uniformity in the addressees of the auditor’s report, the Board is adopting the addressee requirement as reproposed. Since inclusion of additional addressees is voluntary, auditors could assess, based on the individual circumstances, whether or not to include additional addressees in the auditor’s report. In addition, the Board believes that it is appropriate for the auditor’s report to be addressed to the board of directors and not just to the shareholders, because of the role of the board of directors in the governance of the company. Requirements of Other Regulators and Standard Setters The IAASB requires that the auditor’s report be addressed as appropriate, based on the circumstances of the engagement.62 The EU does not specify the addressee of the auditor’s report. The FRC requires that the auditor’s report be addressed as required by the circumstances of the engagement.63 UK auditor’s reports are typically addressed to either the members or the shareholders of the company.64 Other Enhancements to the Basic Elements The reproposal would have changed the language for certain elements in the existing auditor’s report. These elements included: • Financial statement notes—The identification of the financial statements, including the related notes and, if applicable, schedules, as part of the financial statements that were audited.65 Under the existing standard, the notes to the financial statements and the related schedules are not identified as part of the financial statements. 62 See paragraph 22 of ISA 700. paragraph 13 of UK ISA 700 (2013). 64 See paragraph A5 of UK ISA 700 (2013). 65 The final standard uses the term ‘‘financial statements’’ to include all notes to the statements and all related schedules, as used under SEC rules that apply to issuers. See Regulation S–X Section 1–01(b), 17 CFR 210.1–01(b), which states in part, ‘‘the term financial statements . . . shall be deemed to include all notes to the statements and all related schedules.’’ The final standard will not apply to schedules included as supplemental information, as defined in AS 2701, Auditing Supplemental Information Accompanying Audited Financial Statements, because those schedules are not considered part of the financial statements. The auditor should continue to look to the requirements of AS 2701 for the auditor’s reporting responsibilities regarding supplemental information accompanying audited financial statements. asabaliauskas on DSKBBXCHB2PROD with NOTICES 63 See VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 • Error or fraud—A description of the auditor’s responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud.66 The existing standard does not require the auditor’s report to contain the phrase whether due to error or fraud. • Nature of the audit—The description of the nature of the audit reflected the auditor’s responsibilities in a risk-based audit and aligned the description with the language in the Board’s risk assessment standards, including: • Performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks; • Examining, on a test basis, appropriate evidence regarding the amounts and disclosures in the financial statements; • Evaluating the accounting principles used and significant estimates made by management; and • Evaluating the overall presentation of the financial statements. Commenters generally supported the reproposed language for these basic elements of the auditor’s report. These elements are adopted as reproposed. Additional Basic Elements Suggested by Commenters In addition to the changes proposed by the Board, commenters on the reproposal suggested additional elements to be included in the auditor’s report. Several commenters suggested that the PCAOB consider additional standardized language in the auditor’s report to describe the responsibilities of the auditor, management, and the audit committee. In doing so, some of these commenters suggested that the PCAOB consider additional language adopted by the IAASB, in order to promote consistency in reporting and to help users understand more fully the separate responsibilities of each of the parties with respect to the audited financial statements. In contrast, another commenter cautioned that a thorough description of everyone’s roles and responsibilities would further add to repetitive boilerplate language. This commenter suggested instead that the auditor’s report provide a cross reference to a more complete description of the roles and responsibilities of the auditor, 66 See paragraph .02 of AS 1001, Responsibilities and Functions of the Independent Auditor. PO 00000 Frm 00017 Fmt 4701 Sfmt 4703 35411 management, and the audit committee. This commenter did not indicate where such cross-referenced material would appear. Given little interest from investors in such additional language during the Board’s initial outreach and the risk that it would be boilerplate, the final standard does not include these additional elements. Two accounting firms suggested describing the meaning of reasonable assurance. The final standard requires a statement in the ‘‘Basis for Opinion’’ section of the auditor’s report that the auditor ‘‘plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.’’ The auditing standards describe reasonable assurance as a high level of assurance, although not absolute assurance.67 During the Board’s initial outreach such additional language was considered, but there was no investor demand for it. As a result, the final standard does not expand the description of reasonable assurance in the auditor’s report. Some commenters also suggested that the auditor’s report should include disclosure of the materiality measures used by auditors in planning the audit. These commenters asserted that it could help inform investors’ proxy voting process for auditor ratification, as such disclosure could be a valuable supplement to an audit fee analysis and used to compare materiality over time to trends in restatements and adjustments. These commenters also observed that materiality disclosures are provided in the auditor’s reports in the U.K. Other commenters from the Board’s initial outreach stated that disclosing materiality levels in the auditor’s report could have negative implications on audit quality by reducing the element of surprise necessary in an audit.68 One commenter opposed a disclosure of materiality on the basis that it may encourage disclosure of quantitative materiality levels and ignore qualitative aspects of materiality, which cannot be described in a meaningful way in the auditor’s report. The Board has decided not to include this additional element in the auditor’s report at this time because disclosure may reduce the element of surprise in the audit and overstate the importance of quantitative rather than qualitative factors in the auditor’s overall consideration of materiality. However, the Board will monitor the implementation of the final standard, as 67 Paragraph .10 of AS 1015, Due Professional Care in the Performance of Work. 68 See PCAOB Release No. 2011–003, Appendix C, for a detailed discussion of the staff’s outreach regarding reporting materiality levels. E:\FR\FM\28JYN2.SGM 28JYN2 35412 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices well as the developments of expanded auditor reporting in other jurisdictions, to determine if future enhancements to the auditor’s report may be warranted in this area. Additionally, some commenters suggested that the auditor’s report should define the auditor’s responsibility for other information in documents containing audited financial statements so that financial statement users have a clear understanding. The Board’s proposal included another new auditing standard, The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report, regarding the auditor’s responsibilities for other information outside the financial statements. The Board has not taken any further action since the proposal. A few commenters suggested including other elements, such as the date when the auditor completed fieldwork, a statement that the auditor looked for material fraud, disclosure when alternative dispute resolution clauses are included in engagement letters, and disclosure of reasons for change in the engagement partner prior to mandatory rotation. The final standard does not include these elements because the Board believes they would not add meaningfully to the information already provided in the final standard or the elements go beyond what was considered in this standard-setting project and, thus, the Board is not including these elements at this time. Explanatory Language and Emphasis of a Matter asabaliauskas on DSKBBXCHB2PROD with NOTICES Explanatory Language Required by Other PCAOB Standards The reproposed standard, similar to the existing standard,69 provided a list of circumstances in which the auditor is required to add explanatory language to the auditor’s report and included references to other PCAOB standards in which these circumstances and related reporting requirements are described. These circumstances included when there is substantial doubt about the company’s ability to continue as a going concern and a restatement of previously issued financial statements, among others. The list of circumstances from the Board’s reproposal did not attract much comment, although one commenter affirmed support for including the list. Commenters on the Board’s proposal 69 See existing AS 3101.11. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 supported providing a list in the standard of the circumstances that require explanatory language in the auditor’s report on the basis that keeping this information in a single place would facilitate consistency in execution. The final standard includes the list of explanatory paragraphs and related references as reproposed. The reproposed standard included a requirement for the auditor to add explanatory language in cases where the company is required to report on ICFR but has determined that it is not required to obtain, and did not request the auditor to perform, an audit of ICFR.70 The reproposed standard included a reference to a new proposed requirement in AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances, for the auditor to add such explanatory language. Some commenters were supportive of the reproposed requirement, while one commenter did not believe such a requirement was necessary but did not object to its inclusion. The Board also sought comment on whether the requirement to include an explanatory paragraph in the auditor’s report when the auditor did not perform an audit of ICFR should apply not only if company’s management is required to report on ICFR, but also if management is not required to report, such as for investment companies. Several commenters supported expanding the requirement to all instances in which the auditor is not engaged to opine on ICFR, and not limit it to only when management is required to report on ICFR. In the Board’s view, it is appropriate to add explanatory language to the auditor’s report when management has a reporting responsibility on ICFR but the auditor is not engaged to opine on ICFR, in order to clarify the auditor’s responsibilities in this situation. For companies for which management is not required to report on ICFR, the Board does not believe that the auditor should have a separate reporting responsibility. Accordingly, the final standard retains the requirement as reproposed.71 The auditor may, however, choose to 70 This may be the case for companies that are subject to Section 404(a) of Sarbanes-Oxley, which mandates management ICFR reporting, but not Section 404(b), which mandates auditor ICFR reporting. Section 404(a) generally applies to companies that are subject to the reporting requirements of the Exchange Act, other than registered investment companies. Certain categories of companies that are subject to Section 404(a), such as nonaccelerated filers and emerging growth companies, are not subject to Section 404(b). 71 See amendments to AS 3105.59–.60. PO 00000 Frm 00018 Fmt 4701 Sfmt 4703 include such a paragraph in the auditor’s report voluntarily. Interaction between critical audit matters and explanatory paragraphs. The reproposed standard clarified that critical audit matters are not a substitute for required explanatory paragraphs. However, there could be situations in which a matter meets the definition of a critical audit matter and also requires an explanatory paragraph, such as going concern. For these situations, the reproposal contemplated that both the explanatory paragraph and the required communication regarding the critical audit matter would be provided. The auditor could include the communication required for a critical audit matter in the explanatory paragraph, with a cross-reference in the critical audit matter section to the explanatory paragraph. Alternatively, the auditor could choose to provide both an explanatory paragraph and the critical audit matter communication separately in the auditor’s report, with a cross-reference between the two sections.72 While the information reported in a critical audit matter may overlap with some of the information already provided in the explanatory paragraph, the critical audit matter would provide incremental information, such as how the matter was addressed in the audit. Commenters were generally supportive of the interaction between the communication of critical audit matters and required explanatory paragraphs as described in the reproposed standard. Some alternative views, however, were expressed. One commenter thought that if a required explanatory paragraph is also a critical audit matter, disclosure in the auditor’s report should be limited to one place in the auditor’ report. The commenter suggested that the communication requirements for both a critical audit matter and an explanatory paragraph be reported in the critical audit matter section of the auditor’s report with a cross reference in the explanatory paragraph section. Another commenter suggested that the PCAOB harmonize its approach with that of the IAASB, which requires a reference in the key audit matter section but waives the requirements to describe the key audit matter and how it was addressed during the audit. Finally, another commenter thought that critical audit matter communications should not be 72 When both an explanatory paragraph and a critical audit matter communication are provided, the critical audit matter description should not include conditional language that would not be permissible in the explanatory paragraph. See footnote 5 of AS 2415. E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES permitted to be integrated with explanatory paragraphs, on the basis that explanatory paragraphs are about matters in the financial statements to which the auditor wants to draw the reader’s attention and are not necessarily critical audit matters. The final standard retains the interaction between critical audit matters and explanatory paragraphs as reproposed. The approach provides flexibility on auditor disclosure, yet also ensures that the communication requirements are met. Emphasis of a Matter The reproposed standard, similar to the existing standard, provided the ability for the auditor to add a paragraph to the auditor’s report to emphasize a matter regarding the financial statements (‘‘emphasis paragraph’’).73 Emphasis paragraphs are not required, but may be used by auditors to draw the reader’s attention to matters such as significant transactions with related parties and unusually important subsequent events. The reproposed standard provided a list of potential matters that the auditor may emphasize in the auditor’s report, although the auditor may also decide to emphasize other matters. Commenters were supportive of emphasis paragraphs as described in the reproposed standard and did not suggest any additional matters to be included in the list of potential emphasis paragraphs. The final standard includes emphasis paragraphs as reproposed. Interaction between critical audit matters and emphasis paragraphs. The reproposed standard stated that emphasis paragraphs are not a substitute for required critical audit matters. If a matter that the auditor considers emphasizing meets the definition of a critical audit matter, the auditor would provide the information required for critical audit matters, and would not be expected to include an emphasis paragraph in the auditor’s report. Although this did not generate much comment, one commenter affirmed support for the interaction between critical audit matters and emphasis paragraphs. The final standard retains the interaction between critical audit matters and emphasis paragraphs as reproposed. Requirements of Other Regulators and Standard Setters Under the requirements of other regulators and standard setters, there are no analogous explanatory paragraphs, except for reporting on going concern. 73 See existing AS 3101.19. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 The Board’s reproposed approach is similar to the IAASB’s approach to the interaction between a paragraph regarding the company’s ability to continue as a going concern and key audit matters, although the underlying requirements for auditor reporting on going concern vary.74 Under the IAASB’s approach, an emphasis of matter paragraph is not required for a matter that was determined to be a key audit matter.75 The EU and the FRC have separate requirements related to going concern reporting that do not specifically address the interaction with their expanded auditor reporting.76 The IAASB, FRC, and EU do not have requirements for reporting on ICFR. 35413 the audit report in all EU countries, including the United Kingdom.80 Unlike disclosure of the engagement partner’s name, disclosure of other accounting firms that participated in the audit is not required by the IAASB, FRC, or the EU. Form of the Auditor’s Report The reproposed standard required the ‘‘Opinion on the Financial Statements’’ section to be the first section of the auditor’s report, immediately followed by the ‘‘Basis for Opinion’’ section. The reproposed standard did not specify an order for the remaining sections of the auditor’s report, which would include explanatory paragraphs and critical audit matters. This approach allowed Information About Certain Audit for consistency in the location of the Participants opinion and basis for opinion sections, On May 9, 2016, the SEC approved with flexibility for the other elements of new rules and related amendments to the auditor’s report. The reproposed the Board’s auditing standards, standard also required titles for all including amendments to AS 3101, that sections of the auditor’s report to will provide investors and other provide consistency and assist users in financial statement users with identifying the individual sections of information about engagement partners the auditor’s report. and other accounting firms that Commenters were generally participate in audits of issuers.77 Firms supportive of the proposed changes to will be required to file Form AP with the form of the auditor’s report, because the PCAOB for each issuer audit, the changes will: disclosing this information. In addition • Enhance the clarity and to filing Form AP, firms will also have the choice to include this information in comparability of disclosures; • Make it easier for investors to find the auditor’s report.78 The final standard the opinion since it will be listed first; incorporates the adopted amendments to AS 3101 for situations in which the • Help facilitate a comparison auditor decides to include information between auditor’s reports; and about certain audit participants in the • Allow for an appropriate level of auditor’s report. The final standard flexibility and ease of use without being requires the auditor to use an overly prescriptive. appropriate section title when providing Some commenters suggested the this information in the auditor’s report, PCAOB should be consistent with other but does not require a specific location standard setters in the ordering of in the auditor’s report. section titles in the auditor’s report. One Requirements of Other Regulators and commenter expressed concern that the Standard Setters ordering of the components of the opinion and the heading of the critical The IAASB requires the auditor to audit matter section of the report may be include the name of the engagement partner in the auditor’s report for audits misunderstood to imply that critical audit matter communications are of listed entities.79 Under EU law, the separate and distinct from the auditor’s engagement partner is required to sign opinion, which could be misinterpreted as a piecemeal opinion. In light of the 74 See paragraph A1 of ISA 570, Going Concern, and paragraph 15 of ISA 701. commenter support described above, the 75 See paragraph 8 of ISA 706, Emphasis of Matter Board is adopting the form of the Paragraphs and Other Matter Paragraphs in the auditor’s report as reproposed. As Independent Auditor’s Report. previously discussed, the final standard 76 See ISA (UK and Ireland) 570, Going Concern, includes revised introductory language and see Article 28, Audit Reporting, of Directive 2014/56/EU of the European Parliament and of the in the auditor’s report to avoid the Council (Apr. 16, 2014). potential misperception that the 77 See PCAOB Release No. 2015–008. communication of critical audit matters 78 When the auditor divides responsibility for the provides piecemeal opinions. audit under AS 1205, Part of the Audit Performed by Other Independent Auditors, the auditor’s report must acknowledge the involvement of the other auditor. 79 See paragraph 45 of ISA 700. PO 00000 Frm 00019 Fmt 4701 Sfmt 4703 80 Directive 2006/43/EC of the European Parliament and of the Council, Article 28, Audit Reporting (May 17, 2006). E:\FR\FM\28JYN2.SGM 28JYN2 35414 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices Requirements of Other Regulators and Standard Setters The reproposed approach with respect to the order of the sections of the auditor’s report is generally consistent with that of the IAASB.81 The EU and FRC do not specify an order to the auditor’s report. Application to Other Audits Performed Under PCAOB Standards There are situations in which an auditor may be required by law or regulation, or voluntarily agrees, to perform an audit engagement in accordance with PCAOB standards for a company whose audit is not subject to PCAOB oversight.82 For example, SEC rules permit audits under PCAOB standards in connection with offerings under Regulation A and Regulation Crowdfunding.83 In these situations, certain elements of the auditor’s report required under the final standard, such as the use of ‘‘registered public accounting firm’’ in the title or the statement regarding independence requirements, may not apply. Additional guidance for these situations will be provided. Amendments to Other PCAOB Standards The Board has adopted amendments to several of its existing auditing standards solely to conform to the final standard. The Board is not adopting any further changes to these existing auditing standards at this time, although the Board recognizes that some of the existing auditing standards, such as the redesignated standard AS 3105, may need further updating. The Board may consider proposing further changes to these standards under separate standard-setting projects. AS 3105, Departures From Unqualified Opinions and Other Reporting Circumstances Existing AS 3101.10 and .20–.76 address departures from the auditor’s unqualified opinion, such as a qualified opinion, an adverse opinion, or a 81 See paragraphs 23–28 of ISA 700. the Sarbanes-Oxley Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the PCAOB oversees the audits of ‘‘issuers’’ and brokers and dealers reporting under Exchange Act Rule 17a–5. See Sarbanes-Oxley Act Section 101. An ‘‘issuer’’ under the Sarbanes-Oxley Act is an entity whose securities are registered under Section 12 of the Exchange Act, or that is required to file reports under Section 15(d) of the Exchange Act, or that files or has filed a Securities Act registration statement that has not yet become effective and that it has not withdrawn. See Sarbanes-Oxley Section 2(a). 83 See Securities Act Form 1–A, Part F/S (b)(2) and (c)(1)(iii); Regulation Crowdfunding Rule 201(t) instruction 9, 17 CFR 227.201(t). asabaliauskas on DSKBBXCHB2PROD with NOTICES 82 Under VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 disclaimer of opinion, and other reporting circumstances, such as reporting on comparative financial statements. These paragraphs are redesignated as AS 3105.84 Commenters who addressed this topic generally supported the reproposed amendments to AS 3105, including amending the example auditor’s reports to conform with the example auditor’s report in the final standard. The Board also received some comments suggesting further changes to AS 3105, such as updating descriptions of and references to accounting requirements that are no longer current 85 and updating certain terminology (e.g., changing references from ‘‘entity’’ to ‘‘company’’). The Board may consider such updates as part of a separate standard-setting project. The Board has adopted final amendments to AS 3105 that are substantially similar to the reproposal. The amendments to AS 3105 are not intended to change the circumstances in which the auditor would depart from an unqualified opinion. The changes from the current standard will primarily: (1) Require the communication of critical audit matters in certain circumstances; (2) revise certain terminology to align with the final standard; and (3) amend the illustrative reports for the basic elements of the final standard and the required order of certain sections of the auditor’s report. AS 3105 includes: Communication of Critical Audit Matters in Reports Containing Other Than Unqualified Opinions a. Qualified opinion—Amendments to AS 3105 will require that when the auditor expresses a qualified opinion, the auditor’s report also include communication of critical audit matters, if critical audit matter requirements apply. b. Adverse opinion—The existing requirements related to an adverse opinion are not amended to require the auditor to communicate critical audit matters. In the Board’s view, the most important matter to investors and other financial statement users in such circumstances would be the reason for the adverse opinion. 84 AS 3101.01–.09 and .11–.19 are amended and restated as AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion. 85 The Board has issued guidance regarding the status of outdated descriptions of and references to U.S. GAAP in PCAOB standards. See PCAOB, Staff Questions and Answers, References to Authoritative Accounting Guidance in PCAOB Standards (Sept. 2, 2009). Among other things, this guidance provides that auditors should disregard descriptions of and references to accounting requirements in PCAOB standards that are inconsistent with the FASB Accounting Standards Codification (‘‘ASC’’). PO 00000 Frm 00020 Fmt 4701 Sfmt 4703 c. Disclaimer of opinion—The existing requirements related to a disclaimer of an opinion are not amended to require the auditor to communicate critical audit matters. In the Board’s view, the most important matter to investors and other financial statement users in such circumstances would be the reason for the disclaimer of opinion. Requirements of Other Regulators and Standard Setters Under the IAASB’s approach, a matter giving rise to a qualified, adverse, or disclaimer of opinion is by nature a key audit matter.86 However, in such circumstances: (1) The matter should not be described in the key audit matter section of the auditor’s report, (2) the auditor should report on the matter in accordance with applicable standards, and (3) the auditor should include a reference in the key audit matter section to the basis for modified opinion section where the matter is reported.87 The requirements to determine and communicate key audit matters, other than the matters giving rise to the modified opinion, would still apply when the auditor expresses a qualified or adverse opinion, but not when the auditor disclaims an opinion on the financial statements.88 The FRC and the EU do not include specific requirements for expanded auditor reporting when the auditor’s report contains other than an unqualified opinion. Other Amendments to PCAOB Standards The amendments to other PCAOB standards are substantially as reproposed. These include: • AS 1220, Engagement Quality Review—amending to require the engagement quality reviewer to evaluate the engagement team’s determination, communication, and documentation of critical audit matters; • AS 1301, Communications with Audit Committees—amending to require the auditor to provide to and discuss with the audit committee a draft of the auditor’s report; • AS 2201, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements—amending the example auditor’s report to conform with the example auditor’s report on the financial statements in the final standard; • AS 2820, Evaluating Consistency of Financial Statements—amending to 86 See paragraph 15 of ISA 701. 87 Id. 88 See paragraph A7 of ISA 701 and paragraph 29 of ISA 705, Modifications to the Opinion in the Independent Auditor’s Report. E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES include the existing reporting requirements and illustrative explanatory language related to a change in accounting principle or a restatement that is currently in AS 3105; and • AS 4105, Reviews of Interim Financial Information—amending to include the basic elements of the final standard, where applicable. Conforming amendments were also made to every PCAOB standard that refers to the auditor’s report. Commenters generally supported the amendments as reproposed. A commenter suggested revising AS 3305, Special Reports, to conform to the example auditor’s report in the final standard. Since reports pursuant to AS 3305 are rarely filed with the SEC, as noted by this commenter, the Board does not believe these reports should be updated at this time. As described above, the Board may consider updating this standard as part of a separate standard-setting project. D. Economic Considerations and Application to Audits of Emerging Growth Companies The Board is committed to analyzing the economic impacts of its standard setting. The following discussion addresses the potential economic impacts, including potential benefits and costs, considered by the Board. The Board has sought information relevant to economic consequences several times over the course of the rulemaking. Commenters provided views on a wide range of issues pertinent to economic considerations, including potential benefits and costs, but did not provide empirical data or quantified estimates of the costs or other potential impacts of the standard. The potential benefits and costs considered by the Board are inherently difficult to quantify, therefore the Board’s economic discussion is primarily qualitative in nature. Commenters who discussed the economic analysis in the Board’s reproposal provided a wide range of views. Some commenters pointed to academic research for the Board to consider in support of their views. One commenter asserted that the Board’s release did not provide a true economic analysis of the pros and cons of mandating the reporting of critical audit matters, but only referenced academic studies on the purported benefits of such reporting. Another argued that the changes described in the reproposal would lead to a significant increase in costs, and that no compelling case had been made that the benefits would exceed the costs. The SEC’s Investor Advocate said that the Board’s VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 economic analysis made a compelling case as to why the required reporting of critical audit matters would reduce informational asymmetries and add to the total mix of information available to investors.89 The Board has considered all comments received and has sought to develop an economic analysis that evaluates the potential benefits and costs of the final standard, as well as facilitates comparisons to alternative Board actions. Need for the Rulemaking Critical Audit Matters Generally, investors and other financial statement users know less about a company’s financial performance than do others closer to the financial reporting process, particularly management. This information asymmetry 90 can result in situations where capital is allocated suboptimally. The system of financial reporting in the United States, which requires periodic reporting of information, including annual financial statements, helps address the information asymmetry between investors and management. Board of directors and audit committee oversight of the financial reporting process can further reduce this information asymmetry by enhancing the quality of the information disclosed to the public. As part of this system, the audit of the financial statements also helps reduce the information asymmetry investors face by providing an independent opinion about whether the financial statements are presented fairly in all material respects. Companies’ operations continue to become more complex and global. In addition, over the last decade, there have been changes in the financial reporting frameworks relating to accounting estimates and an increasing use of fair value as a measurement attribute, together with new related disclosure requirements.91 These estimates and fair value measurements, which are important to a financial statement user’s understanding of the company’s financial position and results of operations, can be highly subjective, require significant judgment, and can result in increased measurement uncertainty in financial statements.92 89 See letter from Rick A. Fleming, Investor Advocate, SEC (Aug. 15, 2016) at 3, available on the Board’s Web site in Docket 034. 90 Economists often describe ‘‘information asymmetry’’ as an imbalance, where one party has more or better information than another party. 91 See PCAOB Staff Consultation Paper, Auditing Accounting Estimates and Fair Value Measurements (Aug. 19, 2014). 92 See IAASB Project Proposal, Revision of ISA 540, Auditing Accounting Estimates, Including Fair PO 00000 Frm 00021 Fmt 4701 Sfmt 4703 35415 The increased complexity of financial reporting, including the growing use of complex accounting estimates and fair value measurements, may contribute to the information asymmetry between investors and management, despite the fact that management is required to provide significant disclosures to investors and other financial statement users. Some commenters on the reproposal have stated that investors would find information provided by the auditor, an independent third party, particularly relevant in this setting. As part of the audit, auditors often perform procedures involving challenging, subjective, or complex judgments, such as evaluating calculations or models, the impact of unusual transactions, and areas of significant risk. Although the auditor is required to communicate with the audit committee regarding such matters, the auditor’s report has not been expanded to provide this information to investors and generally provides only a standardized pass/fail opinion. Because the auditor’s report generally does not contain audit-specific information, it provides very little of the information the auditor knows about the company, its financial reporting, and the challenges of the audit. Given the increased complexity of financial reporting, which requires the auditor to evaluate complex calculations or models and make challenging or subjective judgments, the current form of the auditor’s report does little to address the information asymmetry between investors and auditors. The Board believes that expanding the auditor’s report to provide information about especially challenging, subjective, or complex auditor judgments will help investors and other financial statement users ‘‘consume’’ the information presented in management’s financial statements more effectively. Stated in economic terms, in the Board’s view, an expanded auditor’s report will reduce the information asymmetry between investors and auditors, which should in turn reduce the information asymmetry between investors and management about the company’s financial performance. Reducing information asymmetry about the company’s financial reporting should lead to a more efficient allocation of capital. Some commenters supported the reporting of critical audit matters as a means of reducing the information asymmetry between investors and auditors. Other commenters disagreed with the Board’s approach and Value Accounting Estimates, and Related Disclosures (Mar. 2016). E:\FR\FM\28JYN2.SGM 28JYN2 35416 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES questioned whether the Board could or should attempt to reduce information asymmetry by requiring expanded auditor reporting. The Board believes that requiring expanded auditor reporting as a means of reducing the information asymmetry between investors and auditors is consistent with its statutory mandate to ‘‘protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.’’ 93 Investors are the intended beneficiaries of the audit, but investors do not receive information about specific work performed during the audit. The final standard seeks to enhance the form and content of the auditor’s report to make it more relevant and informative to investors and other financial statement users. Increasing the Informativeness of the Auditor’s Report To Address Information Asymmetry The communication of critical audit matters will reduce the information asymmetry between investors and auditors by informing investors and other financial statement users about areas of the audit that required especially challenging, subjective, or complex auditor judgment, including the principal considerations for determining the matters and how the matters were addressed in the audit. The Board believes that auditor reporting of critical audit matters will provide investors with audit-specific information that should facilitate their analysis of the financial statements and other related disclosures. The communication of critical audit matters in the auditor’s report should also help investors and analysts who are interested in doing so to engage management and the audit committee with targeted questions about these issues.94 Ultimately, while not every critical audit matter will be useful for every investor, broadly, the Board believes that having the auditor provide investors and other financial statements users with additional information about especially challenging, subjective, or complex auditor judgments should help reduce the information asymmetry that exists between investors and management by providing additional insights on the financial statements. The communication of critical audit matters should also assist investors in 93 Section 101(a) of Sarbanes-Oxley. FRC observes that, in some instances, investors have begun to use the information provided in the expanded auditor’s reports in the U.K. to engage with audit committees. See FRC, Extended Auditor’s Reports, A Further Review of Experience (Jan. 2016) (‘‘FRC 2016 Report’’). 94 The VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 assessing the credibility of the financial statements and, in at least some instances, audit quality.95 For example, the description of how the auditor addressed the critical audit matter will help investors understand the types of issues that the auditor grappled with in addressing these challenging, subjective, or complex areas of the audit, which should allow a deeper and more nuanced understanding of the related financial statement accounts and disclosures. Furthermore, investors have consistently stated that having the auditor rather than the company, provide this type of information would be of added value to investment decision making.96 Commenting on the reproposal, the SEC’s Investor Advocate noted that investors want to hear directly from the auditor and that this point is confirmed by surveys of professional investors, as well as by certain academic research.97 This commenter agreed with the premise in the reproposal that, because the auditor is required to be independent, information provided by the auditor may be viewed by investors as having greater credibility than information provided by management alone. Reporting of critical audit matters should provide insights that will add to the mix of information that could be used in investors’ capital allocation decisions, for example, by: • Highlighting the aspects of the financial statement audit that the auditor found to be especially challenging, subjective, or complex; • Enabling comparison of these aspects of the audit across companies, for example audits of companies within the same industry; and • Enabling comparison of these aspects of the audit for the same company over time. 95 It is often not possible to observe the difference between financial reporting quality and audit quality. An academic study conceptually models the path through which the financial reporting and audit processes result in audited financial reporting outcomes. The authors postulate that although audit quality and pre-audit financial reporting quality are distinct constructs, the two processes are often inseparable in terms of observable financial reporting outcomes in archival research. See Lisa Milici Gaynor, Andrea Seaton Kelton, Molly Mercer, and Teri Lombardi Yohn, Understanding the Relation between Financial Reporting Quality and Audit Quality, 35 Auditing: A Journal of Practice & Theory 1, 1–22 (2016). 96 See IAG 2011 survey and CFA survey and poll results. 97 See letter from Rick A. Fleming, Investor Advocate, SEC (Aug. 15, 2016) at 3, available on the Board’s Web site in Docket 034 (citing Brant E. Christensen, Steven M. Glover, and Christopher J. Wolfe, Do Critical Audit Matter Paragraphs in the Audit Report Change Nonprofessional Investors’ Decision to Invest? 33 Auditing: A Journal of Practice & Theory 71, 71–93 (2014)). PO 00000 Frm 00022 Fmt 4701 Sfmt 4703 Many companies commenting on the reproposal argued that the reporting of critical audit matters would not increase the informativeness of the auditor’s report. For example, several of these commenters claimed that the reporting of critical audit matters would simply duplicate management disclosure without adding additional information, or that critical audit matters would not provide value-relevant information. Other commenters asserted that the reporting of critical audit matters would result in the auditor’s report becoming a lengthy list of boilerplate disclosures, which would contribute to disclosure overload or run contrary to the SEC’s disclosure effectiveness initiative. Several commenters said that critical audit matters could confuse investors if the information in the auditor’s report was duplicative of management’s disclosures but was presented in a different manner, or if the critical audit matter presented information without appropriate context. By contrast, investor commenters overwhelmingly agreed that the communication of critical audit matters would make the auditor’s report more informative. One commenter said that, although critical audit matters in themselves would not provide investors with all the information needed in the face of growing financial complexity, critical audit matters would add to the total mix of information available to investors, and would contribute to their ability to analyze companies, form a multifaceted understanding of them, and make informed investment decisions. Another commenter noted that, in jurisdictions where the expanded auditor’s report is available, it is one of the earliest elements of the company’s annual report that they read because it typically highlights the more judgmental elements of the company’s accounting, which often provides insights that form a basis for discussions with management. Mandated Rather Than Voluntary Reporting Auditors have not developed a practice of providing information in the auditor’s report beyond what is required, even though investors have consistently requested that the auditor’s report become more informative. Current standards provide a framework for auditors to provide limited additional information through emphasis paragraphs,98 but in general these only point to a disclosure in the company’s financial statements without providing any additional description of 98 See E:\FR\FM\28JYN2.SGM existing AS 3101.19. 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES the matter and, as noted below, emphasis paragraphs are infrequent in practice. Auditor reporting about matters significant to the audit is not prohibited in an emphasis paragraph, but current standards do not encourage auditors to include such information in their report and do not provide a framework for doing so. There are many other potential reasons why auditors are not providing information voluntarily in the auditor’s report, whether about the financial statements or the audit. For example, the historical model of management disclosing information and the auditor attesting to the information may lead companies to resist voluntary additional reporting by the auditor, either through emphasis paragraphs or with respect to information about the audit, which the auditor would be better positioned to communicate than management. Further, auditors may believe that providing additional information could potentially expose them to liability or that doing so could be interpreted as a disclaimer of opinion or a partial opinion as to the identified matters. Finally, in general, there may be disincentives to voluntary reporting if the disclosing party is not able to fully capture the benefits of the disclosures,99 and parties may also exhibit a bias toward the status quo.100 All of these factors disincentivize auditors from voluntarily providing further information about the audit, even if investors and other financial statement users would respond favorably to receiving additional information. The Board believes that the required reporting of critical audit matters will promote more complete and consistent disclosure of audit-specific information to financial statement users who may be 99 Academic research finds that there are certain situations in which disclosure may be socially optimal but not privately optimal. Auditors and companies may resist voluntary expanded auditor reporting because of concerns that certain types of spillover effects (or externalities) may create a competitive disadvantage. For a summary of this line of research, see Luigi Zingales, The Future of Securities Regulation, 47 Journal of Accounting Research 391, 394–395 (2009). Professor Zingales is the founding director of the PCAOB’s Center for Economic Analysis, now known as the Office of Economic and Risk Analysis. The research cited above was published before he joined the PCAOB. 100 Research in behavioral economics suggests that when facing a set of decisions, individuals are more likely to stick to the known outcome (status quo) than would be expected based on the theory of rational decision making under uncertainty. There are a variety of reasons why individuals may choose the status quo outcome in lieu of an unknown outcome, including aversion to the uncertainty inherent in moving from the status quo to another option. See William Samuelson and Richard Zeckhauser, Status Quo Bias in Decision Making, 1 Journal of Risk and Uncertainty 7, 7–59 (1988). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 interested in it.101 Mandatory disclosure can also improve the allocative efficiency of capital markets by decreasing the costs associated with gathering information, or by providing market participants with information that otherwise would have been difficult or impossible for them to gather.102 Additional Improvements to the Auditor’s Report The final standard requires auditors to disclose in the auditor’s report the number of years they have served consecutively as the auditor for the company. Although some commenters dispute the value of this information, investor commenters have indicated that the length of the relationship between the auditor and the company would be a useful data point. The growing trend toward voluntary disclosure of this information by companies suggests that increasing numbers of companies believe that the market finds the disclosure useful.103 Further, there is a line of academic research suggesting that there is an association between auditor tenure and increases or decreases in audit quality.104 Although investors may be able to determine auditor tenure by, for example, reviewing past auditor’s reports, for many companies the information is not readily available even through a manual search process. Furthermore, while some companies voluntarily provide information about auditor tenure in the proxy statement, many do not. Many companies are also not subject to the proxy rules (for example, most investment companies, foreign private issuers, and many companies whose securities are not listed on a national securities exchange). In cases where the information is provided voluntarily, it is not provided in a consistent location. The Board believes that these issues create unnecessary search costs for investors 101 Academic research on disclosure explores these types of positive externalities, as well as certain negative externalities. See, e.g., Ronald A. Dye, Mandatory versus Voluntary Disclosures: The Cases of Financial and Real Externalities, 65 The Accounting Review 1, 1–24 (1990); or Anat R. Admati and Paul Pfleiderer, Forcing Firms to Talk: Financial Disclosure Regulation and Externalities, 13 The Review of Financial Studies 479, 479–519 (2000). 102 See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Virginia Law Review 717, 717–753 (1984). 103 See Center for Audit Quality and Audit Analytics, 2016 Audit Committee Transparency Barometer (Nov. 2016). See also Ernst & Young, Audit Committee Reporting to Shareholders 2016 (Sept. 2016). 104 See below for a discussion of academic research regarding auditor tenure. PO 00000 Frm 00023 Fmt 4701 Sfmt 4703 35417 who wish to evaluate information about auditor tenure. Mandatory disclosure of auditor tenure in the auditor’s report will provide a consistent location for this information and will reduce search costs relative to the current baseline for investors who are interested in auditor tenure, especially in the case of companies that do not voluntarily provide such information or for which the information is not available through the EDGAR system. Mandatory disclosure of auditor tenure in the auditor’s report may also be more likely to encourage further discussion of auditor tenure by management and the audit committee and potential disclosure in company filings. The existing auditor’s report also does not describe important aspects of the auditor’s responsibilities under existing auditing standards, such as the auditor’s responsibility to detect material misstatements, whether due to error or fraud; the auditor’s responsibility for the notes to the financial statements; and the auditor independence requirement. This may contribute to misperceptions by investors and other financial statement users about the auditor’s role and responsibilities, including with respect to these matters. Academic research suggests that there are a number of ways in which investor perceptions of the role and responsibilities of the auditor may diverge from what current professional standards require.105 In addition, the existing standards do not require a uniform approach to basic content, such as the addressee of the report and the form of the auditor’s report, which may increase the time and costs of processing the information in the auditor’s report. The final standard contains provisions requiring the basic elements in the auditor’s report to be presented more uniformly. Commenters generally supported the reproposed changes to these basic elements of the auditor’s report. Some commenters noted that the enhanced descriptions of the auditor’s responsibility to detect material misstatements would clarify the auditor’s responsibilities for financial 105 See, e.g., Bryan K. Church, Shawn M. Davis, and Susan A. McCracken, The Auditor’s Reporting Model: A Literature Overview and Research Synthesis, 22 Accounting Horizons 69, 69–90 (2008); Glen L. Gray, Jerry L. Turner, Paul J. Coram, and Theodore J. Mock, Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statement Preparers, Users, and Auditors, 25 Accounting Horizons 659, 675– ´ 676 (2011); or Theodore J. Mock, Jean Bedard, Paul J. Coram, Shawn M. Davis, Reza Espahbodi, and Rick C. Warne, The Audit Reporting Model: Current Research Synthesis and Implications, 32 Auditing: A Journal of Practice & Theory 323, 323–351 (2013). E:\FR\FM\28JYN2.SGM 28JYN2 35418 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices statement users, other commenters offered suggestions for refinement, such as aligning the requirements to the IAASB model or amending the description to more clearly define the auditor’s role within the context of the financial reporting regulatory framework. Commenters also generally supported including a statement on the auditor’s independence requirement. For example, some commenters stated that adding a statement by the auditor on their independence would reinforce investors’ understanding of the auditor’s requirement to remain independent and objective in expressing the audit opinion. Other commenters said that the enhanced description of the independence requirement could provide a meaningful reminder of the importance of auditor independence. However, other commenters said that the enhanced description of auditor independence was either unnecessary, or would not have a significant impact on auditor behavior. Based on broad commenter support, the Board is adopting these additional improvements to the auditor’s report as reproposed. Baseline asabaliauskas on DSKBBXCHB2PROD with NOTICES Critical Audit Matters The auditor’s report in the United States today generally consists of three paragraphs that include limited auditspecific information. The existing auditor’s report identifies the company’s financial statements that were audited, provides a standardized description about the nature of an audit, and provides an opinion on whether the company’s financial statements are fairly presented, in all material respects, in conformity with the applicable financial reporting framework. The auditor’s report is often described as a pass/fail model because the report only conveys the auditor’s opinion on whether the financial statements are fairly presented (pass) or not (fail) and typically provides limited information about the nature of the work on which the opinion is based. The Board’s current standards also require that the auditor add explanatory paragraphs to the auditor’s report under specific circumstances, such as when there is substantial doubt about the company’s ability to continue as a going concern or a restatement of previously issued financial statements. When included, these paragraphs generally consist of standardized language that provides limited audit-specific information. The auditor may also, at his or her discretion, include emphasis paragraphs VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 in the auditor’s report to emphasize a matter regarding the financial statements. Generally, an emphasis paragraph only points to a disclosure in the company’s financial statements without providing any additional description. Under current practice, emphasis paragraphs are infrequent.106 Auditors may also, at their discretion, include language in the auditor’s report indicating that they were not engaged to examine management’s assertion about the effectiveness of internal control over financial reporting.107 Academic research confirms the view of the Board and many commenters that the current form of the auditor’s report conveys little of the audit-specific information obtained and evaluated by the auditor.108 Academic research also finds that investors and other financial statement users refer to the existing auditor’s report only to determine whether the opinion is unqualified because it does not provide much additional informational value about a particular audit.109 These findings align with the consistent call from investors, over the course of the Board’s rulemaking process, for a more informative auditor’s report.110 Additional Improvements to the Auditor’s Report The existing auditor’s report is not required to have a specified addressee but it may be addressed to the company whose financial statements are being audited, its board of directors, or 106 In the audit reports of approximately 6,350 issuers with fiscal year 2014 filings, PCAOB staff identified audit reports containing explanatory paragraphs to emphasize matters in the financial statements in approximately 2 percent of the filings. 107 See paragraph .10 of AI 20, Other Information in Documents Containing Audited Financial Statements: Auditing Interpretations of AS 2710. 108 See Church et al., The Auditor’s Reporting Model: A Literature Overview and Research Synthesis 69–90. 109 See Gray et al., Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statement Preparers, Users, and Auditors 659–684; Mock et al., The Audit Reporting Model: Current Research Synthesis and Implications 323–351. 110 Academic research has found that, in some instances, the inclusion of explanatory language in the auditor’s report may provide investors with additional value-relevant information. A recent academic study suggests that auditor’s reports containing certain types of explanatory paragraphs required under existing standards may provide information about the likelihood that financial statements will be subsequently restated. The authors argue that the inclusion of such an explanatory paragraph in the auditor’s report can provide a signal to investors about the risk of misstatement of the company’s financial statements. See Keith Czerney, Jaime J. Schmidt, and Anne M. Thompson, Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk? 89 The Accounting Review 2115, 2115–2149 (2014). PO 00000 Frm 00024 Fmt 4701 Sfmt 4703 stockholders.111 Under current practice, the auditor’s report is generally addressed to one or more of the following: (1) The board of directors and stockholders/shareholders, or their equivalent for issuers that are not organized as corporations; (2) the plan administrator or plan participants for benefit plans; and (3) the directors or equity owners for brokers or dealers.112 The current auditor’s report also includes the report title, the date, and the name and location of the accounting firm’s office issuing the report. The auditor is not currently required to disclose in the auditor’s report the number of years it has served as auditor for the company. However, as noted earlier, many larger companies have begun voluntarily disclosing auditor tenure in the proxy statement. Currently, the title of the auditor’s report, ‘‘Report of Independent Registered Public Accounting Firm,’’ provides the only indication of the auditor’s independence. Benefits Critical Audit Matters Economic theory commonly attributes two benefits to mandatory disclosure. First, the disclosure of previously unknown, value-relevant information directly benefits the market because it allows market participants to make better-informed decisions. Second, the disclosure of such information may indirectly benefit the market because some parties may change their behavior in positive ways after information is disclosed. Direct Benefit: More Informative and Useful Auditor’s Report The Board believes that auditor communication of critical audit matters will reduce the information asymmetry between investors and auditors, which should in turn reduce the information asymmetry between investors and management about the company’s financial performance. Some commenters on the reproposal agreed that the information provided in critical audit matters would be used by various types of investors in a number of different ways that are consistent with the framework outlined in the reproposal: • Informing—Identification of the matters arising from the audit that the auditor considered especially challenging, subjective, or complex, 111 See existing AS 3101.09. information is based on a review by PCAOB staff of a random sample of 2014 fiscal yearend auditor’s reports for issuers, benefit plans, and brokers and dealers. 112 This E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices together with a description of how the auditor addressed those matters, which should provide valuable information. For example, some commenters said that: • Critical audit matters would add to the total mix of information available to investors, and would contribute to their ability to analyze companies and make investment decisions; • Investors would use critical audit matters in the same way that they use any other financial disclosure; critical audit matters would add an additional perspective to management’s disclosures; • Insights on critical audit matters may be relevant in analyzing and pricing risks in capital valuation and allocation; • Critical audit matters would inform investor models of company financial performance; • Critical audit matters would augment and add more dimension to the information provided by the financial statements and the critical accounting policies and estimates; and • The communication of critical audit matters would lower the cost of acquiring information for financial statement users. • Framing—Critical audit matters should provide investors with a new perspective on the financial statements and focus their attention on the related financial statement accounts and disclosures, which should facilitate their analysis of the financial statements, and help them assess financial performance, for example by highlighting potentially relevant information or by reducing the costs to process or search for the information. For example, some commenters said that: • Critical audit matters would focus investors’ attention on key financial reporting issues and identify areas that deserve more attention; • In jurisdictions where expanded auditor reporting is available, it focuses users’ attention on issues that would be pertinent to understanding a company as a long-term investor; and • Information in critical audit matters would contribute to investor understanding and consumption of information in the financial statements. • Monitoring—The ability to identify and evaluate the matters identified as critical audit matters should also help investors and analysts engage management with targeted questions about these issues and support investor decisions on ratification of the auditor. For example, some commenters said that: VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 • Critical audit matters would facilitate the ability of investors to monitor management’s and the board of director’s stewardship of the company by highlighting accounting and auditing issues and other matters that investors may wish to emphasize in their engagement with management; and • Critical audit matters would provide important information on how the auditor has addressed an issue, which investors can use in evaluating the rigor of the audit and making proxy voting decisions, including ratification of the audit committee’s choice of external auditor. Critical audit matters may be used by different types of investors in different ways. For example, retail investors (or others who may act on their behalf, such as analysts, credit rating agencies, or the financial press) may use the additional information to help them identify and analyze important aspects of the financial statements. Larger investors, on the other hand, may also use critical audit matters as a basis for engagement with management. The communication of critical audit matters aims to provide investors and financial statement users with specific information about the audit of a company’s financial statements. Some commenters were concerned, however, that the communication of critical audit matters could lead to a reduction in comparability of auditor’s reports. Although differences in critical audit matters from period to period and across companies may make auditor’s reports less uniform, to the extent the information provided is useful in evaluating the financial performance, highlighting these differences should contribute to the overall mix of information. Further, some commenters on the proposal said that investors are interested in information that is specific to the audit of a company’s financial statements, and therefore, would expect differences in auditor’s reports across companies and reporting periods. Investors also have indicated that they are accustomed to analyzing companyspecific information, such as information in financial statements or MD&A that is specific to a company or a reporting period. A body of academic research regarding the possible effects of expanded auditor reporting is emerging.113 The Board has been monitoring this research with a view towards assessing its potential relevance 113 For a review of relevant academic research, ´ see Jean Bedard, Paul Coram, Reza Espahbodi, and Theodore J. Mock, Does Recent Academic Research Support Changes to Audit Reporting Standards? 30 Accounting Horizons 255, 255–275 (2016). PO 00000 Frm 00025 Fmt 4701 Sfmt 4703 35419 to this rulemaking. The Board is mindful of several issues that limit the extent to which this research can inform its decision making. Much of this research is unpublished and at a relatively early stage. The current conclusions may be subject to multiple interpretations and it is possible that results from this research may be revised during the peer review process. Moreover, it may be difficult to generalize results outside the context of specific studies. For example, in considering the implications of academic studies based on data from other jurisdictions, differences between the Board’s final standard and the requirements in other jurisdictions must be taken into account. In addition, specific characteristics of the U.S.-issuer audit market may make it difficult to generalize observations made in other markets because of differences in baseline conditions (for example, market efficiency, affected parties, policy choices, legal environment, and regulatory oversight). As to experimental research in particular, it should be noted that the experimental setting may not provide study participants with information that is representative of the information environment in which market participants actually operate; for instance, if new information appeared more salient to study participants than it would to a market participant, the impact of expanded auditor reporting would be overstated in an experimental setting. In addition, some of these studies were conducted based on earlier versions of rule text that differs from the final standard, which may affect the extent to which the results can inform the Board in evaluating potential effects of the final standard. As discussed in more detail in the economic analysis contained in the reproposal, the results from early research analyzing the informational value of expanded auditor reporting are inconclusive.114 Some studies found that expanded auditor reporting could provide investors with new and useful information, while other studies found that the benefits attributable to expanded auditor reporting were not statistically significant, but that it could produce unintended consequences. These limited findings may be due to the fact that the results of the studies represent averages for large samples of companies. On average, investors may already have access to a variety of information sources (such as annual reports, news media, and analyst 114 See PCAOB Release No. 2016–003, Section VI.C.1.a. E:\FR\FM\28JYN2.SGM 28JYN2 35420 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES research reports) which may contain similar information about a company. However, expanded auditor reporting may be relatively more informative for companies where alternative sources of information are less available (e.g., those companies with less analyst coverage). In response to the reproposal, two commenters submitted studies suggesting that expanded auditor reporting has increased the informative value of the auditor’s report. One experimental study tested the communicative value of expanded auditor reporting by analyzing how key audit matters affected investment professionals’ assessment of a company’s business economics, as well as their confidence in making that assessment.115 The authors found that specific informational content of the key audit matter affected the study participants’ perceived level of trust associated with the auditor’s report, which then affected the perceived level of trust associated with the financial statements and their assessment of the company’s business economics. Another study analyzed whether the communicative value of auditor’s reports changed following the implementation of expanded auditor reporting in the United Kingdom.116 The author found that the readability of auditor’s reports increased in the postimplementation period, and that the use of negative and uncertain words in expanded auditor’s reports captured more client-specific audit risk.117 In addition, the author found limited evidence that the dispersion of analysts’ EPS forecasts decreased following the implementation of expanded auditor reporting, suggesting an improved information environment. The author argued that expanded auditor reporting was successful at increasing the communicative value of the auditor’s report, and that analyst behavior changed accordingly. In contrast, another recent experimental study found that including critical audit matters reduced the readability of the auditor’s report but did not 115 See Annette Koehler, Nicole Ratzinger-Sakel, and Jochen Theis, Does the Reporting of Key Audit Matters Affect the Auditor’s Report’s Communicative Value? Experimental Evidence from Investment Professionals (working paper submitted as comment letter No. 18, available on the Board’s Web site in Docket 034). 116 See Kecia Williams Smith, Tell Me More: A Content Analysis of Expanded Auditor Reporting in the United Kingdom (working paper submitted as comment letter No. 71, available on the Board’s Web site in Docket 034). 117 The author uses several measures designed to assess the readability of texts which, the study notes, have been used in several other published academic studies addressing the readability of financial disclosure. See id. at 5. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 incrementally inform nonprofessional investors’ valuation judgments. However, the study suggested that the reporting of a critical audit matter lowers nonprofessional investors’ perceptions of management’s credibility when earnings just meet analysts’ expectations. The study was designed and implemented using the definition of critical audit matters and related reporting requirements from the Board’s proposal, which differ from the final standard.118 In addition, in reviewing the experience of expanded auditor reporting in the United Kingdom, the FRC observed that investors greatly value the information provided in expanded auditor reporting.119 This view is confirmed by UK investors that commented on the reproposal. The FRC noted that, in the two years following the implementation of the new requirements, an association of investment managers has recognized in an annual awards ceremony those specific auditor’s reports found to be most clear and most innovative in providing insight into the audit of the company’s financial statements.120 In addition, the FRC notes that users of the new auditor’s reports identified certain descriptions of risks that they found to be more useful—such as descriptions that are specific to the entity being audited. Further, the FRC report noted that, in the second year of implementation, a much greater proportion of risks were set out in a more meaningful and transparent way.121 As noted above, the FRC’s requirements for expanded auditor reporting are different from the final standard, and the baseline legal and regulatory environment is not the same as in the United States. Nevertheless, the Board believes that there are sufficient similarities for the UK experience to be generally informative in its decision-making. While it is too early for the body of academic research on expanded auditor reporting to provide a conclusive answer, investors commenting during the Board’s standard-setting process have consistently affirmed the usefulness of expanded auditor reporting and the FRC’s observations on the early experience of investors in the 118 See Brian Carver and Brad Trinkle, Nonprofessional Investors’ Reactions to the PCAOB’s Proposed Changes to the Standard Audit Report (March 2017) (working paper, available in Social Science Research Network). 119 See FRC 2016 Report. 120 See FRC, March 2015—Extended Auditor’s Reports, A Review of Experience in the First Year; and FRC 2016 Report. 121 Id. PO 00000 Frm 00026 Fmt 4701 Sfmt 4703 United Kingdom are consistent with this view. Accordingly, the Board believes that auditor communication of critical audit matters will add to the mix of information that investors can use. Indirect Benefit: Improved Audit and Financial Reporting Quality In general, information asymmetry can lead to situations in which an agent (such as an auditor) takes actions that do not coincide with the best interests of the principal (such as an investor), if the agent’s incentives are misaligned.122 This type of problem is the result of the inability of the principal to observe or monitor the agent’s behavior, which also inhibits the principal’s ability to identify and reward optimal behavior, or punish sub-optimal behavior. Economic theory posits that the disclosure of information can have indirect effects that lead to changes in behavior.123 In the context of expanded auditor reporting, the additional information provided in the auditor’s report could be beneficial to investors by providing more information about the audit, which could affect their voting decisions. To the extent that this could influence the terms of the auditor’s engagement, academic research suggests ‘‘any additional information about the agent’s action, however imperfect, can be used to improve the welfare of both the principal and the agent.’’ 124 This suggests that making aspects of the audit more visible to investors through the communication of critical audit matters should provide some auditors, management, and audit committees with additional incentives to change their behavior in ways that may enhance audit quality and ultimately financial reporting quality. For instance, the communication of critical audit matters could lead: • Auditors to focus more closely on the matters identified as critical audit matters; • Audit committees to focus more closely on the matters identified as critical audit matters and to engage the 122 Economists use principal-agent theory to analyze situations where one party (the principal) hires another party (the agent) to perform certain tasks and decision-making ability is delegated to the agent. For a general discussion of principal-agent theory, see, e.g., Michael C. Jensen and William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 Journal of Financial Economics 305, 305–360 (1976), or Bengt Holmstrom, Moral Hazard and Observability, 10 The Bell Journal of Economics 74, 74–91 (1979). 123 See, e.g., George Loewenstein, Cass R. Sunstein, and Russell Golman, Disclosure: Psychology Changes Everything, 6 Annual Review of Economics 391, 391–419 (2014). 124 See Holmstrom, Moral Hazard and Observability at 75. E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES auditor and management about the adequacy of the related disclosures; and • Management to improve the quality of their disclosures because they know that investors and the auditor will be scrutinizing more closely the matters identified as critical audit matters. The communication of critical audit matters could lead auditors to increase their focus on the matters identified in the auditor’s report as critical audit matters. As suggested by commenters, the communication of critical audit matters could further incentivize auditors to demonstrate the level of professional skepticism necessary for high quality audits in the areas of the critical audit matters. Other commenters stated that the reporting of critical audit matters could result in increased audit quality. For example, auditors could feel that the potentially heightened scrutiny of the matters identified as critical audit matters may warrant additional effort to satisfy themselves that they have obtained an appropriate amount of audit evidence to support their opinion. The communication of critical audit matters could also heighten management’s attention to the relevant areas of financial statements and related disclosures. Several commenters stated that the reporting of critical audit matters would lead management to improve the quality of their disclosures or adopt more widely accepted financial reporting approaches in these areas.125 An experimental study analyzed the joint effect of expanded auditor reporting and audit committee oversight on management disclosure choices.126 The author found that the study participants, who were currently serving as public company financial executives, chose to provide the greatest level of disclosure when they knew that the auditor’s report would provide a more detailed description of the accounting estimate, and the audit committee exhibited strong oversight. The author argued that, similar to what other academic research has found regarding the resolution of audit adjustments, information presented in critical audit 125 To substantiate this point, one commenter cited a memo prepared for the clients of an international law firm that noted management should consider revising or supplementing their own disclosures relating to issues raised in expanded auditor’s reports to ensure that the totality of disclosures around the issue are complete and accurate. See Sullivan & Cromwell LLP, Audit Reports, PCAOB Releases Reproposal of Amendments to Its Audit Report Standard (May 25, 2016). 126 See Stephen H. Fuller, The Effect of Auditor Reporting Choice and Audit Committee Oversight Strength on Management Financial Disclosure Decisions (working paper submitted as comment letter No. 49, available on the Board’s Web site in Docket 034). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 matters would be the outcome of a negotiation process between the auditor and management. Increased management attention to the related aspects of the financial statement accounts and disclosures described in the critical audit matters should, at least in some cases, lead to an incremental increase in the quality of the information presented. Academic research has shown that increased quality of information could result in a reduction in the average cost of capital.127 In addition, the communication of critical audit matters may enhance the audit committee’s oversight efforts by providing an additional incentive for the audit committee to engage with the auditor and management about the matters identified as critical audit matters and the adequacy of the company’s related disclosures. Although some commenters stated that the required communication of critical audit matters would ‘‘chill’’ communications between the auditor and the audit committee, others said that it would enhance communications between these parties. Further, it should be noted that the final standard does not change the Board’s existing requirements on audit committee communications, other than requiring the auditor to provide the audit committee with a draft of the auditor’s report. To the extent changes in the behavior of auditors, audit committees, and management occur, they could lead to an incremental increase in audit quality and financial reporting quality, which should increase investors’ confidence in the reliability of the financial statements. Some commenters stated that a more transparent and informative auditor’s report could heighten user confidence in the audit and the audited financial statements. Academic research suggests that an increase in investor confidence should decrease the average cost of capital.128 As discussed in the economic analysis of the reproposal, some empirical studies conducted in other jurisdictions provide evidence 127 See, e.g., Richard A. Lambert, Christian Leuz, and Robert E. Verrecchia, Information Asymmetry, Information Precision, and the Cost of Capital, 16 Review of Finance 1, 1–29 (2012). Professor Leuz is an economic advisor at the PCAOB. The research cited above was published before he joined the PCAOB. 128 See Luigi Guiso, Paola Sapienza, and Luigi Zingales, Trusting the Stock Market, 63 The Journal of Finance 2557, 2557–2600 (2008). Professor Zingales is the Founding Director of the PCAOB’s Center for Economic Analysis, now known as the Office of Economic and Risk Analysis. The research cited here was published before he joined the PCAOB. PO 00000 Frm 00027 Fmt 4701 Sfmt 4703 35421 that expanded auditor reporting increased audit quality, while other studies found that it did not have a measurable effect on audit quality.129 The Board is not aware of any empirical studies indicating that expanded auditor reporting had a negative effect on audit quality. Indirect Benefit: Differentiation Among Auditor’s Reports If investors and other financial statement users perceive and respond to differences in the quality and usefulness of the information communicated by auditors regarding critical audit matters, expanded auditor reporting should serve as a potential means of greater differentiation among accounting firms and engagement partners.130 One commenter stated that the reporting of critical audit matters would allow auditors to differentiate themselves, and that this differentiation would provide useful information to investors and other financial statement users. If expanded auditor reporting allows investors to differentiate among accounting firms and engagement partners, it should provide a more nuanced signal of audit quality and financial reporting reliability. The FRC report also noted that there are clear differences among accounting firms in the approaches taken to implement the requirements.131 For example, one firm went beyond the FRC’s requirements by including audit findings for the risks of material misstatement in the majority of its auditor’s reports in the second year of implementation, which other firms did far less frequently. The FRC’s observations may suggest that accounting firms took different approaches to expanded auditor reporting as a means of distinguishing themselves based on the quality and usefulness of the information provided in their auditor’s reports. Furthermore, as discussed in the economic analysis of the reproposal, an academic study argued that investors found the auditor’s reports issued by some accounting firms to be more useful than others.132 One commenter specifically noted that mandatory auditor rotation was introduced in the UK at the same time 129 See PCAOB Release No. 2016–003, Section VI.C.1.b, footnotes 154–156 and accompanying text. 130 On May 9, 2016, the SEC approved new rules and related amendments to the Board’s auditing standards, including amendments to AS 3101, that will provide investors and other financial statement users with information about engagement partners and other accounting firms that participate in audits of issuers. See PCAOB Release No. 2015–008. 131 See FRC 2016 report. 132 See PCAOB Release No. 2016–003, Section VI.C.1.b, footnote 161 and accompanying text. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES 35422 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices as expanded auditor reporting, and that this may have provided accounting firms with motivation to differentiate themselves. In addition to relying on the audit committee (which, at least for exchangelisted companies, is charged with overseeing the external auditor), in the absence of differentiation based on the auditor’s report, users of financial statements may rely on proxies such as the reputation of the accounting firm issuing the auditor’s report, aggregated measures of auditor expertise (for example, dollar value of issuer market capitalization audited or audit fees charged), or information about the geographic location of the office where the auditor’s report was signed as signals for audit quality. Academic research finds, however, that these are imperfect signals of audit quality.133 The identification and description of critical audit matters should permit differentiation among auditor’s reports based on investor perceptions of their informativeness and usefulness. In some instances it may also provide a signal of audit quality. Because the determination and communication of critical audit matters may reflect a variety of considerations, however, critical audit matters may not bear directly on audit quality. For example, the choice of which critical audit matters to communicate or how to describe them may reflect considerations such as the company’s business environment and financial reporting choices, accounting firm methodology, engagement partner characteristics, and legal advice. Thus, a more detailed description of critical audit matters may not necessarily reflect a higher quality audit than a less informative description of such matters. Nevertheless, informative descriptions of how the audit addressed critical audit matters should provide insight into the extent and appropriateness of the auditor’s work. Moreover, it is possible that thoughtful, audit-specific, and useful critical audit matters (or, conversely, generic and uninformative critical audit matters) could affect investor perceptions of the auditor’s work and willingness to provide useful information. As a result, the communication of critical audit matters, potentially in conjunction with disclosures regarding the identity of the engagement partner and other accounting firms that participated in the audit,134 and other relevant information should enable differentiation among engagement partners and accounting firms on that basis. Additional Improvements to the Auditor’s Report The final standard will introduce new requirements regarding auditor tenure, the addressee of the auditor’s report, and statements in the auditor’s report related to auditor independence and the auditor’s responsibility for reporting on ICFR.135 In addition, the final standard contains other changes to the form of the auditor’s report, which are intended to improve and clarify the language for certain elements, such as statements related to the auditor’s responsibilities regarding the notes to the financial statements, and to promote a consistent presentation of this information across auditor’s reports. Investor commenters have consistently supported disclosing tenure in the auditor’s report. In the Board’s view, which is consistent with the views of some commenters,136 disclosing information about auditor tenure in the auditor’s report will provide a consistent location for this information and decrease the search costs, relative to the current environment of voluntary reporting, for some investors and other financial statement users who are interested in this information. The statement regarding the auditor’s existing obligation to be independent of the company is intended to enhance investors’ and other financial statement users’ understanding about the auditor’s obligations related to independence and to serve as a reminder to auditors of these obligations. By requiring the auditor’s report to be addressed to certain parties, the Board will be promoting uniformity in the addressees of the auditor’s report. Commenters were generally supportive of the reproposed changes to the form of the auditor’s report. For example, some commenters stated these enhancements would make the auditor’s report easier to read and would facilitate comparisons between auditor’s reports for different companies by providing a consistent format. 134 See PCAOB Release No. 2015–008. circumstances where management is required to report on ICFR but the auditor is not and has not performed an audit of ICFR, the final standard requires a statement to that effect in the auditor’s report. 136 See below for a discussion of academic research regarding auditor tenure. 135 In 133 See, e.g., Jere R. Francis, A Framework for Understanding and Researching Audit Quality, 30 Auditing: A Journal of Practice & Theory 125, 125– 152 (2011) and Mark DeFond and Jieying Zhang, A Review of Archival Auditing Research, 58 Journal of Accounting and Economics 275, 275–326 (2014). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 PO 00000 Frm 00028 Fmt 4701 Sfmt 4703 Costs and Potential Unintended Consequences Costs Commenters on the reproposal raised concerns that the rule would impose various types of costs, but generally did not quantify those costs. Even those that, at an earlier stage of the rulemaking, conducted limited implementation testing of the proposal were unable to provide a quantified cost estimate. Given lack of data, the Board is unable to quantify costs, but provides a qualitative cost analysis. As an additional means of assessing potential cost implications of the final standard, PCAOB staff has reviewed data from the first year of implementation of expanded auditor reporting in the United Kingdom.137 As discussed below, staff analyzed a variety of data points that may be associated with potential costs, including audit fees, days required to issue the auditor’s report, and the content of the expanded auditor’s report. It should be noted that it may be difficult to generalize observations from the UK experience. For example, the reporting and documentation requirements relating to expanded auditor’s reports in the United Kingdom differ from those in the final standard, the baseline legal environments are different, and the UK requirements apply only to companies with a premium listing on the London Stock Exchange and not, for example, to smaller companies that list on London’s AIM market. Critical Audit Matters The Board anticipates that the final requirements regarding critical audit matters will have potential cost implications for auditors and companies, including their audit committees. Such costs will likely relate to additional time to prepare and review auditor’s reports, including discussions with management and audit committees, as well as legal costs for review of the information provided in the critical audit matters. In addition, auditors may choose to perform more audit procedures related to areas reported as critical audit matters (even though performance requirements have not changed in those areas), with cost implications for both auditors and companies. For auditors, costs might represent both one-time costs and recurring costs. One-time costs could be incurred as a 137 See PCAOB, White Paper on the Auditor’s Reports of Certain UK Companies that Comply with International Auditing Standard (UK and Ireland) 700 (‘‘PCAOB White Paper’’) (May 2016), available on the Board’s Web site in Docket 034. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices result of: (1) Updating accounting firm audit and quality control methodologies to reflect the new reporting requirements; and (2) developing and conducting training of accounting firm personnel on the new reporting requirements. When updating methodologies, some accounting firms will likely also develop new quality control processes related to additional review or consultation on the determination, communication, and documentation of critical audit matters. One commenter suggested that the initial implementation costs could place a significant and possibly disproportionate burden on smaller accounting firms. Recurring costs will primarily reflect additional effort expended in individual audits. The final standard does not impose new performance requirements other than the determination, communication, and documentation of critical audit matters, which will be based on work the auditor has already performed. However, there will be some additional recurring costs associated with drafting descriptions of critical audit matters and related documentation. It is likely that senior members of the engagement teams, such as partners and senior managers, will be involved in determining the critical audit matters and developing the language to be included in the auditor’s report. In addition, reviews by others, such as the engagement quality reviewer and national office, will also result in recurring costs. Additional time might also be incurred by the auditor as a result of discussions with management or the audit committee regarding critical audit matters. Companies, including audit committees, will likely also incur both one-time and recurring costs as a result of the final standard. One-time costs could be incurred, for example, in educating audit committee members about the requirements of the new standard and in developing management and audit committee processes for the review of draft descriptions of critical audit matters and the related interaction with auditors. Recurring costs will include the costs associated with carrying out those processes, as well as any increase in audit fees associated with the new reporting requirements or legal fees stemming from a review of critical audit matter communications. If the drafting and review of critical audit matter reporting takes place towards the end of the audit, there will also be an opportunity cost associated with the time constraints on the parties involved (including, for example, VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 management, the engagement partner, the audit committee, and the auditor’s and company’s respective legal counsel). The end of the audit is a busy period in which multiple issues may need to be resolved before the auditor’s report can be issued. At the same time, companies and management may also be in the process of finalizing the annual report. Time spent drafting and reviewing the communication of critical audit matters could occur at the same time as other important work in the financial reporting and audit process, and would likely involve senior management that command relatively high annual salaries or experienced auditors and lawyers with relatively high hourly billing rates. In addition, the communication of critical audit matters could lead to changes in management’s disclosures, which may result in more effort and cost in the financial reporting process. Several commenters on the reproposal claimed that the required reporting of critical audit matters would lead to increased audit fees, but none provided data or estimates regarding the magnitude of the increases they expected. Commenters on the proposal had differing views about the likely magnitude of direct costs associated with auditor reporting of critical audit matters. Some commenters said that there would not be material additional costs for communication of critical audit matters, as these matters would already have been communicated to the audit committee. This may suggest that a substantial amount of the work required to communicate critical audit matters would already have been completed earlier in the audit. One commenter argued that the changes described in the reproposal would lead to a significant increase in costs, and that no compelling case had been made that the benefits would exceed the costs. Some commenters noted that investors would be expected to ultimately bear the cost of the audit, and these commenters have voiced strong support for expanded auditor reporting since the project’s inception. This suggests that they consider the benefits of expanded auditor reporting to justify the costs, and would support additional fees for additional useful information. Audit fees do not fully reflect the cost of implementing expanded auditor reporting to the extent that accounting firms choose to absorb those additional costs and because audit fees do not reflect the impact of any additional demand on management’s time associated with expanded auditor reporting. Subject to those limitations, PO 00000 Frm 00029 Fmt 4701 Sfmt 4703 35423 in its review of the implementation of expanded auditor reporting in the United Kingdom, the PCAOB staff did not find evidence of statistically significant increases in audit fees following the first year of expanded auditor reporting.138 For 53 percent of the companies analyzed, audit fees for the year of implementation remained the same or decreased as compared to the prior year’s audit fees. Audit fees increased for the remaining companies. The PCAOB staff found that the average change in audit fees was an increase of approximately 5 percent, roughly consistent with the findings of academic research described in the economic analysis in the reproposal. However, the staff found that the median change in audit fees was zero. Collectively, these results seem to suggest that outlier companies with relatively large increases in audit fees drove the result for the average change in audit fees. It should be noted that the PCAOB staff’s review did not analyze whether other factors, such as inflation, changes in the economic environment and corporate risk, corporate acquisitions, or the implementation of other regulatory changes, contributed to the documented increase in audit fees. One commenter on the reproposal noted that the caveats described above are important because the inability to fully gauge the costs of expanded auditor reporting could lead the Board to underestimate the costs associated with the rule, which may bear disproportionately on smaller companies and their auditors. Another commenter also asserted that the costs of expanded auditor reporting are likely to be disproportionately borne by smaller companies because the reproposed rule had, in their estimation, limited scalability. The Board believes that the complexity and costs associated with determining, documenting, and communicating critical audit matters should generally depend on the nature and complexity of the audit. This would in turn depend on the complexity of the operations and accounting and control systems of the company. Additional Improvements to the Auditor’s Report The changes adopted to the basic elements of the auditor’s report do not represent a significant departure from the reproposal. Some of the enhanced basic elements will have cost implications for auditors, although these costs are not expected to be significant. One-time costs will primarily relate to updating methodology and training and 138 Id. E:\FR\FM\28JYN2.SGM 28JYN2 35424 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices the initial determination of the first year the auditor began serving consecutively as the company’s auditor. Based on comments received, it does not appear that the changes adopted to the basic elements will impose significant recurring costs, because the year in which tenure began will not change and the other amendments involve standardized language that, once implemented, will be the same or very similar across different auditor’s reports every year. Potential Unintended Consequences asabaliauskas on DSKBBXCHB2PROD with NOTICES Time Needed To Issue the Auditor’s Report As a result of the additional effort required to determine, communicate, and document critical audit matters, some commenters said that it would take auditors longer to issue their reports. On this point, the PCAOB staff study did not find evidence that compliance with the United Kingdom’s expanded auditor reporting requirements delayed the issuance of auditor’s reports in the first year of implementation. Based on the study, for companies that had three years of financial statements, a new form auditor’s report was issued, on average, in 63 days from the company’s fiscal year end date in the year of implementation, as compared to 64 days in the prior year and 65 days two years earlier. Further, academic research cited in the economic analysis of the reproposal similarly did not find that the UK reporting requirements led to delays in financial reporting.139 Number and Content of Critical Audit Matters Some commenters indicated an expectation that the auditor’s report would include a long list of critical audit matters or that auditors would have incentives to communicate an overly long list of critical audit matters. For example, some commenters said that this would occur because the auditor would be motivated to communicate as much as possible in an effort to mitigate any future liability for unidentified critical audit matters, or as a means to avoid potential consequences of being second-guessed by regulators or others. Other commenters asserted that such a development could make the auditor’s report overly long, contributing to disclosure overload and conflicting with the SEC’s disclosure effectiveness project. Other commenters indicated that expanded auditor reporting could lead to boilerplate language that would diminish the expected value of the critical audit matters and obscure the clarity of the auditor’s opinion. If auditors fail to provide audit-specific information, the communication of critical audit matters will not decrease information asymmetry about the audit, and may obscure other important information included in the auditor’s report and the audited financial statements. The final requirements aim to provide investors with the auditor’s unique perspective on the areas of the audit that involved the auditor’s especially challenging, subjective, or complex judgments. Limiting critical audit matters to these areas should mitigate the extent to which expanded auditor reporting could become standardized. Focusing on auditor judgment should limit the extent to which expanded auditor reporting could become duplicative of management’s reporting. Also, while some commenters argued that liability concerns would increase the number of critical audit matters auditors communicate, others suggested that liability concerns would minimize the additional statements auditors make. The PCAOB staff study did not find evidence that expanded auditor reporting in the United Kingdom resulted in a very large number of risk topics or none at all in the first year of implementation.140 On average, the auditor’s reports in the first year of implementation included descriptions of four risk topics, with total risk topics ranging from one to eight. Additionally, the descriptions of the risks of material misstatement in the auditor’s reports in the first year of implementation were not presented in standardized language, but included variations in content length, description, and presentation. The most frequently described risk topics related to revenue recognition, tax, and goodwill and intangible assets. The FRC report on the first two years of expanded auditor reporting in the United Kingdom finds a similar range and average number of risk topics disclosed in both the first and second year of implementation.141 The FRC report also finds disclosure of similar risk topics in the second year of implementation of expanded auditor reporting in the United Kingdom.142 Further, the FRC found that, in the second year of expanded auditor reporting in the United Kingdom, the discussion of risks has improved relative to the first year of 140 See 141 See 139 See PCAOB Release No. 2016–003, section VI.D.2.a, footnote 169 and accompanying text. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 PCAOB White Paper. FRC 2016 Report. 142 Id. PO 00000 Frm 00030 Fmt 4701 Sfmt 4703 implementation and that the majority of auditor’s reports provided discussion of risks that were more tailored to the company under audit, thus avoiding generic or standardized wording.143 These findings suggest that, thus far, expanded auditor reporting has not become standardized in the United Kingdom.144 Effects of Increased Attention to Critical Audit Matters The communication of critical audit matters could lead auditors, company management, and the audit committee to spend additional time and resources on reviewing the adequacy of the work performed on the related financial statement accounts and disclosures. While this could lead to an incremental improvement in audit and financial reporting quality for the identified critical audit matters, it is also possible that there may be increased costs for auditors as a result of the requirements. For example, even though the final standard does not mandate the performance of additional audit procedures other than with respect to communication of critical audit matters, it is possible that some auditors may perform additional procedures. If that occurs, the associated costs may be passed on—in whole, in part, or not at all—to companies and their investors in the form of higher audit fees. Further, increased procedures may also require additional time from the company’s management to deal with such procedures. Some commenters suggested that the increased attention on certain matters could also lead to a related decrease in audit and financial reporting quality if other material aspects of the financial statements and disclosures receive less attention. Some commenters argued that including critical audit matters in the auditor’s report would impair the relationship between auditors and management or auditors and the audit committee. Other commenters suggested that the required reporting of critical audit matters would inhibit communication among the auditor, management, and the audit committee because of concerns about what would be publicly communicated in the auditor’s report. One commenter also suggested that auditors may include additional matters in audit committee communications out of concern that an 143 Id. 144 The Board finds the UK experience instructive, although it is, of course, possible that differences between the UK and U.S. litigation and regulatory environments may influence the extent to which these findings would generalize to the U.S. market. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices omission could lead to regulatory sanctions or liability. Other commenters have said that it would enhance communication among the participants in the financial reporting process. An experimental study analyzed how the strength of audit committee oversight of the financial reporting process varied with the presence of sophisticated investors and knowledge of forthcoming expanded auditor reporting.145 The author found that study participants, most of whom were experienced audit committee members, asked fewer probing questions if they knew that the auditor would be providing a discussion of the significant accounting estimate in the auditor’s report. The author argued that by asking fewer probing questions audit committee members subconsciously insulated themselves from potential challenges mounted by investors regarding the appropriateness of the company’s financial reporting. The Board is not aware of evidence this has occurred in the jurisdictions that have adopted expanded auditor reporting. Moreover, it may be difficult in an experimental setting to recreate the actual legal responsibility and potential liability that audit committee members face, which may limit the extent to which the experimental results would generalize to actual behavior in realworld settings. Similarly, as described in the economic analysis of the reproposal and asserted by at least one commenter, management may have an incentive to withhold information from the auditor in order to prevent an issue from being described in the auditor’s report. It seems unlikely, however, that management would or could withhold information from the auditor on the most critical issues in the audit because it could result in a scope limitation. On the contrary, it may be just as likely that management would communicate more information to the auditor as a means of demonstrating that an issue is not challenging, subjective, or complex, and, therefore, would not need to be described in the auditor’s report. Under the final standard, critical audit matters are determined from the matters communicated or required to be communicated to the audit committee. As noted earlier, with respect to any matters already required to be communicated to the audit committee, there should not be a chilling effect or 145 Yoon Ju Kang, Are Audit Committees More Challenging Given a Sophisticated Investor Base? Does the Answer Change Given Anticipation of Additional Mandatory Audit Report Disclosure? (working paper submitted as comment letter No. 17, available on the Board’s Web site in Docket 034). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 reduced communications to the audit committee. Therefore, it would seem that any chilling effect would relate to matters that are not explicitly required to be communicated to the audit committee, although, as previously described, given the breadth of current communication requirements, the Board believes there will likely be few communications affected by that possibility. Potential Impact on Management Disclosure Several commenters stated that the communication of critical audit matters would give auditors leverage to encourage disclosure of information by management. While some commenters asserted that this would be beneficial, others claimed it would be an unintended negative consequence of requiring the communication of critical audit matters. Several commenters characterized this as inappropriately expanding the role of the auditor in the financial reporting process, while undermining the role of management and the audit committee. In their view, this would be especially problematic if the final standard permitted the auditor to communicate information that was not otherwise required to be disclosed (for example, because it did not meet a specified threshold for disclosure, such as a significant deficiency in internal control over financial reporting). Commenters claimed that auditor communication of this ‘‘original information’’ would cause a number of unintended consequences, including significant costs, disclosure of confidential or competitively sensitive information, and potentially misleading or incomplete information. Investors and other commenters pointed out that, although expanded auditor reporting would give the auditor additional leverage over management’s disclosure choices, this could result in improvements in the usability of financial statements and increases in financial reporting quality. One of these commenters cited academic research noting that, in current practice, disclosure is already guided by an iterative process between management and the auditor. This commenter reasoned that concerns regarding ‘‘original information’’ were misplaced because the iterative process would reduce the likelihood that the auditor would be a source of original information since critical audit matters would likely overlap with increased management disclosure. Another commenter pointed out that auditors would not have incentives to interpret the Board’s rule to require PO 00000 Frm 00031 Fmt 4701 Sfmt 4703 35425 disclosure of original information in most situations. For example, concerns about the limitations of their knowledge and expertise, potential liability implications, and friction in the relationship with the company are likely to discourage auditors from going beyond management disclosures. Nevertheless, the final standard contemplates that the auditor will do so only when it is necessary to describe the principal considerations that led the auditor to determine that a matter was especially challenging, subjective, or complex and how the matter was addressed in the audit. The Board believes that this provision is needed in order to ensure that the fact that management did not provide a disclosure would not prevent the auditor from communicating a critical audit matter. Although the communication of critical audit matters may lead to changes in the incentives for the auditor, company management, and the audit committee to communicate with each other, initial anecdotal evidence from the Board’s outreach activities suggests that the implementation of expanded auditor reporting in the United Kingdom has not chilled such communications. Changes in Perceived Assurance on the Auditor’s Report, Including Perceptions of Auditor Liability The communication of critical audit matters could have liability implications for auditors. In addition, because the communication of critical audit matters requires auditors to discuss aspects of the audit that they found to be especially challenging, subjective, or complex, it is possible that some investors and financial statement users may misconstrue the communications to mean that auditors were unable to obtain reasonable assurance about the matters identified as critical audit matters. Some commenters have said that the communication of critical audit matters could lead to changes in the way investors and financial statements users perceive the level of assurance provided by the auditor on matters identified as critical audit matters, including that it could undermine the basic pass/fail opinion. This could lead investors to erroneously conclude that there is a problem with the audit either in the areas identified in critical audit matters or other areas, or that auditors are providing separate assurance about the presentation of the financial statements, which may have implications for perceptions of auditor responsibility in the event of an audit failure. E:\FR\FM\28JYN2.SGM 28JYN2 35426 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices As discussed in the economic analysis of the reproposal, several academic papers analyze certain risks associated with communicating critical audit matters, including perception of auditor responsibility.146 If the communication of critical audit matters were to lead to a reduction in perceived auditor responsibility, as is suggested by some academic research, and this in turn reduced auditor liability, it is possible that auditors may feel that less audit work is needed on the matters identified as critical audit matters, which could adversely affect audit quality (although the Board’s other auditing standards, reinforced through firm quality control and Board inspections and enforcement activity, should provide a disincentive for auditors to decrease the amount or quality of audit work performed). It is difficult to draw generalizable conclusions based on the findings of these studies. In part, this is because their results vary and are sometimes contradictory, with some studies finding that expanded auditor reporting increases perceived auditor responsibility and others finding that it decreases perceived auditor responsibility. This may suggest that the results are sensitive to the experimental design and the context in which information is presented to study participants. In addition, it is not clear how the findings would correlate with changes in auditor behavior, because perceptions of auditor responsibility may be a poor proxy for actual auditor responsibility or liability. To address the risk that the communication of critical audit matters could result in the perception of separate assurance, the final standard requires the following statement in the auditor’s report: asabaliauskas on DSKBBXCHB2PROD with NOTICES The communication of critical audit matters does not alter in any way [the auditor’s] opinion on the financial statements, taken as a whole, and [the auditor is not] by communicating the critical audit matters . . . providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. The purpose of this statement is to make clear that the communication of critical audit matters in an auditor’s report should not be interpreted as altering the level of assurance on any aspect of the audit report, including the identified critical audit matters. In this regard, the Board also notes the view of some commenters that critical audit matters are likely to be used by institutional investors that are unlikely to misinterpret the information. 146 See PCAOB Release No. 2016–003, Section VI.D.2.d, footnotes 182–186 and accompanying text. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 Auditor Tenure Many commenters stated that information regarding the auditor’s tenure included in the auditor’s report could result in inappropriate and inconsistent assumptions about correlations between auditor tenure and/or independence and audit quality. Academic research on the relationship of tenure to audit quality has varied conclusions. For instance, some academic research indicates that engagements with short-term tenure are relatively riskier or that audit quality is improved when auditors have time to gain expertise in the company under audit and in the related industry.147 Other academic research suggests that, at least prior to 2001, both short tenure (less than five years) and long tenure (greater than fifteen years) can have detrimental effects on audit quality.148 Still other academic research indicates that investors are more likely to vote against, or abstain from, auditor ratification as auditor tenure increases, which may suggest that investors view long-term auditor-company relationships as adversely affecting audit quality.149 The disclosure of auditor tenure is intended to add to the mix of information that investors can use. However, commenters other than investors did not support disclosure of auditor tenure in the auditor’s report on the basis that such disclosure would not provide value to investors or could result in false conclusions about correlations between auditor tenure and audit quality or between auditor tenure and auditor independence. Many of these commenters recommended that, if the Board determined to require disclosure of auditor tenure, it should be disclosed in Form AP rather than in the auditor’s report as a means of avoiding these inferences. Alternatives Considered, Including Policy Choices Under the Final Standard After considering the comments received, the Board is adopting a new 147 See, e.g., Joseph V. Carcello and Albert L. Nagy, Audit Firm Tenure and Fraudulent Financial Reporting, 23 Auditing: A Journal of Practice & Theory 55, 55–69 (2004) and Timothy B. Bell, Monika Causholli, and W. Robert Knechel, Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality, 53 Journal of Accounting Research 461, 461–509 (2015). 148 See, e.g., Larry R. Davis, Billy S. Soo, and Gregory M. Trompeter, Auditor Tenure and the Ability to Meet or Beat Earnings Forecasts, 26 Contemporary Accounting Research 517, 517–548 (2009). 149 See, e.g., Mai Dao, Suchismita Mishra, and K. Raghunandan, Auditor Tenure and Shareholder Ratification of the Auditor, 22 Accounting Horizons 297, 297–314 (2008). PO 00000 Frm 00032 Fmt 4701 Sfmt 4703 auditor reporting standard, AS 3101 and related amendments to its standards. The final standard retains the pass/fail model while expanding auditor reporting to include the communication of critical audit matters. Investor commenters have consistently asked for additional information in the auditor’s report to make it more informative about the audit of the company’s financial statements. As described below, the Board has considered a number of alternative approaches to achieve the potential benefits of enhanced auditor reporting. Alternatives Raised by Commenters Only Cross-Reference to Management’s Disclosures Some commenters suggested that, instead of communicating critical audit matters as reproposed, auditors should only identify the critical audit matters and provide a cross-reference to management disclosures (i.e., not describe the principal considerations that led the auditor to determine a matter is a critical audit matter or how it was addressed in the audit), or refer to or list critical accounting policies and estimates as disclosed by management. The Board believes that communicating the principal considerations that led the auditor to determine that a matter is a critical audit matter and how it was addressed in the audit will provide useful information beyond simply referencing existing management disclosure, and is more responsive to investor requests for more information from the auditor’s perspective. Auditor Association With Other Company Disclosures Other commenters suggested more specific auditor assurance on particular management disclosures, such as inclusion of a statement in the auditor’s report that the audit included evaluation of the accounting policies and significant estimates, with a crossreference to management’s disclosures, or a statement of auditor concurrence with the critical accounting policies and estimates of the company. One commenter suggested that audit committees should disclose critical audit matters with a corresponding confirmation from the independent auditor. Several commenters on the proposal also suggested that the Board should consider auditor association with, or attestation on, portions of MD&A, specifically management’s critical accounting policies and estimates, as an alternative to expanded auditor reporting. These commenters have E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices argued that such an association could increase the quality and reliability of the information subject to the procedures. Some commenters on the concept release, including investors, said that they were not supportive of separate assurance by the auditor on information outside of the financial statements as an alternative to expanded auditor reporting, primarily because the related auditor reporting would have appeared in a standardized form and would not provide audit-specific information. Requiring such reporting might necessitate action by the SEC, as well as the PCAOB, to implement, including new SEC rules regarding management reporting and auditor attestation. In addition to reporting requirements, the PCAOB might have to develop new performance requirements and auditors would be required to undertake additional audit work in order to provide attestation in these areas. Based on concerns about the complexity of such an approach, as well as the comments received as to its limited benefits, the Board determined not to pursue auditor association with portions of MD&A as an alternative to expanded auditor reporting at this time. The Board believes that this approach would fail to deliver the audit-specific information requested by investors, while also raising potential concerns about separate assurance on the identified matters. asabaliauskas on DSKBBXCHB2PROD with NOTICES No Change to Auditor Reporting Requirements The Board considered whether changes to the existing auditor reporting requirements were needed. Auditor reporting under the current model has been criticized by many commenters as providing limited information. Auditors have not voluntarily provided more information in the auditor’s report in response to investors’ requests. A number of factors described above, such as potential costs and uncertainties related to voluntary auditor reporting and the potential for auditor status quo bias, may explain why voluntary reporting would not be expected to become prevalent. These factors suggest that voluntary reporting, with or without guidance to encourage it, could also create uncertainty about the content of auditor’s reports because auditors would be able to choose whether to provide information about the audit, what information to provide, and the form in which to provide it. On that basis, the Board believes that standard setting is appropriate. VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 Consideration of Analogous Requirements of Other Regulators and Standard Setters In developing the final standard, the Board took into account the requirements for expanded auditor reporting of other regulators and standard setters, such as the IAASB, the FRC, and the EU. Changes to the auditor’s report that other regulators and standard setters have adopted include some commonality, such as communicating information about audit-specific matters in the auditor’s report. Several commenters suggested that the Board align its requirements for expanded auditor reporting more closely with the requirements of the IAASB to provide more consistent global auditor reporting requirements. However, the Board recognizes that the regulatory environments in other jurisdictions are different from the United States, requiring the Board to address unique U.S. requirements and characteristics in its standard-setting projects. Because the Board’s standards have the force of law, the Board aims to make them as clear and easy to apply as it can. For example, the factors that the auditor considers in determining whether a matter involved especially challenging, subjective, or complex auditor judgment are included in the standard; by contrast, while the IAASB approach includes similar factors, they appear in the application and other explanatory material. In addition, there are differences between requirements and terminology of the Board’s auditing standards and those of other regulators and standard setters that may cause inconsistent application, even if the Board were to adopt the approach of another standard setter. For example, the Board’s requirements for communications to the audit committee are not identical to the analogous requirements of the IAASB. Therefore, although both critical audit matters and the IAASB’s key audit matters are derived from such communications, the matters ultimately discussed with the audit committee under each framework would not necessarily be the same, which could result in differences in which matters are reported even if the language in the auditor reporting standards were identical. Also, the component of the definition of critical audit matter in the final standard, namely ‘‘matters that involve especially challenging, subjective, or complex auditor judgment’’ grounds the definition in the auditor’s expertise and judgment. Although the processes of identifying these matters vary across jurisdictions, PO 00000 Frm 00033 Fmt 4701 Sfmt 4703 35427 there are commonalities in the underlying criteria regarding matters to be communicated and the communication requirements, such that expanded auditor reporting could result in the communication of many of the same matters under the various approaches. Auditor Assessment and Descriptions of Certain Financial Statement Areas Several commenters on the concept release suggested that investors would be most interested in auditor reporting on the categories of information identified by investor respondents to the 2011 survey conducted by a working group of the IAG: (1) Significant management estimates and judgments made in preparing the financial statements and the auditor’s assessment of them; (2) areas of high financial statement and audit risk; (3) unusual transactions, restatements, and other significant changes in the financial statements; and (4) the quality, not just the acceptability, of the company’s accounting practices and policies.150 This request was reiterated by several commenters on the proposal, who continued to believe that this approach would provide the information investors want most. In a similar vein, other commenters on the reproposal have requested that the auditor provide a ‘‘grade’’ on management’s significant accounting estimates and judgments. The Board believes that the final critical audit matter definition will likely cover many of the topic areas requested by investors. For example, the auditor may communicate critical audit matters related to significant management estimates and judgments, highlight areas of high financial statement and audit risk, and discuss significant unusual transactions. However, the auditor will not be required to report on its assessment of management’s significant estimates and judgments or on the quality (as opposed to merely the acceptability), of the company’s accounting practices and policies or of the financial statements as a whole. The final standard seeks to strike an appropriate balance between the value of the information being provided and the costs of providing it. Requiring auditors to report their qualitative assessments in a manner that appears very precise (for example, describing an estimate as ‘‘conservative’’ or ‘‘aggressive’’ or assigning the financial statements an ‘‘A’’ or a ‘‘B’’) may impose significantly greater costs and unintended consequences than the 150 See E:\FR\FM\28JYN2.SGM IAG 2011 survey. 28JYN2 35428 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices principles-based reporting of critical audit matters. For example, although the reporting of qualitative assessments would appear to be precise, these qualitative assessments are likely to be applied inconsistently because there is no framework for such assessments and the determinations are inherently subjective. In addition, such assessments may heighten concerns related to the perceived level of assurance provided by the audit or the perception that separate assurance is being provided as to the assessed areas. Also, the reporting of such qualitative assessments may subject auditors and companies to additional litigation risk beyond what may result from the principles-based reporting of critical audit matters because the apparent precision of the reporting may facilitate plaintiffs’ claims. Policy Choices Definition of Critical Audit Matters The Board considered a variety of possible approaches to the definition of critical audit matters suggested by commenters. See above for a discussion of the Board’s considerations of the final standard. asabaliauskas on DSKBBXCHB2PROD with NOTICES Communication of Critical Audit Matters The Board considered a variety of possible approaches to the communication requirements for critical audit matters. See above for a discussion of the Board’s considerations of the final standard. Auditor Tenure The final standard retains the reproposed requirement to include a statement in the auditor’s report about auditor tenure. In the reproposal, the Board solicited comment on whether disclosure of auditor tenure should be made on Form AP instead of in the auditor’s report. Form AP was developed as a means to address commenter concerns about the potential liability implications of naming persons in the auditor’s report. Because the disclosure of auditor tenure does not have the same potential liability consequences, such an approach is unnecessary in this case. In addition, some commenters preferred tenure disclosure on Form AP because of a concern that disclosure in the auditor’s report could result in inappropriate inferences about correlations between auditor tenure and audit quality, or between auditor tenure and auditor independence. The Board is not persuaded by such concerns. Further, the final standard allows the auditor flexibility in the location of the VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 auditor tenure disclosure in the auditor’s report. The Board determined that disclosure will be better achieved through the auditor’s report because the information will be more readily accessible upon the filing with the SEC of a document containing audited financial statements and poses lower search costs, particularly for those investors who may prefer to have the information provided in the auditor’s primary means of communication. In addition, disclosing tenure in the auditor’s report will make information available earlier to investors, which may assist in their voting on auditor ratification. However, disclosing auditor tenure in the auditor’s report rather than Form AP could result in higher costs to investors that wish to accumulate tenure data for a large number of companies or compare data across companies because these investors will have to acquire tenure data from each company’s auditor’s report separately or from a data aggregator. Additional Improvements to the Auditor’s Report The final standard includes a number of requirements that will enhance the standardized content of the auditor’s report by clarifying the auditor’s role and responsibilities related to the audit of the financial statements. These include, for example, statements regarding auditor independence requirements and the addition of the phrase ‘‘whether due to error or fraud,’’ when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements. In addition, the final standard includes requirements intended to promote uniformity in the form of the auditor’s report. These include requirements as to the addressee, a specific order of certain sections of the auditor’s report, and required section headings. Many commenters generally supported these enhancements and suggested that such enhancements will increase the usability of the auditor’s report by improving financial statement users’ understanding of the auditor’s responsibilities, reducing search costs for information in the auditor’s report, and facilitating comparisons across auditor’s reports. PO 00000 Frm 00034 Fmt 4701 Sfmt 4703 Applicability of Critical Audit Matter Requirements Brokers and Dealers, Investment Companies, and Benefit Plans The reproposed standard did not require communication of critical audit matters for audits of brokers and dealers reporting under Exchange Act Rule 17a– 5, investment companies other than business development companies (‘‘BDCs’’), and benefit plans. The reproposing release described the Board’s rationale, including economic considerations, for such exclusions from the critical audit matter requirements and noted that auditors of these entities would not be precluded from including critical audit matters in the auditor’s report voluntarily. Commenters generally supported these exclusions, pointing to the same or similar reasons to those described by the Board in the reproposing release. Some commenters asserted that the communication of critical audit matters should apply to all companies. One commenter supported voluntary communication of critical audit matters for the exempted entities. Another commenter disagreed with providing auditors the ability to voluntarily communicate critical audit matters for brokers and dealers and investment companies. This commenter also suggested that all broker-dealers, including broker-dealers that are issuers, should be excluded from the requirement. After considering the comments received and evaluating benefits and costs, the final standard excludes the audits of brokers and dealers that are reporting under Exchange Act Rule 17a– 5, investment companies other than BDCs, and benefit plans, from the critical audit matter requirements as reproposed.151 Auditors of these entities may choose to include critical audit matters in the auditor’s report voluntarily. The Board’s rationales for these exclusions are described below. Brokers and Dealers Reporting Under Exchange Act Rule 17a–5 Pursuant to Exchange Act Rule 17a– 5, the annual reports that brokers and dealers file with the SEC are public, except that if the statement of financial condition in the financial report is bound separately from the balance of the annual report, the balance of the annual report is deemed confidential and nonpublic.152 In this situation, the 151 The other requirements of the final standard will be applicable to audits of these entities. 152 See Exchange Act Rule 17a–5(e), 17 CFR 240.17a–5(e). E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES auditor would generally issue two separate auditor’s reports that would have different content: (1) An auditor’s report on the statement of financial condition that would be available to the public and (2) an auditor’s report on the complete financial report that, except as provided in paragraph (c)(2)(iv) of Exchange Act Rule 17a–5, would be confidential and not available to the public.153 Research by the PCAOB’s Office of Economic and Risk Analysis (‘‘ERA’’) 154 indicates that, for approximately half of brokers and dealers, the complete financial report and the related auditor’s report are confidential and not available to the public. In 2013, the Board adopted new standards related to brokers and dealers that enhanced the auditor’s performance and reporting responsibilities for financial statement audits, as well as engagements on compliance and exemption reports of brokers and dealers.155 Some commenters on the proposal asserted that the value of reporting critical audit matters for brokers and dealers would be significantly limited by the closely held nature of brokers and dealers; the limited number of users of their financial statements; and the fact that, in many cases, only the statement of financial condition is available publicly. Some commenters also recognized that both the SEC and PCAOB recently updated their rules to further enhance reporting by brokers and dealers and their auditors. Research by ERA indicates that currently there are no brokers or dealers that are issuers. Rather, brokers and dealers are often owned by a holding company, an individual, or a group of individuals that holds a controlling interest. The owners of brokers and dealers are generally part of the management of the entity and therefore would have direct access to the auditor. Given that, in many cases, there is much less separation of ownership and control 153 See also Exchange Act Rule 17a–5(c)(2), 17 CFR 240.17a–5(c)(2), regarding audited statements required to be provided to customers. 154 ERA’s research was conducted on brokers and dealers who filed financial statements through May 15, 2015, for fiscal years ended during 2014 that included audit reports issued by firms registered with the PCAOB. 155 See Attestation Standards for Engagements Related to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securities and Exchange Commission and Related Amendments to PCAOB Standards, PCAOB Release No. 2013–007 (Oct. 10, 2013) and Auditing Standard No. 17, Auditing Supplemental Information Accompanying Audited Financial Statements and Related Amendments to PCAOB Standards, PCAOB Release No. 2013–008 (Oct. 10, 2013). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 in brokers and dealers than in issuers, the communication of critical audit matters would provide little information about the audit that would otherwise be unobtainable by investors. Although there may be circumstances in which other financial statement users may benefit from reduced information asymmetry about the audits of brokers and dealers, certain aspects of broker and dealer financial reporting may limit the benefits of requiring the communication of critical audit matters. For example, while other financial statement users, such as customers of brokers and dealers, may benefit from increased information about the audit, the ability for brokers and dealers to file certain financial statements and schedules confidentially would require the auditor to identify and communicate critical audit matters that apply only to the publicly available statement of financial condition. This may reduce the value of communicating critical audit matters for brokers and dealers relative to issuers. Moreover, customers of brokers and dealers may be interested in the overall financial position of the broker or dealer but may not benefit from audit-specific information in the same way as investors in an issuer. The communication of critical audit matters may also impose additional costs on the auditors of brokers and dealers relative to the auditors of other types of companies, as they would have to identify critical audit matters that apply exclusively to the publicly available financial information, which may be difficult in some situations. After consideration of the ownership and reporting characteristics of brokers and dealers, the comments received on the proposal and reproposal, and the Board’s recent standard-setting activities related to brokers and dealers, the Board does not believe that reporting of critical audit matters for brokers and dealers will provide meaningful information in the same way as for issuers. Therefore, the communication of critical audit matters is not required for audits of brokers and dealers reporting under Exchange Act Rule 17a–5. If a broker or dealer were an issuer required to file audited financial statements under Section 13 or 15(d) of the Exchange Act, the requirements would apply. Investment Companies The Investment Company Act generally defines an investment company as any issuer that is engaged primarily in the business of investing, reinvesting, or trading in PO 00000 Frm 00035 Fmt 4701 Sfmt 4703 35429 securities.156 Most investment companies registered under the Investment Company Act are required to file with the SEC annual reports on Form N–CSR containing audited financial statements.157 The Investment Company Act includes specific requirements for investment companies, intended to reduce investors’ risks, in areas such as an investment company’s portfolio diversification, liquidity, leverage, and custody of securities.158 In an SEC rulemaking, the SEC observed that commenters believed the key information that investors use in deciding to invest in an investment company includes an investment company’s investment objectives, strategies, risks, costs, and performance.159 The disclosure of information about these items appears in the annual prospectus that investment companies provide to current and future investors.160 Changes to investment objectives and strategies require shareholder approval or disclosure.161 Several commenters on the proposal noted that an investor’s decision to invest in an investment company is primarily based on the investment objectives, risks, performance, and fees, and critical audit matters are not expected to provide information about these items and therefore would not be relevant. These and other commenters generally stated that investment companies are designed for the sole purpose of trading in and holding investments and auditor judgment would arise primarily with respect to valuation of investments, which would tend to be repeated as a critical audit matter. One of these commenters noted that, since the strategies of investment companies do not change significantly over time, the critical audit matters identified could become standardized from one reporting period to the next and also across funds with similar objectives. Even though the disclosures required under the Investment Company Act and 156 See Section 3(a)(1) of the Investment Company Act. 157 See SEC Rules under Section 30(e) of the Investment Company Act. 158 See, e.g., Sections 12, 13, and 17 of the Investment Company Act. 159 See SEC, Enhanced Disclosure and New Prospectus Delivery Option for Registered OpenEnd Management Investment Companies, Securities Act Release No. 8998, 74 FR 4546 (Jan. 26, 2009). See also Investment Company Institute, Understanding Investor Preferences for Mutual Fund Information (Aug. 2006) at 2–3. 160 See SEC Rules under Section 30(e) of the Investment Company Act. 161 See Sections 8(b) and 13(a)(3) of the Investment Company Act and Investment Company Act Rule 8b–16. E:\FR\FM\28JYN2.SGM 28JYN2 asabaliauskas on DSKBBXCHB2PROD with NOTICES 35430 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices other federal securities laws provide investors with useful information, they may not fully substitute for the communication of critical audit matters. The required communication of critical audit matters contemplates that auditors would provide investors with auditspecific information, which is unlikely to appear in the disclosures provided by management. In addition, some academic research documented a difference in the perceived usefulness and reliability of information depending on the location of the disclosure and whether it was disclosed by management or by the independent auditor.162This academic research suggests that the auditor’s communication of information similar to critical audit matters may provide value to investors because it comes from the auditor, even if the same information is disclosed by management in the experimental design of the study. The benefits of providing critical audit matters, however, may be smaller for investment companies, other than BDCs, relative to other types of companies because of their purpose and structure. Unlike companies whose business models can change over time, investment companies have specific investment mandates that are disclosed in the prospectus and rarely change. This creates the potential for critical audit matters of investment companies to become excessively repetitive, making them uninformative. There may also be additional costs of applying critical audit matter requirements to audits of investment companies, other than BDCs, as compared to audits of other types of companies. For example, in some cases, annual shareholder reports of affiliated investment companies with the same fiscal year-end might be filed with the SEC in one document, which generally contains a single auditor’s report that covers multiple audited investment companies. In these situations, communicating critical audit matters specific to each investment company may require the auditor to prepare separate auditor’s reports. This could increase costs for these types of investment companies. After consideration of the purpose and reporting characteristics of investment companies and the comments received on the proposal and reproposal, the Board has determined not to require the communication of critical audit matters for audits of most investment companies, although they 162 See, e.g., Christensen et al., Do Critical Audit Matter Paragraphs in the Audit Report Change Nonprofessional Investors’ Decision to Invest? VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 will apply to audits of investment companies regulated as BDCs.163 Unlike the audits of many other investment companies, auditing the valuation of BDCs’ investments generally involves complexity and auditor judgments due to the nature of the BDCs’ portfolios. Also, because of the more diverse operations of BDCs, such as providing managerial assistance and involvement with more complex debt and equity instruments than other investment companies, communication of critical audit matters in a BDC audit could be more informative to investors. Additionally, BDCs follow a reporting regime under the Exchange Act that is more closely aligned with that of companies to which the Board is applying the requirements for critical audit matters. For these reasons, the Board believes it is appropriate for audits of BDCs to be subject to critical audit matter requirements. Benefit Plans Benefit plans that purchase and hold securities of the plan sponsor using participants’ contributions are generally required to file with the SEC an annual report on Form 11–K 164 that includes the benefit plan’s audited financial statements and the related auditor’s report.165 The audit of the financial statements included in a filing on Form 11–K is performed in accordance with the standards of the PCAOB. Benefit plans are also generally subject to the financial reporting requirements of the Employee Retirement Income Security Act of 1974 (‘‘ERISA’’), including the U.S. Department of Labor’s (‘‘DOL’’) rules and regulations for disclosure under ERISA.166 Participation in a benefit plan is limited to eligible employees of the plan sponsor. Each plan participant in a defined contribution benefit plan is responsible for selecting, from the investment options made available by the plan sponsor, the specific investments in which the participant’s funds are invested. Employee stock benefit plans are generally less complex than other types 163 See Section 54 of the Investment Company Act. Section 15(d) of the Exchange Act. benefit plan’s audited financial statements may also be included as part of the annual report of the issuer sponsoring the benefit plan. See Exchange Act Rule 15d–21, CFR 240.15d–21. 166 ERISA Section 103(a)(3)(A) requires a plan administrator to engage an independent auditor to conduct an examination of the plan’s financial statements and required schedules in accordance with generally accepted auditing standards. See 29 CFR 2520.103–1. Benefit plans subject to ERISA also file with the DOL an annual report on Form 5500, including audited financial statements and an auditor’s report. See also FASB ASC 960–10–05–6. PO 00000 164 See 165 A Frm 00036 Fmt 4701 Sfmt 4703 of companies because they are designed for the sole purpose of holding the plan’s investments for the participants’ benefit. A plan’s financial statements reflect summary information about the plan’s assets and liabilities by aggregating the balances of all plan participants. However, only the individual account statements that plan participants receive periodically provide information specific to each participant’s investments. Several commenters on the proposal suggested excluding audits of benefit plans from the requirement for reporting critical audit matters due to the unique characteristics of these entities and their differences from other types of companies. For example, some commenters indicated that benefit plans are designed for a specific purpose and, as a result, would likely have similar critical audit matters from one reporting period to the next. Other commenters noted that benefit plans are inherently less complex and entail fewer estimates and judgments. The communication of critical audit matters could provide information about any complex issues that were identified during the audit and how the auditor addressed them. However, since a benefit plan’s assets and liabilities aggregate the balances of all plan participants, the financial statements or related critical audit matters would not provide actionable information about a plan participant’s specific investment. Further, given the nature of benefit plans, there is a chance that the same critical audit matters would be communicated each year. For example, the valuation of investments is likely to be the most complex area in the audit of a benefit plan and therefore may be a critical audit matter in each reporting period, making the information less useful. After consideration of the structure and reporting characteristics of benefit plans and the comments received on the proposal and reproposal, the Board has determined not to require the communication of critical audit matters for audits of benefit plans. Smaller Companies The reproposal sought comment on whether the critical audit matter requirements should not apply to audits of other types of companies, in addition to the exempted entities discussed above. Some commenters asserted that the communication of critical audit matters should apply to all companies. Other commenters recommended that the Board give consideration to not applying the critical audit matter requirements to audits of smaller E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES reporting companies 167 and nonaccelerated filers 168 due to their smaller size and because, in the commenters’ view, communication of critical audit matters would not provide sufficient benefits for these companies to justify the costs. Academic research suggests that smaller companies have a higher degree of information asymmetry relative to the broader population of companies. Although the degree of information asymmetry surrounding a particular issuer is unobservable, researchers have developed a number of proxies that are thought to be correlated with information asymmetry, including small issuer size, lower analyst coverage, larger insider holdings, and higher research and development costs.169 To the extent that a smaller company can be characterized as exhibiting one or more of these properties, this may suggest that it has a greater degree of information asymmetry relative to the broader population of companies. This would suggest that there is a higher likelihood that critical audit matters could provide new information about a smaller company than a large one for which there already exists a variety of information sources (such as annual reports, news media, and analyst research reports). After consideration of comments, academic research, and data regarding the number of such companies, the final standard does not exclude smaller companies from the critical audit matter requirements. However, as discussed 167 In general, a ‘‘smaller reporting company’’ means an issuer with less than $75 million in public float or zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. See Exchange Act Rule 12b–2, 17 CFR 240.12b–2. Smaller reporting companies currently make up approximately 42 percent of Form 10–K filers. The SEC recently proposed changes to the definition of smaller reporting companies, which would increase the percentage of smaller reporting companies to approximately 52 percent of Form 10–K filers. See SEC, Amendments to Smaller Reporting Company Definition, Release No. 33–10107 (June 27, 2016), 81 FR 43130 (July 1, 2016). 168 Nonaccelerated filers are not defined in SEC rules but are generally understood to be companies that do not meet the definition of large accelerated filer or accelerated filer. 169 See, e.g., David Aboody, and Baruch Lev, Information Asymmetry, R&D, and Insider Gains, 55 The Journal of Finance 2747, 2747–2766 (2000), Michael J. Brennan and Avanidhar Subrahmanyam, Investment Analysis and Price Formation in Securities Markets, 38 Journal of Financial Economics 361, 361–381 (1995), Varadarajan V. Chari, Ravi Jagannathan, and Aharon R. Ofer, Seasonalities in Security Returns: The Case of Earnings Announcements, 21 Journal of Financial Economics 101, 101–121 (1988), and Raymond Chiang, and P.C. Venkatesh, Insider Holdings and Perceptions of Information Asymmetry: A note, 43 The Journal of Finance 1041, 1041–1048 (1988). VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 below, the Board has determined that it is appropriate to give auditors of smaller companies additional time to implement the new requirements. If approved by the SEC, auditors of companies that are not large accelerated filers will have an additional 18 months to implement the requirements for critical audit matters and will be able to benefit from the experiences of auditors of larger companies. Requirements of Other Regulators and Standard Setters Under the IAASB’s standard, the communication of key audit matters applies to listed entities.170 The EU requirements apply to audits of PIEs, including listed companies, credit institutions, and insurance companies.171 The FRC 2013 requirements apply to auditor’s reports for entities that apply the UK Corporate Governance Code.172 Considerations for Audits of Emerging Growth Companies Section 104 of the Jumpstart Our Business Startups (‘‘JOBS’’) Act imposes certain limitations with respect to application of the Board’s standards to audits of EGCs, as defined in Section 3(a)(80) of the Exchange Act. Section 104 provides that ‘‘[a]ny rules of the Board requiring . . . a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer (auditor discussion and analysis) shall not apply to an audit of an emerging growth company . . .’’ 173 Auditor discussion and analysis (‘‘AD&A’’) does not exist in auditing standards. The idea was introduced in the concept release, which described AD&A as one of several conceptual alternatives for changing the auditor’s reporting model.174 Section 104 of the JOBS Act further provides that any additional rules adopted by the Board subsequent to paragraph 5 of ISA 701. requirements in 1 of Article 2, Audit Report of Regulation (EU) No 537/2014. 172 These include companies with a premium listing of equity shares on the London Stock Exchange regardless of whether they are incorporated in the U.K. or elsewhere. 173 See Public Law 112–106 (Apr. 5, 2012). See Section 103(a)(3)(C) of Sarbanes-Oxley, as added by Section 104 of the JOBS Act. 174 See PCAOB Release No. 2011–003 (June 21, 2011) at 2 (describing one alternative as ‘‘a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the company’s financial statements (an ‘Auditor’s Discussion and Analysis’) ’’). Section IV.A., Auditor’s Discussion and Analysis, of the proposal further described AD&A and related comments received on the concept release. PO 00000 170 See 171 See Frm 00037 Fmt 4701 Sfmt 4703 35431 April 5, 2012, do not apply to the audits of EGCs unless the SEC ‘‘determines that the application of such additional requirements is necessary or appropriate in the public interest, after considering the protection of investors, and whether the action will promote efficiency, competition, and capital formation.’’ 175 As a result of the JOBS Act, the final standard and amendments are subject to an evaluation as to whether they could, and if so, should be applicable to the audits of EGCs. Critical Audit Matters The reproposal solicited comment on the application of critical audit matter requirements to the audits of EGCs. Commenters on this issue generally favored applying the standard to audits of EGCs, primarily because investors in these companies would benefit from the additional information communicated in the auditor’s report in the same way that investors in larger companies would. Two commenters recommended that the critical audit matter requirements not apply to audits of EGCs because there would not be sufficient benefits to justify the costs. Three commenters addressed the legal question of whether the JOBS Act provision on AD&A would prohibit the Board from applying critical audit matter requirements to audits of EGCs. Two of these commenters suggested that this would be prohibited, on the basis that critical audit matters ‘‘appear substantively similar to’’ 176 or ‘‘closely resemble’’ 177AD&A. The SEC’s Investor Advocate stated that, from a policy perspective, critical audit matter requirements should apply to audits of EGCs, and recommended that the PCAOB adopt the standard for policy reasons and let the SEC determine the legal question.178 This commenter also recommended that, ‘‘to prepare for any outcome of the SEC’s determination,’’ the PCAOB should encourage auditors, on a voluntary basis, to include critical audit matter communications in the auditor’s reports on EGCs.’’ 179 The requirements for critical audit matters share characteristics with two of 175 See Section 103(a)(3)(C) of Sarbanes-Oxley. letter from the U.S. Chamber of Commerce, Center for Capital Markets Competitiveness (Aug. 15, 2016) at 10, available on the Board’s Web site in Docket 034. 177 See letter from Robert N. Waxman (Aug. 15, 2016) at 24, available on the Board’s Web site in Docket 034. 178 See letter from Rick A. Fleming, Investor Advocate, SEC (Aug. 15, 2016) at 5–6, available on the Board’s Web site in Docket 034 (noting that ‘‘the SEC will need to make a legal determination on whether such a requirement with respect to the audits of EGCs would accord with certain provisions of’’ the JOBS Act). 179 179 Id. at 6. 176 See E:\FR\FM\28JYN2.SGM 28JYN2 35432 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices the alternative approaches described in the concept release: Required and expanded explanatory paragraphs and AD&A. Similar to critical audit matters, required and expanded explanatory paragraphs involved additional paragraphs in the auditor’s report that would have highlighted areas of critical importance to the financial statements, with auditor comment on key audit procedures and a reference to relevant financial statement accounts and disclosure. AD&A, by contrast, envisioned a supplemental report in addition to the auditor’s report that could cover a broad range of issues, including the auditor’s views regarding the company’s financial statements, material matters as to which the auditor believed disclosure could be enhanced, and areas where management could have applied different accounting or disclosure approaches. However, critical audit matters go beyond the content of a required and expanded explanatory paragraph by including a discussion of the principal reasons the auditor determined that a matter was a critical audit matter. Further, although this is not required, critical audit matters could potentially include a discussion of auditor findings. These additional elements may make critical audit matters resemble AD&A in some respects. This potential similarity, together with the fact that there has been no authoritative interpretation of Section 104 of the JOBS Act, creates some uncertainty as to whether it is legally permissible for critical audit matter requirements to be mandated for EGC audits. In view of this uncertainty, the Board has determined not to apply the requirements regarding critical audit matters to audits of EGCs at this time. As with other audits where critical audit matter requirements do not apply, voluntary application is permissible. EGCs and their auditors can consider whether investors would benefit from additional information about the audit from the auditor’s point of view. asabaliauskas on DSKBBXCHB2PROD with NOTICES Additional Improvements to the Auditor’s Report The additional improvements to the auditor’s report contained in the final standard and amendments do not raise concerns under the AD&A provisions of the JOBS Act, but instead fall within the category of ‘‘additional rules’’ that may not be applied to audits of EGCs unless the SEC determines that doing so ‘‘is necessary or appropriate in the public interest, after considering the protection of investors, and whether the action will promote efficiency, competition, and capital formation.’’ The Board is VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 providing this analysis to assist the SEC in making this determination. To inform consideration of the application of auditing standards to audits of EGCs, the staff has also published a white paper that provides general information about characteristics of EGCs.180 The data on EGCs outlined in the white paper remains generally consistent with the data discussed in the reproposal. A majority of EGCs continue to be smaller public companies that are generally new to the SEC reporting process. This suggests that there is less information available to investors regarding such companies (a higher degree of information asymmetry) relative to the broader population of public companies because, in general, investors are less informed about companies that are smaller and newer. For example, smaller companies have very little, if any, analyst coverage which reduces the amount of information made available to financial statement users and therefore makes markets less efficient.181 The reproposal solicited comment on whether the elements of the reproposed standard and amendments other than the requirements for critical audit matters should apply to the audits of EGCs. As noted above, one commenter supported application of the entire standard and amendments to EGCs (without differentiating between critical audit matters and other elements), and one commenter opposed application of the entire standard and amendments. In addition, one commenter supported applying some of the reproposed improvements to the auditor’s report to audits of EGCs (the requirement as to addressee and the clarifications of existing auditor responsibilities, as well as a modified version of the statement regarding auditor independence), but generally opposed the other aspects of the reproposal for both EGCs and other companies. As described above, the additional improvements to the auditor’s report are intended to provide a consistent location and decrease search costs with respect to information about auditor tenure, enhance users’ understanding of the auditor’s role, make the auditor’s report easier to read and facilitate comparison across companies by making the format consistent. As described above, the costs associated with these changes are not expected to be significant and are primarily onetime, rather than recurring, costs. For the reasons explained above, the Board believes that the additional improvements to the auditor’s report contained in the final standard and amendments are in the public interest and, after considering the protection of investors and the promotion of efficiency, competition, and capital formation, recommends that the final standard and amendments should apply to audits of EGCs. Accordingly, the Board recommends that the SEC determine that it is necessary or appropriate in the public interest, after considering the protection of investors and whether the action will promote efficiency, competition, and capital formation, to apply the final standard and amendments, other than the provisions relating to critical audit matters, to audits of EGCs. The Board stands ready to assist the SEC in considering any comments the SEC receives on these matters during the SEC’s public comment process. III. Date of Effectiveness of the Proposed Rules and Timing for Commission Action Pursuant to Section 19(b)(2)(A)(ii) of the Exchange Act, and based on its determination that an extension of the period set forth in Section 19(b)(2)(A)(i) of the Exchange Act is appropriate in light of the PCAOB’s request that the Commission, pursuant to Section 103(a)(3)(C) of the Sarbanes-Oxley Act, determine that the proposed rules, other than the provisions relating to critical audit matters, apply to audits of emerging growth companies, as defined in Section 3(a)(80) of the Exchange Act, the Commission has determined to extend to October 26, 2017 the date by which the Commission should take action on the proposed rules. IV. Solicitation of Comments Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rules are consistent with the requirements of Title I of the Act. Comments may be submitted by any of the following methods: Electronic Comments White Paper on Characteristics of Emerging Growth Companies as of November 15, 2016 (Mar. 28, 2017), available on the Board’s Web site in Docket 034. 181 See SEC, Final Report of the Advisory Committee on Smaller Public Companies to the U.S. Securities and Exchange Commission (Apr. 23, 2006) at 73. PO 00000 180 See Frm 00038 Fmt 4701 Sfmt 4703 • Use the Commission’s Internet comment form (http://www.sec.gov/ rules/pcaob.shtml); or • Send an email to rule-comments@ sec.gov. Please include File Number PCAOB–2017–01 on the subject line. E:\FR\FM\28JYN2.SGM 28JYN2 Federal Register / Vol. 82, No. 144 / Friday, July 28, 2017 / Notices asabaliauskas on DSKBBXCHB2PROD with NOTICES Paper Comments • Send paper comments in triplicate to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–1090. All submissions should refer to File Number PCAOB–2017–01. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/ rules/pcaob.shtml). Copies of the submission, all subsequent amendments, all written statements VerDate Sep<11>2014 23:22 Jul 27, 2017 Jkt 241001 with respect to the proposed rules that are filed with the Commission, and all written communications relating to the proposed rules between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for Web site viewing and printing in the Commission’s Public Reference Room, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Copies of such filing will also be available for inspection and copying at the principal office of the PCAOB. All comments received will be posted without charge; we do not edit personal PO 00000 Frm 00039 Fmt 4701 Sfmt 9990 35433 identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number PCAOB– 2017–01 and should be submitted on or before August 18, 2017. For the Commission, by the Office of the Chief Accountant, by delegated authority.182 Eduardo A. Aleman, Assistant Secretary. [FR Doc. 2017–15718 Filed 7–27–17; 8:45 am] BILLING CODE 8011–01–P 182 17 E:\FR\FM\28JYN2.SGM CFR 200.30–11(b)(1) and (3). 28JYN2

Agencies

[Federal Register Volume 82, Number 144 (Friday, July 28, 2017)]
[Notices]
[Pages 35396-35433]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-15718]



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Vol. 82

Friday,

No. 144

July 28, 2017

Part III





 Securities and Exchange Commission





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Public Company Accounting Oversight Board; Notice of Filing of Proposed 
Rules on the Auditor's Report on an Audit of Financial Statements When 
the Auditor Expresses an Unqualified Opinion, and Departures From 
Unqualified Opinions and Other Reporting Circumstances, and Related 
Amendments to Auditing Standards; Notice

Federal Register / Vol. 82 , No. 144 / Friday, July 28, 2017 / 
Notices

[[Page 35396]]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-81187; File No. PCAOB-2017-01]


Public Company Accounting Oversight Board; Notice of Filing of 
Proposed Rules on the Auditor's Report on an Audit of Financial 
Statements When the Auditor Expresses an Unqualified Opinion, and 
Departures From Unqualified Opinions and Other Reporting Circumstances, 
and Related Amendments to Auditing Standards

July 21, 2017.
    Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the 
``Act'' or ``Sarbanes-Oxley Act''), notice is hereby given that on July 
19, 2017, the Public Company Accounting Oversight Board (the ``Board'' 
or ``PCAOB'') filed with the Securities and Exchange Commission (the 
``Commission'' or ``SEC'') the proposed rules described in Items I and 
II below, which items have been prepared by the Board. The Commission 
is publishing this notice to solicit comments on the proposed rules 
from interested persons.

I. Board's Statement of the Terms of Substance of the Proposed Rules

    On June 1, 2017, the Board adopted new rules and amendments to 
auditing standards (collectively, the ``proposed rules'') to make the 
auditor's report more informative and relevant to investors and other 
financial statement users. The text of the proposed rules appears in 
Exhibit A to the SEC Filing Form 19b-4 and is available on the Board's 
Web site at https://pcaobus.org/Rulemaking/Pages/Docket034.aspx and at 
the Commission's Public Reference Room.

II. Board's Statement of the Purpose of, and Statutory Basis for, the 
Proposed Rules

    In its filing with the Commission, the Board included statements 
concerning the purpose of, and basis for, the proposed rules and 
discussed any comments it received on the proposed rules. The text of 
these statements may be examined at the places specified in Item IV 
below. The Board has prepared summaries, set forth in sections A, B, 
and C below, of the most significant aspects of such statements. In 
addition, the Board is requesting that the Commission approve the 
proposed rules and related amendments, with the exception of the 
requirements related to critical audit matters, pursuant to Section 
103(a)(3)(C) of the Sarbanes-Oxley Act, for application to audits of 
emerging growth companies (``EGCs''), as that term is defined in 
Section 3(a)(80) of the Securities Exchange Act of 1934 (``Exchange 
Act''). The Board's request is set forth in section D.

A. Board's Statement of the Purpose of, and Statutory Basis for, the 
Proposed Rules

(a) Purpose
Summary
    The Board has adopted a new auditor reporting standard, AS 3101, 
The Auditor's Report on an Audit of Financial Statements When the 
Auditor Expresses an Unqualified Opinion (the ``final standard'' or 
``AS 3101'') and related amendments to its auditing standards that will 
require the auditor to provide new information about the audit and make 
the auditor's report more informative and relevant to investors and 
other financial statement users. The final standard retains the pass/
fail opinion of the existing auditor's report but makes significant 
changes to the existing auditor's report, including the following:
     Communication of critical audit matters--matters 
communicated or required to be communicated to the audit committee and 
that: (1) Relate to accounts or disclosures that are material to the 
financial statements; and (2) involved especially challenging, 
subjective, or complex auditor judgment;
     Disclosure of auditor tenure--the year in which the 
auditor began serving consecutively as the company's auditor; and
     Other improvements to the auditor's report--a number of 
other improvements to the auditor's report to clarify the auditor's 
role and responsibilities, and make the auditor's report easier to 
read.
    The Board believes that adopting these requirements responds to the 
strong interest of investors for enhanced communication about the audit 
and is consistent with its mandate to ``protect the interests of 
investors and further the public interest in the preparation of 
informative, accurate and independent audit reports.'' \1\
    The Board has adopted the final standard after more than six years 
of outreach and public comment, including comments from members of the 
Board's Standing Advisory Group (``SAG'') and Investor Advisory Group 
(``IAG''). The Board has taken into consideration all comments and 
believes its approach responds to investor requests for additional 
information about the financial statement audit without imposing 
requirements beyond the auditor's expertise or mandate.
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    \1\ Section 101(a) of the Sarbanes-Oxley Act of 2002 
(``Sarbanes-Oxley''), 15 U.S.C. 7211(a).
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    Investors are the beneficiaries of the audit and the auditor's 
report is the primary means by which the auditor communicates with 
them. Currently, however, the auditor's report conveys little of the 
information obtained and evaluated by the auditor as part of the audit. 
And while the auditor's report has generally remained unchanged since 
the 1940s, companies' operations have become more complex and global, 
and the financial reporting frameworks have evolved toward an 
increasing use of estimates, including fair value measurements. As part 
of the audit, auditors often perform procedures involving challenging, 
subjective, or complex judgments, but the auditor's report does not 
communicate this information to investors. Stated differently, the 
auditor's report does little to address the information asymmetry 
between investors and auditors,\2\ even though investors have 
consistently asked to hear more from the auditor, an independent third-
party expert whose work is undertaken for their benefit.\3\ The Board 
believes that reducing the information asymmetry between investors and 
auditors should, in turn, reduce the information asymmetry between 
investors and management. Outside the United States, other regulators 
and standard setters have already adopted expanded auditor reporting.
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    \2\ Economists often describe this imbalance, where one party 
has more or better information than another party, as ``information 
asymmetry.'' As part of the system of financial reporting, the audit 
of the financial statements helps reduce the information asymmetry 
investors face by providing an independent opinion about whether the 
financial statements are presented fairly in all material respects.
    \3\ See PCAOB IAG survey, Improving the Auditor's Report (Mar. 
16, 2011) (``IAG 2011 survey''). See also CFA Institute's Usefulness 
of the Independent Auditor's Report Survey Results (May 4, 2011), 
Independent Auditor's Report Survey Results (Mar. 31, 2010), and 
Independent Auditor's Report Monthly Poll Results (Mar. 12, 2008) 
(``CFA survey and poll results''). See also Board public meeting 
transcripts and participant statements (Apr. 2-3, 2014), available 
on the Board's Web site in Rulemaking Docket Matter No. 034, 
Proposed Auditing Standards on the Auditor's Report and the 
Auditor's Responsibilities Regarding Other Information and Related 
Amendments (``Docket 034'').
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    The communication of critical audit matters will inform investors 
and other financial statement users of matters arising from the audit 
that involved especially challenging, subjective, or complex auditor 
judgment, and how the auditor addressed these matters. The Board 
believes that these matters will

[[Page 35397]]

likely be identified in areas that investors have indicated would be of 
particular interest to them, such as significant management estimates 
and judgments made in preparing the financial statements; areas of high 
financial statement and audit risk; significant unusual transactions; 
and other significant changes in the financial statements. The final 
standard is designed to elicit more information about the audit 
directly from the auditor. The Board believes that the critical audit 
matter requirements will respond to requests from investors for more 
information from the auditor while appropriately addressing concerns 
raised by other commenters.
    Investors and investor advocates have suggested a variety of ways 
in which investors can use the information provided in critical audit 
matters. In the view of some investors, critical audit matters will add 
to the total mix of information, providing insights relevant in 
analyzing and pricing risks in capital valuation and allocation, and 
contributing to their ability to make investment decisions. Investors 
also stated that critical audit matters will focus their attention on 
key financial reporting areas and identify areas that deserve more 
attention, enhancing the efficiency of investors and others in the 
consumption of financial information. Some investors believe that 
critical audit matters will highlight areas that they may wish to 
emphasize in their engagement with the company and provide important 
information that they can use in making proxy voting decisions, 
including ratification of the appointment of auditors.
    The final standard also includes a new required statement in the 
auditor's report disclosing the year in which the auditor began serving 
consecutively as the company's auditor, as well as a number of other 
improvements to the auditor's report, such as a statement regarding the 
requirement for the auditor to be independent. Requiring disclosure of 
auditor tenure in the auditor's report will make this information 
readily accessible in a timely way for investors who find it useful. 
The other improvements to the auditor's report are intended to enhance 
the user's understanding of the auditor's role and responsibilities 
related to the audit of the financial statements, make the auditor's 
report easier to read, and provide a consistent format.
    The final standard will generally apply to audits conducted under 
PCAOB standards. However, communication of critical audit matters is 
not required for audits of brokers and dealers reporting under the 
Securities Exchange Act of 1934 (the ``Exchange Act'') Rule 17a-5; 
investment companies other than business development companies; 
employee stock purchase, savings, and similar plans (``benefit 
plans''); and emerging growth companies (``EGCs''), as defined in 
Section 3(a)(80) of the Exchange Act. Auditors of these entities may 
choose to include critical audit matters in the auditor's report 
voluntarily. The other requirements of the final standard will apply to 
these audits.
    Critical audit matters are determined using a principles-based 
framework and the Board anticipates that the level of auditor effort 
will depend on the nature and complexity of the audit.
    The Board has adopted a phased approach to the effective dates for 
the new requirements to provide accounting firms, companies, and audit 
committees more time to prepare for implementation of the critical 
audit matter requirements, which are expected to require more effort to 
implement than the additional improvements to the auditor's report. 
Subject to approval by the Securities and Exchange Commission 
(``SEC''), the final standard and amendments will take effect as 
follows:
     All provisions other than those related to critical audit 
matters will take effect for audits of fiscal years ending on or after 
December 15, 2017; and
     Provisions related to critical audit matters will take 
effect for audits of fiscal years ending on or after June 30, 2019, for 
large accelerated filers; and for fiscal years ending on or after 
December 15, 2020, for all other companies to which the requirements 
apply.
    Auditors may elect to comply before the effective date, at any 
point after SEC approval of the final standard.
(b) Statutory Basis
    The statutory basis for the proposed rules is Title I of the Act.

B. Board's Statement on Burden on Competition

    Not applicable.

C. Board's Statement on Comments on the Proposed Rules Received From 
Members, Participants or Others

    The Board released the proposed rule amendment for public comment 
in Concept Release on Possible Revisions to PCAOB Standards Related to 
Reports on Audited Financial Statements; and Related Amendments to 
PCAOB Standards, PCAOB Release No. 2011-003 (June 21, 2011) (``concept 
release''), Proposed Auditing Standards--The Auditor's Report on an 
Audit of Financial Statements When the Auditor Expresses an Unqualified 
Opinion; The Auditor's Responsibilities Regarding Other Information in 
Certain Documents Containing Audited Financial Statements and the 
Related Auditor's Report; and Related Amendments to PCAOB Standards, 
PCAOB Release No. 2013-005 (Aug. 13, 2013) (``proposal''), Proposed 
Auditing Standard--The Auditor's Report on an Audit of Financial 
Statements When the Auditor Expresses an Unqualified Opinion and 
Related Amendments to PCAOB Standards, PCAOB Release No. 2016-003 (May 
11, 2016) (``reproposal''). See Exhibit 2(a)(A). A copy of Release Nos. 
2011-003, 2013-005, 2016-003 and the comment letters received in 
response to the PCAOB's requests for comment are available on the 
PCAOB's Web site at https://pcaobus.org/Rulemaking/Pages/Docket034.aspx. The Board received 491 written comment letters. The 
Board's response to the comments it received and the changes made to 
the rules in response to the comments received are discussed below.
Discussion of the Final Standard
Critical Audit Matters
    Under the final standard, the auditor will be required to 
communicate critical audit matters in the auditor's report in order to 
provide more information about the audit and make the auditor's report 
more informative and relevant to investors and other financial 
statement users.
    Investor, investor advocate, and analyst commenters generally 
supported the reproposed requirement to communicate critical audit 
matters. Some of them stated that the communication of critical audit 
matters would be relevant to investors and other financial statement 
users by informing them of issues identified in the audit that were 
significant to the auditor, focusing attention on issues that would be 
pertinent to understanding the financial statements, and enhancing 
investor confidence in the financial statements.
    The larger and some smaller accounting firms generally supported 
including critical audit matters in the auditor's report with some 
modification of the reproposed requirements. Other commenters, 
including other smaller accounting firms, companies, and audit 
committee members, did not support the requirements. Some of these 
commenters asserted that critical audit matters would not provide 
relevant information to investors, may be duplicative of the company's 
disclosure, may result in disclosing information not otherwise required 
to be disclosed,

[[Page 35398]]

could increase cost, or could delay completion of the audit.
    Other commenters suggested that the Board align the definition of 
critical audit matters with the International Auditing and Assurance 
Standards Board's (``IAASB'') definition of key audit matters to 
enhance overall consistency.
    Consistent with the Board's statutory mandate under Section 101(a) 
of Sarbanes-Oxley and in response to the 2008 U.S. Department of the 
Treasury Advisory Committee on the Auditing Profession (``ACAP'') 
recommendation and continued investor support for expanded auditor 
reporting, the final standard includes the requirement to communicate 
critical audit matters substantially as reproposed. The Board has taken 
into consideration all comments, including concerns raised by some 
commenters, which are described in more detail below, and believes its 
approach responds to investor requests for additional information about 
the financial statement audit without imposing requirements beyond the 
auditor's expertise or mandate. The communication of critical audit 
matters will inform investors and other financial statement users of 
matters arising from the audit that involved especially challenging, 
subjective, or complex auditor judgment, and how the auditor addressed 
those matters.
    Critical audit matters are determined using a principles-based 
framework and the Board anticipates that the level of auditor effort 
will depend on the nature and complexity of the audit. This would in 
turn depend on the complexity of the operations and accounting and 
control systems of the company.
Determination of Critical Audit Matters
Definition of Critical Audit Matter
    The reproposed standard defined a critical audit matter as any 
matter arising from the audit of the financial statements that was 
communicated or required to be communicated to the audit committee and 
that relates to accounts or disclosures that are material to the 
financial statements and involved especially challenging, subjective, 
or complex auditor judgment. For the reasons explained below, the Board 
is adopting the definition as reproposed.
Communicated or Required To Be Communicated to the Audit Committee
    Most commenters agreed that matters communicated or required to be 
communicated to the audit committee would be the appropriate source for 
critical audit matters. These commenters stated that matters 
communicated to the audit committee are the most meaningful to users of 
the financial statements and using them as the source of critical audit 
matters would assist the auditor in determining critical audit matters 
in the most efficient and effective manner.
    PCAOB standards require the auditor to communicate to the audit 
committee, among other things:
     Significant risks identified by the auditor;
     Certain matters regarding the company's accounting 
policies, practices, and estimates;
     Significant unusual transactions;
     Certain matters regarding the auditor's evaluation of the 
company's relationships and transactions with related parties; and
     Other matters arising from the audit that are significant 
to the oversight of the company's financial reporting process.
    Several commenters suggested revising the source of critical audit 
matters. Some suggested narrowing the source of critical audit matters 
only to matters required to be communicated to the audit committee, on 
the basis that this would avoid chilling communications regarding non-
required matters and reduce the burden of documentation. Other 
commenters suggested that the Board consider, as an alternative, 
selecting critical audit matters only from critical accounting policies 
and estimates disclosed by management, which some said would eliminate 
the potential for the auditor to become the original source of 
information, as well as the potential for conflicting disclosures 
between the auditor and management. Some commenters also recommended 
not specifying the source for critical audit matters and leaving it up 
to auditor judgment. Other commenters suggested broadening the source 
of critical audit matters to include matters documented in the 
engagement completion document, reviewed by the engagement quality 
reviewer, or communicated with management and other members of the 
board of directors, as the Board had originally proposed in 2013.
    The final standard retains the source of critical audit matters as 
reproposed. Critical audit matters will be drawn from matters required 
to be communicated to the audit committee (even if not actually 
communicated) and matters actually communicated (even if not required). 
The source will include auditor communication requirements under AS 
1301, Communications with Audit Committees, other PCAOB rules and 
standards,\4\ and applicable law,\5\ as well as communications made to 
the audit committee that were not required. This approach scopes in the 
broadest population of audit committee communications and will not 
require the auditor to determine whether matters communicated to the 
audit committee were required to be communicated. However, it seems 
likely that matters that meet the definition of a critical audit matter 
will usually relate to areas that are required to be communicated to 
the audit committee, either under a specific communication requirement 
or the broad provisions of paragraph .24 of AS 1301, which requires 
communication of matters arising from the audit that are significant to 
audit committee oversight of the financial reporting process.
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    \4\ See Appendix B of AS 1301, which identifies other PCAOB 
rules and standards that require audit committee communication, such 
as AS 2410, Related Parties, and AS 2502, Auditing Fair Value 
Measurements and Disclosures.
    \5\ See, e.g., Section 10A(k) of the Exchange Act, 15 U.S.C. 
78j-1(k); Rule 2-07 of Regulation S-X, 17 CFR 210.2-07; and Exchange 
Act Rule 10A-3, 17 CFR 240.10A-3.
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    Required communications to the audit committee generally include 
the areas in which investors have expressed particular interest in 
obtaining information in the auditor's report, such as significant 
management estimates and judgments made in preparing the financial 
statements; areas of high financial statement and audit risk; 
significant unusual transactions; and other significant changes in the 
financial statements.
    The final standard does not limit the source of critical audit 
matters to critical accounting policies and estimates because the Board 
does not believe this would be an appropriate starting point in light 
of investor interest in a broader range of topics related to the audit. 
Additionally, the final standard does not broaden the source, as 
proposed in 2013, to also include matters documented in the engagement 
completion document and reviewed by the engagement quality reviewer 
because it is unlikely that a matter that is determined to be a 
critical audit matter would not have already been communicated to the 
audit committee.
    Some commenters suggested that using audit committee communications 
as the source for critical audit matters could impair the relationship 
between auditor, management, and the audit committee (e.g., chill 
communications, give rise to conflict, or cause auditors to communicate 
more than they otherwise would). However, other commenters argued that 
critical audit matters would

[[Page 35399]]

enhance, not impair, communications between auditors, investors, and 
those charged with governance (including audit committees). For matters 
required to be communicated to the audit committee, the Board believes 
there should not be a chilling effect or reduced communications to the 
audit committee because the requirements for such communications are 
not changing. It would seem that any chilling effect would more likely 
relate to matters that are not explicitly required to be communicated 
to the audit committee, although given the broad requirements of AS 
1301 (particularly paragraph .24), the Board believes that there may be 
few, if any, relevant communications affected by that possibility.
    Some commenters suggested excluding certain required audit 
committee communications from the source of critical audit matters, 
generally because these communications relate to sensitive areas and 
may result in the auditor communicating information not disclosed by 
management. Suggestions included: Corrected and uncorrected 
misstatements, qualitative aspects of significant accounting policies 
and practices, alternative treatments within generally accepted 
accounting principles (``GAAP'') for policies and practices related to 
material accounts, violations or possible violations of law or 
regulation, independence considerations, disagreements with management, 
other material written communications between the auditor and 
management, overall planned audit strategy, delays encountered in the 
audit, and competency issues of management. Other commenters argued 
that no audit committee communications should be specifically excluded 
from consideration as a source of potential critical audit matters.
    The final standard does not exclude any required audit committee 
communications from the source of critical audit matters. To the extent 
that any such communication met the critical audit matter definition 
(including that it (1) relates to accounts or disclosures that are 
material to the financial statements and (2) involved especially 
challenging, subjective, or complex auditor judgment), the Board 
believes it will be an appropriate subject for an auditor to 
communicate as a critical audit matter.
Relates to Accounts or Disclosures That Are Material to the Financial 
Statements
    The materiality component of the reproposed definition of critical 
audit matters--that the matter ``relates to accounts or disclosures 
that are material \6\ to the financial statements''--was intended to 
respond to investor requests for informative and relevant auditor's 
reports while, at the same time, addressing other commenters' concerns 
regarding auditor communication of immaterial information that 
management is not required to disclose under the applicable financial 
reporting framework and SEC reporting requirements.
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    \6\ The definition of materiality is established under the U.S. 
federal securities laws. In interpreting those laws, the U.S. 
Supreme Court has held that a fact is material if there is ``a 
substantial likelihood that the . . . fact would have been viewed by 
the reasonable investor as having significantly altered the `total 
mix' of information made available.'' See TSC Industries v. 
Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. 
Levinson, 485 U.S. 224, 231-32 (1988). As the Supreme Court has 
further explained, determinations of materiality require ``delicate 
assessments of the inferences a `reasonable shareholder' would draw 
from a given set of facts and the significance of those inferences 
to him . . .'' TSC Industries, 426 U.S. at 450.
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    Some investor commenters suggested removing the materiality 
component of the reproposed definition of critical audit matters, 
arguing that it made the definition too narrow and would unnecessarily 
exclude relevant information. Some of these commenters observed that 
many cases of material accounting problems or fraud started as 
``immaterial'' to the financial statements and built over time, and 
that such matters may not meet the reproposed definition of a critical 
audit matter because of the materiality component.
    Other commenters, primarily companies and accounting firms, argued 
that the reproposed definition was too broad and suggested modifying 
the materiality component such that a critical audit matter would 
itself have to be material to the financial statements as a whole, 
rather than relating to accounts or disclosures that are material to 
the financial statements. These commenters expressed concern that the 
phrase ``relates to accounts or disclosures that are material to the 
financial statements'' could apply to too many matters, resulting in 
the auditor disclosing immaterial matters that would not otherwise be 
disclosed by management, or give the impression of a piecemeal opinion.
    After consideration of comments, the Board has determined to adopt 
the materiality component in the final definition of critical audit 
matter as reproposed. In the Board's view, the purpose of the 
standard--making the auditor's report more useful and informative to 
investors--is better served by auditor communication of matters related 
to accounts or disclosures that are material to the financial 
statements. As one commenter noted, limiting the source of critical 
audit matters and adding a materiality component that directly relates 
to accounts and disclosures ``would allow the auditor to emphasize the 
most important matters to users of the financial statements, and limit 
the inclusion of an overabundance of [critical audit matters] within 
the auditor's report that could deemphasize their importance.'' \7\
---------------------------------------------------------------------------

    \7\ See letter from Dixon Hughes Goodman, LLP (Aug. 15, 2016) at 
2, available on the Board's Web site in Docket 034 (also noting that 
there is a continuing risk that the auditor could disclose 
information about the company that was not previously disclosed by 
the company).
---------------------------------------------------------------------------

    At the same time, in the Board's view, limiting critical audit 
matters to those that are, in and of themselves, material to the 
financial statements as a whole would not serve the intended purpose of 
the standard. If the auditor were required to determine that a critical 
audit matter itself is material, rather than related to an account or 
disclosure that is material, it is likely that fewer matters would meet 
the definition of a critical audit matter and, thus, investors would 
likely receive less, and less audit-specific, information than under 
the standard as adopted.
    Accordingly, as in the reproposal, the final standard provides that 
each critical audit matter relates to accounts or disclosures that are 
material to the financial statements. Consistent with the reproposal, 
``relates to'' clarifies that the critical audit matter could be a 
component of a material account or disclosure and does not necessarily 
need to correspond to the entire account or disclosure in the financial 
statements. For example, the auditor's evaluation of the company's 
goodwill impairment assessment could be a critical audit matter if 
goodwill was material to the financial statements, even if there was no 
impairment; it would relate to goodwill recorded on the balance sheet 
and the disclosure in the notes to the financial statements about the 
company's impairment policy and goodwill. In addition, a critical audit 
matter may not necessarily relate to a single account or disclosure but 
could have a pervasive effect on the financial statements if it relates 
to many accounts or disclosures. For example, the auditor's evaluation 
of the company's ability to continue as a going concern could also 
represent a critical audit matter depending on the circumstances of a 
particular audit.
    On the other hand, a matter that does not relate to accounts or 
disclosures that are material to the financial statements

[[Page 35400]]

cannot be a critical audit matter. For example, a potential loss 
contingency that was communicated to the audit committee, but that was 
determined to be remote and was not recorded in the financial 
statements or otherwise disclosed under the applicable financial 
reporting framework, would not meet the definition of a critical audit 
matter; it does not relate to an account or disclosure in the financial 
statements, even if it involved especially challenging auditor 
judgment. The same rationale would apply to a potential illegal act if 
an appropriate determination had been made that no disclosure of it was 
required in the financial statements; the matter would not relate to an 
account or disclosure that is material to the financial statements.
    For the same reason, the determination that there is a significant 
deficiency in internal control over financial reporting, in and of 
itself, cannot be a critical audit matter; such determination, in and 
of itself, does not relate to an account or disclosure that is material 
to the financial statements as no disclosure of the determination is 
required. A significant deficiency could, however, be among the 
principal considerations that led the auditor to determine that a 
matter is a critical audit matter.\8\
---------------------------------------------------------------------------

    \8\ See below for additional considerations related to auditor 
disclosure of original information.
---------------------------------------------------------------------------

Involved Especially Challenging, Subjective, or Complex Auditor 
Judgment
    Many commenters supported including ``matters that involved 
especially challenging, subjective, or complex auditor judgment'' in 
the reproposed definition of a critical audit matter. Other commenters 
argued that the phrase ``especially challenging, subjective, or complex 
auditor judgment'' is broad and subjective and would lead to 
inconsistent application of the reproposed definition. For example, 
some commenters said that critical audit matters would vary based on 
the experience and competence of the auditor, even if the underlying 
facts and circumstances were the same. One commenter urged disclosure 
of the auditor's perspective on material related party transactions. 
Another commenter suggested that the standard include a note stating 
that it is expected that in most audits, financial statement matters 
involving the application of significant judgment or estimation by 
management would involve especially challenging, subjective, or complex 
auditor judgment.
    Several commenters suggested using the IAASB's definition of key 
audit matters, which includes those matters that were of most 
significance in the audit of the financial statements and that required 
significant auditor attention. One commenter argued that this would 
avoid reliance on the auditor's determination of whether a matter 
involved especially challenging, subjective, or complex auditor 
judgment, which the commenter said would give auditors too much 
discretion.
    After consideration of comments, the Board is adopting this 
component of the definition of critical audit matter as reproposed, 
namely ``matters that involved especially challenging, subjective, or 
complex auditor judgment.'' This grounds the definition in the 
auditor's expertise and judgment, which is directly responsive to 
investor requests for information from the auditor's point of view. 
Thus, the Board believes that this definition will focus critical audit 
matters in areas where investors will particularly benefit from 
expanded reporting by the auditor.
    The determination of critical audit matters is principles-based and 
the final standard does not specify any items that would always 
constitute critical audit matters. For example, the standard does not 
provide that all matters determined to be ``significant risks'' under 
PCAOB standards would be critical audit matters.\9\ Some significant 
risks may be determined to be critical audit matters, but not every 
significant risk would involve especially challenging, subjective, or 
complex auditor judgment. To illustrate, improper revenue recognition 
is a presumed fraud risk and all fraud risks are significant risks; 
\10\ however, if a matter related to revenue recognition does not 
involve especially challenging, subjective, or complex auditor 
judgment, it will not be a critical audit matter. Similarly, the final 
standard does not provide, as some commenters suggested, that material 
related party transactions or matters involving the application of 
significant judgment or estimation by management always constitute 
critical audit matters. The auditor must determine, in the context of 
the specific audit, that a matter involved especially challenging, 
subjective, or complex auditor judgment. In addition, focusing on 
auditor judgment should limit the extent to which expanded auditor 
reporting could become duplicative of management's reporting. To the 
extent that critical audit matters reflect differences in auditors' 
experience and competence, this in itself should also be informative.
---------------------------------------------------------------------------

    \9\ A significant risk is a ``risk of material misstatement that 
requires special audit consideration.'' Paragraph .A5 of AS 2110, 
Identifying and Assessing Risks of Material Misstatement.
    \10\ See AS 2110.71.
---------------------------------------------------------------------------

Factors
    The reproposal included the following nonexclusive list of factors 
for the auditor to take into account, together with audit-specific 
factors, when determining whether a matter involved especially 
challenging, subjective, or complex auditor judgment:
    a. The auditor's assessment of the risks of material misstatement, 
including significant risks;
    b. The degree of auditor subjectivity in determining or applying 
audit procedures to address the matter or in evaluating the results of 
those procedures;
    c. The nature and extent of audit effort required to address the 
matter, including the extent of specialized skill or knowledge needed 
or the nature of consultations outside the engagement team regarding 
the matter;
    d. The degree of auditor judgment related to areas in the financial 
statements that involved the application of significant judgment or 
estimation by management, including estimates with significant 
measurement uncertainty;
    e. The nature and timing of significant unusual transactions and 
the extent of audit effort and judgment related to these transactions; 
and
    f. The nature of audit evidence obtained regarding the matter.
    Commenters in general agreed that including such factors would 
assist the auditor in determining critical audit matters.
    Some commenters suggested changes to better align the factors with 
areas of complex management judgment, to reduce the risk that the 
auditor would be the source of original information, to clarify the 
linkage of procedures performed by the auditor and sufficient 
appropriate audit evidence obtained in performing those procedures, and 
to focus the auditor on the audit procedures executed to obtain 
sufficient and appropriate audit evidence rather than audit strategy 
decisions. Some commenters suggested harmonizing the factors with the 
IAASB's factors for determining key audit matters.
    After considering the comments received, the Board has modified the 
factors by reordering them and revising the factor relating to the 
degree of auditor subjectivity (factor b above) to refer to the 
application (rather than determination) of audit procedures, which 
focuses it more clearly on the

[[Page 35401]]

performance of the audit rather than audit strategy.
    Some commenters suggested that the factor pertaining to the nature 
and extent of the audit effort (factor c) be revised to relate to the 
nature and extent of audit effort required to obtain sufficient 
appropriate audit evidence to address a matter and the factor 
pertaining to the nature of audit evidence (factor f) be deleted to 
clarify that obtaining audit evidence is a component of audit effort. 
The final standard does not change factor c as suggested because it 
would inappropriately narrow the factor exclusively to considerations 
related to obtaining audit evidence rather than the nature of the 
overall audit effort. Additionally, the Board determined to retain 
factor f as a stand-alone factor because, as stated in the reproposal, 
in the limited implementation trial conducted by several accounting 
firms, this factor appeared to be one of the most useful in determining 
critical audit matters.\11\
---------------------------------------------------------------------------

    \11\ See letter from the Center for Audit Quality (June 19, 
2014) at 5, available on the Board's Web site in Docket 034.
---------------------------------------------------------------------------

    A commenter recommended including a factor based on the extent of 
interaction with the audit committee. The final standard does not 
include this factor because the extent of interaction might not be a 
meaningful indicator of the complexity or subjectivity of the matter 
and it could create incentives to limit communication between the 
auditor and the audit committee.
    One commenter did not agree with elimination of two proposed 
factors that related to the severity of control deficiencies and 
corrected and uncorrected misstatements. These factors were eliminated 
from the reproposal in response to comments that the factors would lead 
the auditor to determine matters as critical audit matters in areas 
where the company has no existing reporting obligation, or where the 
company has determined that the matters are not material and therefore 
do not require disclosure under the financial reporting framework. For 
these reasons, the final standard does not include these factors.
    Under the final standard, once the auditor identifies a matter 
communicated or required to be communicated to the audit committee that 
relates to accounts or disclosures that are material to the company's 
financial statements, the auditor should take into account the 
following nonexclusive list of factors, as well as other audit-specific 
factors, when determining whether a matter involved especially 
challenging, subjective, or complex auditor judgment:
    a. The auditor's assessment of the risks of material misstatement, 
including significant risks;
    b. The degree of auditor judgment related to areas in the financial 
statements that involved the application of significant judgment or 
estimation by management, including estimates with significant 
measurement uncertainty;
    c. The nature and timing of significant unusual transactions and 
the extent of audit effort and judgment related to these transactions;
    d. The degree of auditor subjectivity in applying audit procedures 
to address the matter or in evaluating the results of those procedures;
    e. The nature and extent of audit effort required to address the 
matter, including the extent of specialized skill or knowledge needed 
or the nature of consultations outside the engagement team regarding 
the matter; and
    f. The nature of audit evidence obtained regarding the matter.
    The determination should be made in the context of the particular 
audit, with the aim of providing audit-specific information rather than 
a discussion of generic risks. The factors provide a principles-based 
framework for the auditor to use in assessing whether a matter involved 
especially challenging, subjective, or complex auditor judgment. 
Depending on the matter, the auditor's determination that a matter is a 
critical audit matter might be based on one or more of these factors, 
other factors specific to the audit, or a combination.
Audit Period Covered by Critical Audit Matters
    The reproposal would have required the auditor to communicate 
critical audit matters for the audit of the current period's financial 
statements. Because the communication of critical audit matters for 
prior periods might also be useful to investors and other financial 
statement users in certain situations, the reproposed standard provided 
that the auditor may communicate critical audit matters relating to a 
prior period when: (1) The prior period's financial statements are made 
public for the first time, such as in an initial public offering, or 
(2) issuing an auditor's report on the prior period's financial 
statements because the previously issued auditor's report could no 
longer be relied upon.
    Some commenters generally supported communicating critical audit 
matters for only the current period's financial statements or for all 
periods if audited financial statements have not been made public 
previously. Other commenters supported communication of critical audit 
matters for all periods presented along with an explanation if prior 
year critical audit matters are not repeated in the current year. Yet 
another commenter stated that the auditor should be encouraged to use 
judgment as to whether to include critical audit matters for prior 
periods and not limit the consideration only to the circumstances 
described in the reproposal.
    The final standard retains the requirement to communicate critical 
audit matters only for the current audit period. While most companies' 
financial statements are presented on a comparative basis, and thus 
most auditor's reports cover a similar period, requiring auditors to 
communicate critical audit matters for the current period, rather than 
for all periods presented, will provide relevant information about the 
most recent audit and is intended to reflect a cost-sensitive approach 
to auditor reporting. In addition, investors and other financial 
statement users will be able to look at prior years' filings to analyze 
critical audit matters over time. However, the auditor could choose to 
include critical audit matters for prior periods. The final standard 
clarifies that the two situations relating to a prior period are 
examples rather than the only situations in which a critical audit 
matter for a prior period may be communicated.
    As noted in the reproposal, if the auditor's report is dual-dated, 
the auditor will determine whether the new information for which the 
auditor's report is dual-dated gives rise to any additional critical 
audit matters.
    In situations in which a predecessor auditor has been asked to 
reissue its auditor's report, the communication of critical audit 
matters for the prior period need not be repeated because it is only 
required for the current year. However, the predecessor auditor could 
choose to include prior year critical audit matters in the reissued 
auditor's report.
Requirements of Other Regulators and Standard Setters
    IAASB. Under the IAASB's standard, ``key audit matters'' are 
defined as those matters that, in the auditor's professional judgment, 
were of most significance in the audit of the financial statements of 
the current period. Key audit matters are determined using a two-step 
process. First, the auditor identifies the matters communicated

[[Page 35402]]

with those charged with governance \12\ that required significant 
auditor attention in performing the audit, taking into account:
---------------------------------------------------------------------------

    \12\ See paragraph 8 of ISA 701. See also ISA 260, Communication 
with Those Charged with Governance, which provides requirements for 
auditor communications with those charged with governance.
---------------------------------------------------------------------------

     Areas of higher assessed risks of material misstatement, 
or significant risks;
     Significant auditor judgments relating to areas in the 
financial statements that involved significant management judgment, 
including accounting estimates that have been identified as having high 
estimation uncertainty; and
     The effect on the audit of significant events or 
transactions that occurred during the period.\13\
---------------------------------------------------------------------------

    \13\ See paragraph 9 of ISA 701.
---------------------------------------------------------------------------

    Second, of the matters that required significant auditor attention, 
the auditor identifies those of most significance in the audit as the 
key audit matters.\14\ The IAASB requires the communication of key 
audit matters for the current period only.\15\
---------------------------------------------------------------------------

    \14\ See paragraph 10 of ISA 701.
    \15\ See paragraphs 8 and 10 of ISA 701.
---------------------------------------------------------------------------

    European Union (``EU''). The EU requires the auditor to describe 
the most significant assessed risks of material misstatement, including 
assessed risks of material misstatement due to fraud.\16\ The EU does 
not specify the period for which these need to be described.
---------------------------------------------------------------------------

    \16\ See requirements in 2(c) of Article 10, Audit Report, of 
Regulation (EU) No. 537/2014.
---------------------------------------------------------------------------

    Financial Reporting Council in the United Kingdom (``FRC''). The 
FRC requires the auditor to describe the risks of material misstatement 
that had the greatest effect on: (1) The overall audit strategy; (2) 
the allocation of resources in the audit; and (3) directing the efforts 
of the engagement team.\17\ The FRC does not specify the period for 
which these need to be described.
---------------------------------------------------------------------------

    \17\ See paragraph 19A of UK ISA 700 (2013).
---------------------------------------------------------------------------

Communication of Critical Audit Matters
    Under the reproposal, the auditor would have been required to 
include introductory language in the auditor's report preceding the 
communication of critical audit matters and to communicate critical 
audit matters by identifying each matter, describing the auditor's 
principal considerations for determining that the matter was a critical 
audit matter, describing how the critical audit matter was addressed in 
the audit, and referring to the relevant financial statement accounts 
and disclosures.
    Comments varied on the reproposed requirements for communication of 
critical audit matters and the level of detail the auditor should 
provide, including whether the auditor should be permitted to provide 
information about the company that has not been previously disclosed by 
the company (which commenters referred to as ``original information''). 
Commenters generally agreed with identifying each critical audit matter 
and referring to the relevant financial statement accounts and 
disclosures. One commenter suggested removing the requirements to 
describe the considerations for determining that a matter was a 
critical audit matter and how the critical audit matter was addressed 
in the audit. While some commenters stated that the proposed 
requirements regarding auditor's communication of critical audit 
matters are sufficiently clear, many suggested improvements to some of 
the components of the communication requirements. After consideration 
of comments, the Board has made some enhancements to the communication 
requirements, as described below.
Introductory Language
    The reproposed standard provided introductory language to be 
included in the ``Critical Audit Matters'' section of the auditor's 
report indicating that critical audit matters did not alter the opinion 
on the financial statements and that the auditor was not providing a 
separate opinion on the critical audit matters. Some commenters 
supported the introductory language on the basis that it could minimize 
users' potential misunderstanding of the critical audit matters.
    Some commenters suggested additions to the introductory language to 
emphasize that critical audit matters are subjective and may not 
represent the most important aspects of the financial statements, to 
clarify that the description of procedures should not be taken as 
indicative of results of any individual procedure, or to limit reliance 
on critical audit matters by adding language similar to that used in a 
report on an audit of internal control over financial reporting 
(``ICFR'').\18\ The introductory language in the final standard does 
not include the suggested additions because such language could be 
interpreted as disclaiming or inappropriately minimizing the 
communication of critical audit matters.
---------------------------------------------------------------------------

    \18\ The auditor's report on the audit of internal control over 
financial reporting requires a paragraph stating that, ``because of 
inherent limitations, internal control over financial reporting may 
not prevent or detect misstatements and that projections of any 
evaluation of effectiveness to future periods are subject to the 
risk that controls may become inadequate because of changes in 
conditions, or that the degree of compliance with the policies or 
procedures may deteriorate.'' See paragraph .85j of AS 2201, An 
Audit of Internal Control Over Financial Reporting That Is 
Integrated with An Audit of Financial Statements.
---------------------------------------------------------------------------

    Other commenters suggested minor revisions in the introductory 
language to refer to the ``communication of critical audit matters'' 
rather than the critical audit matters themselves. In response to this 
comment, the required introductory language in the final standard has 
been revised as follows (additions are in italic and deletions are in 
{brackets{time} ):

    The critical audit matters communicated below are matters 
arising from the current period audit of the financial statements 
that were communicated or required to be communicated to the audit 
committee and that: (1) Relate to accounts or disclosures that are 
material to the financial statements and (2) involved our especially 
challenging, subjective, or complex judgments. The communication of 
{C{time} critical audit matters does not alter in any way our 
opinion on the financial statements, taken as a whole, and we 
{do{time}  are not, by communicating the critical audit matters 
below, {provide{time}  providing separate opinions on the critical 
audit matters or on the accounts or disclosures to which they 
relate.
Communication Requirements
    The reproposal required that, for each critical audit matter, the 
auditor would:
     Identify the critical audit matter;
     Describe the principal considerations that led the auditor 
to determine that the matter is a critical audit matter;
     Describe how the critical audit matter was addressed in 
the audit; and
     Refer to the relevant financial statement accounts and 
disclosures that relate to the critical audit matter.
    As discussed in more detail below, these requirements have been 
adopted substantially as reproposed.\19\
---------------------------------------------------------------------------

    \19\ The reproposing release included two illustrative examples 
of the communication of critical audit matters. See PCAOB Release 
No. 2016-003, Section IV.A.2.b. Given the principles-based nature of 
the requirements for critical audit matters and the objective of 
providing tailored, audit-specific information, the examples were 
intended to function as illustrations of how critical audit matters 
could be communicated, and not as templates for how critical audit 
matters should be communicated. Comments received on these examples 
were taken into account in the Board's consideration of the final 
standard. Illustrative examples do not appear in the adopting 
release because the Board believes auditors should provide tailored, 
audit-specific information when communicating critical audit matters 
in the auditor's report.

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[[Page 35403]]

Identify the Critical Audit Matter and Describe the Principal 
Considerations That Led the Auditor To Determine That the Matter Is a 
Critical Audit Matter
    Many commenters who addressed this topic supported the 
identification of the critical audit matter and limiting the 
description to ``the principal considerations'' that led the auditor to 
determine that the matter is a critical audit matter, and those aspects 
of the communication requirements are adopted as reproposed. The 
auditor's description of the principal considerations should be 
specific to the circumstances and provide a clear, concise, and 
understandable discussion of why the matter involved especially 
challenging, subjective, or complex auditor judgment. It is expected 
that the communication will be tailored to the audit to avoid 
standardized language and to reflect the specific circumstances of the 
matter.
Describe How the Critical Audit Matter Was Addressed in the Audit
    The reproposed standard included a new requirement for the auditor 
to describe how the critical audit matter was addressed in the audit. 
While the standard did not specify how this should be done, the 
reproposing release provided four examples of potential approaches to 
such descriptions: (1) The auditor's response or approach that was most 
relevant to the matter; (2) a brief overview of the procedures 
performed; (3) an indication of the outcome of the auditor's 
procedures; and (4) key observations with respect to the matter, or 
some combination of these elements.\20\
---------------------------------------------------------------------------

    \20\ These elements are similar to the IAASB's elements 
described in paragraph A46 of ISA 701. The EU also requires that the 
auditor describe key observations with respect to the most 
significant assessed risks of material misstatement.
---------------------------------------------------------------------------

    Many commenters were supportive of a requirement to describe how 
each critical audit matter was addressed in the audit. Some commenters 
asserted that a description of how a critical audit matter was 
addressed would benefit investors by providing insights on how and on 
what basis the auditor developed the opinion or the rigor that 
underlies the audit procedures performed. For example, one investor 
commenter stated that including audit procedures in the description of 
a critical audit matter would make the auditor's report more 
informative and useful. Several investors suggested that the auditor 
should be required or encouraged to provide informative, company-
specific findings when describing how the critical audit matter was 
addressed in the audit, such as whether management's significant 
accounting estimates and judgments were balanced, mildly optimistic, or 
mildly pessimistic.
    One commenter suggested that the description of how the critical 
audit matter was addressed in the audit should be optional. Several 
commenters objected to the auditor including audit procedures in the 
description of critical audit matters because it would not provide any 
incremental value or actionable information to investors, investors may 
not have the expertise or context to understand audit procedures, or 
the description of audit procedures would become boilerplate. One 
commenter suggested adding a note to clarify that the purpose of 
describing audit procedures is to provide information about the audit 
but not specific details that would compromise the effectiveness of 
audit procedures. Other commenters suggested that only the principal 
audit procedures should be provided.
    The final standard includes the requirement for the auditor to 
describe how the critical audit matter was addressed in the audit 
because it is consistent with the Board's objective of providing more 
information about the audit and, if developed with an appropriate focus 
on the intended audience, should be of interest to users. Similar to 
the reproposal, the final standard does not prescribe a specific way to 
meet this requirement. Several commenters suggested that the four 
examples provided in the reproposing release be included in the 
standard because they provide helpful guidance on how the requirement 
could be met. The final standard includes a note incorporating these 
examples, which should clarify the Board's expectations while providing 
flexibility in describing how a critical audit matter was addressed in 
the audit.
    While the description of how the critical audit matter was 
addressed in the audit will require judgment, the auditor should bear 
in mind that the intent of communicating critical audit matters is to 
provide information about the audit of the company's financial 
statements that will be useful to investors. A brief overview of the 
audit procedures performed is one of the alternatives for describing 
how the critical audit matter was addressed. If the auditor chooses to 
describe audit procedures, the descriptions are expected to be at a 
level that investors and other financial statement users would 
understand. In addition, as the four examples should make clear, the 
objective is to provide a useful summary, not to detail every aspect of 
how the matter was addressed in the audit. Limiting the use of highly 
technical accounting and auditing terms in the description of critical 
audit matters, particularly if the auditor chooses to describe audit 
procedures, may help financial statement users better understand these 
matters in relation to the audit of the financial statements.
    In its comment letter, a working group of the IAG stressed the 
importance to investors of auditor findings, which they described as 
``the one item that [they] believe would provide the greatest value to 
investors.'' \21\ Acknowledging the difficulty of mandating reporting 
of findings, the working group recommended that the Board encourage 
auditors to include them voluntarily. Under the final standard, 
communication of the auditor's findings is not required; however, in 
describing the audit response, the auditor may choose to include 
findings as an indication of the outcome of audit procedures or key 
observations about a matter. The Board shares the working group's view 
that the inclusion of informative, company-specific audit findings 
related to critical audit matters may, in appropriate circumstances, be 
valuable to investors and encourages auditors to consider including 
such findings in their auditor's reports. However, in describing 
findings, the language used should not imply that the auditor is 
providing a separate opinion on the critical audit matter or on the 
accounts or disclosures to which they relate.
---------------------------------------------------------------------------

    \21\ Letter from the IAG's auditor's report working group (Aug. 
15, 2016) at 1, available on the Board's Web site in Docket 034. The 
working group made a presentation regarding its comment letter at 
the IAG meeting in October 2016, available on the Board's Web site.
---------------------------------------------------------------------------

Refer to the Relevant Financial Statement Accounts or Disclosures That 
Relate to the Critical Audit Matter
    The reproposed standard would have required the auditor to refer to 
the relevant financial statement accounts and disclosures that relate 
to the critical audit matter. There were few comments on this 
requirement. One commenter suggested that, to avoid duplication, 
reference should be made only to the disclosures and not the financial 
statement accounts. In response to this suggestion, the final standard 
clarifies that the auditor could refer to either the relevant account 
or disclosure, rather than both, to avoid potential duplication.
    The reproposal also solicited comment on whether, in addition to 
referring to the relevant financial

[[Page 35404]]

statement accounts and disclosures, the auditor should refer to 
relevant disclosures outside the financial statements. Commenters that 
addressed this question generally opposed the auditor referencing 
disclosures outside the financial statements when describing a critical 
audit matter because it may incorrectly suggest that such information 
is audited or cause readers to misinterpret the auditor's role in 
relation to such information. The final standard only requires the 
auditor to refer to the relevant financial statement accounts or 
disclosures.
Additional Considerations Related to the Communication Requirements
Auditor Disclosure of ``Original Information'' About the Company
    The reproposed standard included a note to indicate that, when 
describing critical audit matters in the auditor's report, the auditor 
is not expected to provide original information unless it 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.
    Investor commenters, including the auditor's report working group 
of the IAG, argued that there should not be any limitation on the 
auditor providing original information and that the reproposal went too 
far in constraining the auditor from providing original information in 
response to concerns expressed by other commenters (which were 
primarily companies and accounting firms).
    Other commenters expressed the view that auditors should not 
provide original information about the company or should be limited to 
providing information about the audit and not the company. These 
commenters stated that the auditor providing original information about 
the company would be inconsistent with the traditional U.S. regulatory 
framework, whereby management provides information about the company 
and the auditor attests to compliance with the applicable financial 
reporting framework. However, one investor commenter noted that auditor 
reporting should not be limited by ``original information,'' a term 
that is undefined in auditing literature.
    No PCAOB standard, SEC rule, or other financial reporting 
requirement prohibits auditor reporting of information that management 
has not previously disclosed. Rather, there are areas under current law 
and auditing standards that require auditor reporting that goes beyond 
attesting to the compliance of management disclosures (e.g., 
substantial doubt about a company's ability to continue as a going 
concern \22\ or illegal acts \23\). As discussed in more detail below, 
auditors may have professional or state law obligations to maintain 
client confidentiality, but these obligations should not apply to, or 
should be preempted by, reporting obligations arising under federal law 
and regulations, including under PCAOB standards. Accordingly, the 
requirement to communicate critical audit matters is not, as some 
commenters have suggested, inconsistent with the existing U.S. 
financial reporting framework and auditors' other obligations.
---------------------------------------------------------------------------

    \22\ See AS 2415, Consideration of an Entity's Ability to 
Continue as a Going Concern. The auditor is required to include a 
going concern explanatory paragraph if the auditor concludes that 
substantial doubt exists about the entity's ability to continue as a 
going concern for a reasonable period of time (see AS 2415.12). If 
management's disclosure with respect to the company's ability to 
continue as a going concern is inadequate, the auditor's reporting 
responsibility regarding going concern remains and the report 
includes either a qualified or an adverse opinion (see AS 2415.14).
    \23\ Auditors may be required, under certain circumstances, 
pursuant to the Private Securities Litigation Reform Act of 1995 
(codified in Section 10A(b)1 of the Exchange Act), to make a report 
to the SEC relating to an illegal act that has a material effect on 
the financial statements.
---------------------------------------------------------------------------

    Commenters also said that the role of the audit committee or 
management would be undermined by requiring the auditor to disclose 
information about the company's financial statements, since in their 
view it is solely management's responsibility to determine what 
disclosure is appropriate. Several commenters stated that the 
communication of critical audit matters would give auditors leverage to 
encourage disclosure of information by management, and that management 
would likely modify its disclosure in response to the communication of 
critical audit matters in the auditor's report so the auditor would not 
be a source of original information. While some commenters said that 
this would improve management disclosures, others said it would be an 
inappropriate expansion of the auditor's role or would add significant 
costs. Other commenters stated that companies could be harmed by the 
disclosure of confidential or competitively sensitive information. 
Another commenter expressed concern that investors could be confused or 
misled if auditor reporting lacked context or appeared to conflict with 
management disclosures. One commenter suggested that the auditor should 
disclose original information only if a disclosure matter continues to 
be unresolved after discussion with management and the audit committee.
    The Board acknowledges these concerns and, in developing the 
auditor's communication requirements, has sought to strike an 
appropriate balance between investor demands for expanded auditor 
reporting and the costs and potential unintended consequences 
associated with providing it. While auditor reporting of original 
information is not prohibited, it is limited to areas uniquely within 
the perspective of the auditor: Describing the principal considerations 
that led the auditor to determine that the matter is a critical audit 
matter and how the matter was addressed in the audit. The objective of 
critical audit matters--helping investors to focus on identified areas 
of the audit and understand how the auditor addressed them--may not be 
accomplished if the auditor is prohibited from providing such 
information. Moreover, prohibiting the auditor from providing such 
information could make critical audit matter communications incomplete 
in a way that could be confusing to or misunderstood by investors.
    It seems likely, as one commenter observed, that auditors will 
generally not have incentives to provide information about the company 
that the company has not already made public. Another commenter noted 
that, in current practice, disclosure is already guided by an iterative 
process between management and the auditor, and expected that a similar 
process would occur for critical audit matters, reducing the likelihood 
that the auditor would be a source of original information since 
critical audit matters would likely overlap with increased management 
disclosure.\24\ To the extent that an auditor's decision to communicate 
a critical audit matter incents the company to expand or supplement its 
own disclosure, the Board believes this may improve the quality of 
public disclosures, which would be an indirect benefit of the standard. 
However, if the company does not provide additional disclosure, and the 
information is necessary to describe the principal considerations that 
led the auditor to determine that the matter is a critical audit matter 
or how it was addressed in the audit, the Board believes it is in the 
public interest for the auditor to include that information in the 
auditor's report. The final standard therefore retains the note from 
the reproposal explaining that

[[Page 35405]]

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.
---------------------------------------------------------------------------

    \24\ It should be noted, however, that critical audit matters 
are not a substitute for disclosures required of the company under 
the applicable financial reporting framework.
---------------------------------------------------------------------------

    Of course, any matter that will be communicated as a critical audit 
matter will already have been discussed with the audit committee, and 
the auditor will be required to provide a draft of the auditor's report 
to the audit committee and discuss the draft with them.\25\ In 
addition, as the auditor determines how best to comply with the 
communication requirements, the auditor could discuss with management 
and the audit committee the treatment of any sensitive information.
---------------------------------------------------------------------------

    \25\ See AS 1301.21, as amended.
---------------------------------------------------------------------------

    Some commenters also stated that, in areas where there are specific 
reporting obligations under the applicable financial reporting 
framework or SEC reporting requirements but the matter falls below the 
disclosure threshold (for example, a significant deficiency), auditor 
communication could, in effect, impose a lower disclosure threshold. 
With regard to such areas, it is likely that the nature of a critical 
audit matter and its description would be broader than, for instance, 
focusing on a significant deficiency. In addition, while the auditor is 
required to describe the principal considerations that led the auditor 
to determine that the matter is a critical audit matter, (which may 
include, if relevant, information about the company's processes and 
controls) and how the overall matter was addressed, it is not necessary 
for the auditor's description to use the terminology of the other 
auditing standard, such as ``significant deficiency'' within the 
broader context of a critical audit matter. For example, if a 
significant deficiency was among the principal considerations in 
determining that revenue recognition was a critical audit matter, the 
auditor would describe the relevant control-related issues over revenue 
recognition in the broader context of the critical audit matter without 
using the term ``significant deficiency.'' \26\
---------------------------------------------------------------------------

    \26\ It should be noted that the determination that a matter was 
a significant deficiency in internal control over financial 
reporting, on its own, could not be a critical audit matter.
---------------------------------------------------------------------------

    Some commenters suggested that any expanded disclosure requirements 
should come from the SEC and the Financial Accounting Standards Board 
(``FASB''), in the form of additional management disclosures, rather 
than from the Board expanding requirements for auditor reporting. 
However, investors have consistently asked to hear more from the 
auditor, an independent third-party expert whose work is undertaken for 
the investor's benefit. As one commenter noted, the auditor is best 
suited to provide insights on how and on what basis the auditor 
developed its opinion. The final standard is designed to elicit 
information about the audit directly from the auditor's perspective.
    If auditors can adequately convey to investors the principal 
considerations and how the auditor addressed the matter without 
including previously undisclosed information, it is expected that they 
will. However, the standard provides that even when management has not 
disclosed information, the auditor is not constrained from providing 
such information if it 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.
    The Board intends to monitor implementation of the critical audit 
matter requirements to determine if additional guidance is needed in 
this area.
Potential Compliance Issues Related to Critical Audit Matters
    Some commenters suggested that the reporting of critical audit 
matters could create compliance challenges for companies.
    Two commenters expressed concern that companies' SEC filings may 
have to be amended because of changes in the description or reporting 
of critical audit matters. In principle, auditors should approach 
errors and misstatements in the communication of critical audit matters 
in the same way they would approach any other error or misstatement in 
the auditor's report that does not affect the auditor's opinion or the 
ability of market participants to rely on the opinion.\27\ It appears 
that under current practice, SEC filings have been amended solely to 
correct errors in auditor's reports, such as incorrect auditor's report 
dates or missing explanatory paragraphs.
---------------------------------------------------------------------------

    \27\ The final standard indicates that the auditor's 
communication of critical audit matters does not alter in any way 
the auditor's opinion on the financial statements, taken as a whole.
---------------------------------------------------------------------------

    Another commenter expressed concern that management may be asked to 
respond to investor questions regarding issues described in critical 
audit matters and may not be in a position to do so, particularly in 
light of their responsibilities under Regulation FD. Given the 
auditor's responsibility to communicate with the audit committee, and 
the likelihood of extensive discussions between auditors and management 
regarding critical audit matters, it seems likely that management will 
be prepared to respond appropriately and in compliance with their legal 
obligations (including Regulation FD), as they would with regard to any 
other question about information included in an SEC filing.
Ability To Communicate No Critical Audit Matters
    The reproposal provided that the auditor could determine there were 
no critical audit matters and provide a statement to that effect in the 
auditor's report. Commenters generally supported the auditor's ability 
to determine that there are no critical audit matters. Two commenters 
suggested that the auditor should not have to make a statement in the 
auditor's report that there were no critical audit matters because the 
absence of a critical audit matter should be sufficient without the 
definitive statement, similar to an emphasis paragraph. The final 
standard includes the possibility that the auditor could determine, and 
state in the auditor's report, that there are no critical audit 
matters.\28\ The statement that there are no critical audit matters is 
required because unlike an emphasis paragraph, critical audit matters 
are a required element of the auditor's report.
---------------------------------------------------------------------------

    \28\ Since communication of critical audit matters will not be 
required for the audits of EGCs, brokers and dealers reporting under 
Exchange Act Rule 17a-5, 17 CFR 240.17a-5, investment companies 
other than business development companies, and benefit plans, the 
auditor's report for the audits of these entities will not be 
required to include the statement that there are no critical audit 
matters.
---------------------------------------------------------------------------

    The determination of critical audit matters is based on the facts 
and circumstances of each audit. The Board expects that, in most audits 
to which the requirement to communicate critical audit matters applies, 
the auditor will determine that at least one matter involved especially 
challenging, subjective, or complex auditor judgment. There may be 
critical audit matters even in an audit of a company with limited 
operations or activities. However, there may be circumstances in which 
the auditor determines there are no matters that meet the definition of 
a critical audit matter and, in those circumstances, the auditor will 
communicate that there were no critical audit matters.

[[Page 35406]]

Requirements of Other Regulators and Standard Setters
    IAASB. For each key audit matter, the IAASB requires the auditor to 
reference the related disclosures, if any, in the financial statements 
and address: (1) Why the matter was considered to be one of most 
significance in the audit and therefore determined to be a key audit 
matter and (2) how the matter was addressed in the audit.\29\ The IAASB 
allows the auditor to determine that there are no key audit matters to 
communicate in the auditor's report and, if so, requires a statement to 
this effect.\30\
---------------------------------------------------------------------------

    \29\ See paragraph 13 of ISA 701.
    \30\ See paragraphs 14 and 16 of ISA 701.
---------------------------------------------------------------------------

    EU. The EU requires the auditor to include in the auditor's report: 
(1) A description of the most significant assessed risks of material 
misstatement, including assessed risks of material misstatement due to 
fraud; (2) a summary of the auditor's response to the risks; and (3) 
where relevant, key observations arising with respect to the risks.\31\
---------------------------------------------------------------------------

    \31\ See requirements in 2(c) of Article 10, Audit Report, of 
Regulation (EU) No. 537/2014.
---------------------------------------------------------------------------

    FRC. The FRC requires the auditor, among other things, to: (1) 
Describe those assessed risks of material misstatement that were 
identified by the auditor and (2) provide an overview of the scope of 
the audit, including an explanation of how the scope addressed the 
assessed risks of material misstatement.\32\ The explanations of the 
matters set out in the auditor's report should be described in a way 
that: (1) Enables a user to understand their significance in the 
context of the audit of the financial statements as a whole and not as 
discrete opinions on separate elements of the financial statements; (2) 
enables the matters to be related directly to the specific 
circumstances of the audited entity and are not therefore generic or 
abstract matters expressed in standardized language; and (3) 
complements the description of significant issues required to be made 
by the audit committee.\33\
---------------------------------------------------------------------------

    \32\ See paragraph 19A of UK ISA 700 (2013).
    \33\ See paragraph 19B of UK ISA 700 (2013).
---------------------------------------------------------------------------

Documentation of Critical Audit Matters
    The reproposed standard required documentation of the basis for the 
auditor's determination whether each matter that both: (1) Was 
communicated or required to be communicated to the audit committee and 
(2) relates to accounts or disclosures that are material to the 
financial statements, involved or did not involve especially 
challenging, subjective, or complex auditor judgment. Some commenters 
supported a documentation requirement only for matters that were 
determined to be critical audit matters. Some of these commenters 
asserted that documentation about matters determined not to be critical 
audit matters would add costs and primarily benefit PCAOB inspections 
rather than audit quality. Others stated that the requirement is not 
aligned with the IAASB's documentation requirement, which, in their 
view, focuses on rationale for inclusion as a key audit matter rather 
than exclusion. However, another commenter argued that the 
determination that a matter was not a critical audit matter would seem 
to be an important audit judgment that ought to be documented for 
review by the engagement quality reviewer. This commenter suggested 
that documentation be required only for matters required to be 
communicated to the audit committee (which would already have been 
documented) and not for those that are communicated otherwise. One 
auditor argued that the reproposed requirement would lead auditors to 
document all audit committee communications even if not required, and 
that this would disproportionately affect smaller companies whose audit 
committees more commonly request information not required to be 
communicated under PCAOB standards.
    The final standard substantially retains the approach from the 
reproposal of requiring the auditor to document the basis for 
determining critical audit matters.\34\ The objective of the 
requirement is to document how the determination of critical audit 
matters (or the determination that there are no critical audit matters) 
was made from among the matters communicated or required to be 
communicated to the audit committee that relate to accounts or 
disclosures that are material to the financial statements. The 
documentation requirement will also facilitate review by the engagement 
quality reviewer.\35\
---------------------------------------------------------------------------

    \34\ The language of the documentation requirements has been 
redrafted to improve clarity, based on a commenter's suggestion.
    \35\ Under the existing audit documentation requirements, audit 
documentation facilitates the planning, performance, and supervision 
of the engagement, and is the basis for the review of the quality of 
the work because it provides the reviewer with written documentation 
of the evidence supporting the auditor's significant conclusions. 
See paragraph .02 of AS 1215, Audit Documentation.
---------------------------------------------------------------------------

    The amount of documentation required could vary with the 
circumstances. For example, the auditor's basis for the determination 
may be so clear for some matters that a single sentence will be 
sufficient. This situation may arise, for instance, when the auditor's 
documentation prepared in the course of the audit includes sufficient 
detail about whether or not the matter involved especially challenging, 
subjective, or complex auditor judgment. Other matters may require more 
extensive documentation.
    As noted in the reproposing release, for matters determined to be 
critical audit matters, the description in the auditor's report (which, 
among other things, must describe the principal considerations that led 
the auditor to determine that it was a critical audit matter) will 
generally suffice as documentation.
    The auditor could comply with the documentation requirement in a 
variety of different ways. For example, the auditor could start with 
the communications to the audit committee, which are already 
documented, identify which of those matters relate to accounts or 
disclosures that are material to the financial statements, and then 
document the basis for the auditor's determination of whether or not 
each matter involved especially challenging, subjective, or complex 
auditor judgment. In documenting the basis for the determination, the 
auditor may include the factors the auditor took into account. This 
documentation may be prepared as an extension to the audit committee 
documentation or the auditor may prepare separate documentation.
Requirements of Other Regulators and Standard Setters
    The IAASB requires the auditor to document the matters that 
required significant auditor attention and the rationale for the 
auditor's determination as to whether or not each of these matters is a 
key audit matter.\36\ The EU does not include documentation 
requirements for expanded auditor reporting. The FRC does not include 
specific documentation requirements related to expanded auditor 
reporting.\37\
---------------------------------------------------------------------------

    \36\ See paragraph 18(a) of ISA 701.
    \37\ General documentation requirements appear in ISA (UK and 
Ireland) 230, Audit Documentation.
---------------------------------------------------------------------------

Liability Considerations Related to Critical Audit Matters
    In both the proposal and the reproposal, the Board acknowledged 
that including critical audit matters would change the auditor's report 
in ways that could affect auditors' potential liability. As discussed 
in those releases, liability may be imposed on auditors under a number 
of different legal theories depending on the specific

[[Page 35407]]

facts and circumstances of a particular case, including pursuant to 
Section 11 of the Securities Act of 1933, Section 10(b) of the Exchange 
Act, and various state law causes of action. The critical audit matters 
would themselves be new statements that could be the basis for asserted 
claims. In addition, information provided regarding critical audit 
matters could affect other aspects of securities fraud claims against 
either the issuer, the auditor, or both (for example, by being 
described in pleadings in an effort to plead fraud with particularity 
or as a basis to seek to undercut a claim of reliance). The Board 
specifically sought comment on what effect the communication of 
critical audit matters would have on private liability and whether 
there were any steps the Board could or should take to address any 
likelihood of an increase in potential liability in private litigation.
    A number of companies and accountants responded to this request for 
comment. While several of these commenters noted that changes from the 
proposal had addressed certain of their liability concerns, most 
continued to express varying degrees of concern about the potential for 
increased liability, either for auditors or for both auditors and 
companies.
    In particular, commenters expressed concern that investors who 
suffer a financial loss could assert legal claims against the auditor 
based on statements made in identifying and describing critical audit 
matters. As with the proposal, commenters expressed general concerns 
that communication of critical audit matters would encourage baseless 
litigation, would likely lead to increased audit fees, raise the 
settlement value of spurious claims, or potentially undermine the 
stringent pleading standards of the Private Securities Litigation 
Reform Act of 1995, which were intended to curtail non-meritorious 
claims against auditors and avoid the costs and burdens associated with 
them. Some commenters argued that auditors, to avoid being second-
guessed, would have the incentive to communicate matters to the audit 
committee that were not otherwise required or to identify too many 
critical audit matters in an effort to protect themselves from 
liability. Several commenters expressed concern that communicating 
critical audit matters might compromise their ability to argue that the 
statements in the audit report are opinions which, one commenter 
argued, were ``less vulnerable to challenges that they are false or 
misleading.'' \38\ However, at least one of these commenters noted that 
the revised definition of a critical audit matter in the reproposal 
mitigated their concern on that point. Other commenters argued that the 
information communicated in describing critical audit matters could 
potentially be used to attack the audit by challenging the procedures 
performed or the adequacy of audit evidence obtained by the auditor. On 
the other hand, one commenter noted that the communication of critical 
audit matters is about disclosure of risks and challenges and expressed 
the belief that non-communication of such matters would be more 
problematic from a litigation point of view.
---------------------------------------------------------------------------

    \38\ Letter from PricewaterhouseCoopers LLP (Aug. 15, 2016) at 
7, available on the Board's Web site in Docket 034.
---------------------------------------------------------------------------

    Some commenters argued that the risk of liability would be 
heightened if the auditor were providing original information about the 
company. In particular, several commenters contended that doing so 
would conflict with accountants' professional obligation to maintain 
client information in confidence, which could give rise to claims by 
the company against the auditor under state law.
    Some commenters argued that critical audit matters could increase 
litigation risk for companies as well as the auditor because the new 
statements required of the auditor could form a basis for new legal 
claims, could be misinterpreted as acts of negligence on the part of 
the company, or could be used by plaintiffs as a ``road map'' for 
litigation against the company. One commenter argued that, because the 
underlying work papers are subject to discovery, critical audit matters 
would be used as a source for potential litigation against both 
auditors and companies.
    Some of the commenters that expressed concerns about the potential 
for increased auditor liability also suggested changes to the 
reproposal that they maintained would reduce the liability impact of 
determining and communicating critical audit matters. For example, as 
previously discussed, several commenters suggested substantially 
similar changes to modify the materiality component of the definition 
of critical audit matters and to prohibit or discourage auditor 
communication of original information.
    The Board has carefully considered commenters' concerns about 
potential liability throughout this standard-setting process, including 
the comments received on the reproposal. While mandating disclosure of 
critical audit matters will, by design, entail new statements in the 
auditor's report, the Board notes that any claim based on these new 
statements would have to establish all of the elements of the relevant 
cause of action (for example, when applicable, loss causation and 
reliance). Critical audit matters will not replace or alter the 
fundamental requirement that the auditor's report include the auditor's 
opinion that the financial statements are fairly presented in 
accordance with the applicable financial reporting framework, which has 
been, and the Board expects will continue to be, the primary statement 
at issue in most private securities litigation under federal law 
involving auditors.
    Throughout this standard-setting process, the Board has carefully 
considered commenters' suggestions to alter the terms of its proposal 
to mitigate their concerns about potential liability for omitting a 
critical audit matter. As discussed in the reproposal, the Board 
limited and clarified the process for determining critical audit 
matters, including by narrowing the source of critical audit matters to 
matters communicated or required to be communicated to the audit 
committee, adding a materiality component to the critical audit matter 
definition, and refining the factors used to determine critical audit 
matters. Those changes, as well as the critical audit matter 
definition's focus on the auditor's judgment, should mitigate concerns 
about potential liability for omitting a critical audit matter. With 
respect to suggestions to further narrow the definition of critical 
audit matters and the related communication requirements, it is not 
clear, and commenters did not explain, how those changes would mitigate 
liability concerns other than by reducing the number and content of 
required communications of critical audit matters. As described above, 
the Board has determined not to incorporate those suggested changes 
because they appear likely to significantly reduce the number of 
potential critical audit matters and the informativeness of auditor 
communication of critical audit matters.
    With respect to potential state law claims by companies against 
their auditors for disclosing original information, the Board notes 
that, as discussed above, it does not expect that, in general, critical 
audit matters will provide sensitive information that has not been 
disclosed by the company. With respect to the potential for a claim 
based on a situation in which the auditor found such disclosure 
necessary, the Board notes that auditors already have preexisting 
duties to

[[Page 35408]]

disclose original information in certain circumstances.\39\ Commenters 
did not cite any specific examples in which these requirements have 
resulted in unwarranted claims against auditors for disclosing client 
confidences. Because the auditor's obligations under PCAOB standards 
arise under federal law and regulations, professional or state law 
duties of client confidentiality should not apply to,\40\ or should be 
preempted by,\41\ the obligation to communicate critical audit 
matters.\42\
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    \39\ For example, for at least the last 20 years, auditors have 
had duties to disclose in their auditor's reports when they have 
substantial doubt about the company's ability to continue as a going 
concern. See Section 10A of the Exchange Act and AS 2415. In 
addition, when in an audit of internal control over financial 
reporting, the auditor identifies a material weakness that has not 
been included in management's assessment, the auditor must modify 
its report to, among other things, ``include a description of the 
material weakness, which should provide the users of the audit 
report with specific information about the nature of the material 
weakness and its actual and potential effect on the presentation of 
the company's financial statements . . .''. See Note to paragraph 
.91 of AS 2201; cf. Statement of Gaylen R. Hansen, CPA, at the PCAOB 
public meeting (Apr. 2, 2014) (``Client confidentiality has a long-
standing and important place in the accountancy profession. However, 
it doesn't serve investors well when it is parlayed to obfuscate the 
important obligation to call things as they are seen.'').
    \40\ For example, the relevant AICPA rule provides that auditors 
``shall not disclose any confidential client information without the 
specific consent of the client,'' but further provides that the 
confidentiality obligation shall not be construed ``to prohibit . . 
. compliance with applicable laws and government regulations.'' See 
paragraphs .01 and .02 of 1.700.001 Confidential Client Information 
Rule of the AICPA Code of Professional Conduct (as of Dec. 15, 
2014).
    \41\ See Crosby v. Nat'l Foreign Trade Council, 530 U.S. 363, 
372-73 (2000); New York v. FCC, 486 U.S. 57, 64 (1988).
    \42\ Some commenters suggested that safe harbor rules be created 
to protect auditors and companies from liability for statements 
about critical audit matters. While, as noted above, the Board will 
monitor the effects of critical audit matters should the 
requirements be approved by the SEC, the Board is not convinced at 
this time that any such safe harbor is necessary and, in any event, 
such a safe harbor is beyond the Board's authority.
---------------------------------------------------------------------------

    While the Board takes seriously the prospect of potential increases 
in auditors' or companies' liability, the Board believes it has 
appropriately addressed commenters' concerns regarding liability in a 
manner compatible with the objectives of this rulemaking, and in view 
of the rulemaking's anticipated benefits. Indeed, the Board notes that 
at least one of the commenters that expressed concern about potential 
liability, noted that those concerns ``should not stand in the way of 
moving forward'' on the reproposed standard.\43\ At the same time, the 
Board acknowledges that a variety of claims can be raised related to 
the statements in the audit report and that litigation is inherently 
uncertain. If the final standard is approved by the SEC, the Board will 
monitor the standard after implementation for any unintended 
consequences.
---------------------------------------------------------------------------

    \43\ See letter from Deloitte & Touche LLP (Aug. 12, 2016) at 5, 
available on the Board's Web site in Docket 034.
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The reproposal provided a list of basic elements to be included in 
every auditor's report. Some of these basic elements, such as auditor 
tenure, would be new elements in the auditor's report. Other basic 
elements, such as the auditor's opinion, identification of the 
financial statements audited, and management's and auditor's 
responsibilities, were drawn from the existing auditor reporting 
standard.\44\ Yet other basic elements, such as the name of the company 
under audit and the date of the financial statements, were incorporated 
from existing illustrative auditor's reports.
---------------------------------------------------------------------------

    \44\ See existing AS 3101.06-.08.
---------------------------------------------------------------------------

Auditor Tenure
    The reproposal included a required statement in the auditor's 
report of the year the auditor began serving consecutively as the 
company's auditor. The Board also sought comment on whether auditor 
tenure should be disclosed in Form AP, Auditor Reporting of Certain 
Audit Participants (``Form AP''), rather than in the auditor's 
report.\45\
---------------------------------------------------------------------------

    \45\ In December 2015, the Board adopted Form AP, which provides 
investors and other financial statement users with information about 
engagement partners and other accounting firms that participate in 
audits of issuers. See Improving the Transparency of Audits: Rules 
to Require Disclosure of Certain Audit Participants on a New PCAOB 
Form and Related Amendments to Auditing Standards, PCAOB Release No. 
2015-008 (Dec. 15, 2015).
---------------------------------------------------------------------------

Disclosure of Tenure
    Investor commenters stated that information regarding auditor 
tenure would be useful to financial statement users, for example, in 
deciding whether to vote to ratify the appointment of the auditor. 
Investors that expressed a preference supported tenure disclosure in 
the auditor's report, some on the basis of reducing investor search 
costs by ensuring a consistent location for the disclosure. One 
commenter representing a group of investors asserted that since the 
auditor's report is the primary means by which the auditor communicates 
with investors, it is appropriate for auditor tenure to be included in 
the auditor's report. This commenter further stated that disclosure of 
auditor tenure on Form AP would be an acceptable alternative to 
disclosure in the auditor's report only if the timeliness, 
accessibility, searchability, and overall functionality of the 
information disclosed on Form AP were at least equivalent to having the 
information disclosed in the auditor's report. Another commenter 
suggested that, if disclosure were required in the auditor's report, a 
specific location should be designated.
    Currently, information about auditor tenure is not required to be 
communicated to investors by the auditor, management, or the audit 
committee.\46\ However, there is a growing trend toward voluntary 
disclosure of auditor tenure. Recent analysis of corporate proxy 
statements for annual meetings of shareholders has found that a growing 
number of companies are disclosing auditor tenure,\47\ presumably due 
to interest from investors. However, voluntary disclosure is not 
provided for a significant number of audits subject to the Board's 
jurisdiction. Additionally, if disclosed, such information may not be 
provided in the same location in the proxy statement; for instance, 
some disclosures are in the audit committee report while others are in 
another section of the proxy.\48\ Further, the proxy rules do not apply 
to all companies required to be audited under PCAOB standards; for 
example, foreign private issuers, many companies whose

[[Page 35409]]

securities are not listed on a national securities exchange, and most 
investment companies are not required to prepare proxy statements.
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    \46\ In certain instances, investors may be able to manually 
calculate tenure by reviewing company filings on the SEC's 
Electronic Data Gathering, Analysis and Retrieval system (``EDGAR'') 
to determine when a company changed auditors. However, the 
information is not available prior to 1994 and may not be available 
for certain entities, such as investment companies and brokers and 
dealers, that are not required to file Form 8-K. See 17 CFR 249.308, 
Item 4.01 Changes in Registrant's Certifying Accountant. 
Accordingly, currently available information is neither complete nor 
a readily accessible alternative to auditor tenure disclosure.
    \47\ The Center for Audit Quality, together with Audit 
Analytics, reviewed corporate proxies filed through the end of June 
2016, 2015, and 2014 of 1,500 Standard and Poor's (``S&P'') 
Composite companies. Their analysis identified that in 2016, 2015, 
and 2014 auditor tenure was disclosed in the annual proxy statements 
of 59, 54, and 47 percent of the S&P 500 large-cap companies, 
respectively, 45, 44, and 42 percent of the S&P MidCap 400 
companies, respectively, and 48, 46, and 50 percent of the S&P 
SmallCap 600 companies, respectively. See Center for Audit Quality 
and Audit Analytics, 2016 Audit Committee Transparency Barometer 
(Nov. 2016). Separately, during their review of proxy statements of 
Fortune 100 companies, Ernst & Young identified that 63 percent of 
the companies reviewed voluntarily disclosed auditor tenure in 2016 
compared to 62 percent in 2015, 51 percent in 2014, 29 percent in 
2013, and 24 percent in 2012. See Ernst & Young, Audit Committee 
Reporting to Shareholders in 2016 (Sept. 2016).
    \48\ See Center for Audit Quality and Audit Analytics, 2016 
Audit Committee Transparency Barometer (Nov. 2016).
---------------------------------------------------------------------------

    Some commenters, primarily companies, did not support disclosure of 
auditor tenure in the auditor's report on the basis that such 
disclosure would not provide value to investors. Other companies and 
accounting firms raised a concern that tenure disclosure could result 
in inferences that, in their view, would be inappropriate about 
correlations between auditor tenure and audit quality, or between 
auditor tenure and auditor independence. Some commenters also suggested 
that auditor tenure is a corporate governance matter and that 
disclosure should be provided by management or the audit committee 
rather than the auditor. A few commenters suggested that tenure 
disclosure should be addressed by SEC rulemaking or provided only 
voluntarily. Some commenters, many of whom generally opposed auditor 
tenure disclosure, suggested that Form AP would be a preferable 
location for disclosing tenure if the Board proceeded with requiring 
the disclosure.
    The SEC's Investor Advocate stated that he ``strongly support[s] 
requirements for public disclosure of auditor tenure,'' recognizing 
that there were different opinions about the best party and location to 
make that disclosure.\49\ Noting that the SEC had issued a concept 
release asking whether auditor tenure should be disclosed in the audit 
committee report,\50\ the SEC's Investor Advocate stated that he 
believed the SEC should ultimately decide these questions. In light of 
these considerations, the SEC's Investor Advocate recommended that the 
PCAOB act to require disclosure of auditor tenure (either in the 
auditor's report or in Form AP), but also consider including a 
contingent sunset clause such that the auditor disclosure requirement 
would expire if and when the SEC imposed any form of a company 
disclosure requirement.
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    \49\ See letter from Rick A. Fleming, Investor Advocate, SEC 
(Aug. 15, 2016) at 4, available on the Board's Web site in Docket 
034. The letter noted that the views of the Investor Advocate do not 
necessarily reflect the views of the SEC, the Commissioners, or 
staff of the SEC, and the SEC disclaims responsibility for the 
letter and all analyses, findings, and conclusions contained 
therein. Additional information about the Office of the Investor 
Advocate is available on the SEC's Web site.
    \50\ See SEC, Possible Revisions to Audit Committee Disclosures, 
Exchange Act Release No. 75344 (July 1, 2015), 80 FR 38995 (July 8, 
2015).
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    The Board believes that public disclosure of auditor tenure is 
important and in the public interest, and that it is appropriate to 
require disclosure in the auditor's report because it is the primary 
means by which auditors communicate with investors. This will ensure 
that the disclosure is in a readily accessible and consistent 
location--the auditor's report--for all companies. It will make auditor 
tenure information immediately available to investors upon filing with 
the SEC of a document containing the auditor's report. Disclosure of 
auditor tenure in the auditor's report will also reduce search costs 
for investors who are interested in auditor tenure, relative to the 
current environment of voluntary reporting. Disclosure of auditor 
tenure in the auditor's report may also be more likely to encourage 
further discussion of auditor tenure by management and the audit 
committee and potential disclosure in company filings.
    The Board is not persuaded by commenters' concerns that disclosure 
of auditor tenure in the auditor's report necessarily suggests a 
specific correlation between auditor tenure and audit quality, or 
between auditor tenure and auditor independence. In the Board's view, 
auditor tenure is another data point about the auditor, in addition to 
the firm name and the office issuing the auditor's report, for which 
there is demonstrable investor demand.
    The standard does not specify a required location within the 
auditor's report for the statement on auditor tenure; auditors that are 
concerned about the inferences readers may draw based on the placement 
of the disclosure in the auditor's report have discretion to present 
auditor tenure in the part of the auditor's report they consider 
appropriate. Consistent with the reproposal, the illustrative auditor's 
report in the final standard includes the statement on auditor tenure 
at the end of the report.
    The Board considered disclosure of auditor tenure in Form AP, which 
requires disclosure of the name of the engagement partner and of the 
names and percentage of participation of other accounting firms in the 
audit for all issuer audits. Form AP was developed primarily to respond 
to commenter concerns about the potential liability consequences of 
naming persons in the auditor's report, the potential need to obtain 
consents from those named persons in connection with registered 
securities offerings, and the additional time needed to compile 
information about the other accounting firms. The Board's determination 
to require disclosure in Form AP, rather than in the auditor's report, 
was a means to address these concerns. Disclosure of auditor tenure 
does not have the same potential liability or other consequences as 
disclosure of the name of the engagement partner or other accounting 
firms, so such an approach is unnecessary in this case.
    The Board acknowledges that the SEC, given its broader authority 
and responsibility for the financial reporting process, could in the 
future determine that auditor tenure should be disclosed by some other 
party or in some other location, in addition to or instead of in the 
auditor's report. Accordingly, the Board is adopting its requirement 
for tenure disclosure in the auditor's report today. The Board 
anticipates that, if the SEC undertook rulemaking for disclosure of 
auditor tenure, the Board would work with the SEC to ensure that PCAOB 
standards coordinate appropriately with any new SEC requirements.\51\
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    \51\ Of course, the SEC also has authority to abrogate or modify 
PCAOB rules at any time, to, among other things, further the 
purposes of the securities laws. Section 107(b)(5) of Sarbanes-
Oxley, 15 U.S.C. 7217(b)(5).
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Determination of Tenure
    The reproposal contemplated that tenure would be calculated taking 
into account firm or company mergers, acquisitions, or changes in 
ownership structure, and it included a note providing that if the 
auditor is uncertain as to the year the auditor became the company's 
auditor, the auditor should so state and provide the earliest year of 
which the auditor has knowledge. Some commenters objected to this 
approach, saying that it could confuse investors and its relevance is 
unclear. The Board believes that the disclosure of tenure should 
reflect the entire relationship between the company and the auditor, 
including the tenure of predecessor accounting firms and engagement by 
predecessors of the company under audit. No changes have been made to 
the note in the final standard.
    Additionally, if a company went public and maintained the same 
auditor, auditor tenure will include the years the auditor served as 
the company's auditor both before and after the company became subject 
to SEC reporting requirements.
    Because of the unique structure of investment companies, which 
typically includes common accounting, internal control, and oversight 
functions at the group level, the reproposed standard required that, 
for an investment company that is part of a group of investment 
companies,\52\ the auditor's

[[Page 35410]]

statement regarding tenure will contain the year the auditor began 
serving consecutively as the auditor of any investment company in the 
group of investment companies.\53\ For example, if Firm A has been 
auditing investment companies in XYZ group of investment companies 
since 1980, the current auditor's report for XYZ fixed income fund, 
whose inception date was in 2010, will state that Firm A has served as 
the auditor of one or more XYZ investment companies since 1980.
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    \52\ A group of investment companies, as defined by Section 
12(d)(1)(G)(ii) of the Investment Company Act of 1940 (``Investment 
Company Act''), means any two or more registered investment 
companies that hold themselves out to investors as related companies 
for purposes of investment and investor services. For purposes of 
determining auditor tenure, any tenure with other entities that may 
be part of an investment company complex, such as investment 
advisers or private investment companies, is not included.
    \53\ The following is an example of such statement: ``We have 
served as the auditor of one or more [Group Name] investment 
companies since [year].''
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    A commenter asserted that measuring auditor tenure from the first 
year of service to the group of investment companies might confuse or 
even mislead the reader of the auditor's report for a new fund, 
especially if the auditor has served the group for several years. 
Another commenter supported the reproposed methodology for measuring 
tenure for investment companies stating that it is appropriate given 
the common accounting system, system of internal control over financial 
reporting, and board oversight for a group of investment companies.
    After considering the comments received, the Board is adopting the 
requirement regarding auditor tenure for an investment company that is 
part of a group of investment companies as reproposed. The Board 
believes that the length of an auditor's relationship with the group is 
more relevant than the relationship with an individual fund, since 
funds can be started and merged over time but the auditor's 
relationship with the group continues.
Requirements of Other Regulators and Standard Setters
    The EU requires a statement in the auditor's report that indicates 
the total uninterrupted engagement period, including previous renewals 
and reappointments of the statutory auditors or the audit firms.\54\ 
The IAASB and the FRC do not include a similar requirement.
---------------------------------------------------------------------------

    \54\ See requirements in 2(b) of Article 10, Audit Report, of 
Regulation (EU) No 537/2014.
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Clarification of Existing Auditor's Responsibilities
    The reproposed standard included requirements that would enhance 
standardized language of the auditor's report by clarifying the nature 
and scope of the auditor's existing responsibilities, such as a new 
statement regarding auditor independence and the addition of the phrase 
``whether due to error or fraud,'' when describing the auditor's 
responsibility under PCAOB standards to obtain reasonable assurance 
about whether the financial statements are free of material 
misstatements. In addition, the reproposed standard included a 
requirement intended to promote uniformity with respect to the 
addressee of the report.
Auditor Independence
    The reproposed standard included a required statement in the 
auditor's report that the auditor is a public accounting firm 
registered with the PCAOB and is required to be independent with 
respect to the company in accordance with the U.S. federal securities 
laws and the applicable rules and regulations of the SEC \55\ and the 
PCAOB.\56\
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    \55\ See Regulation S-X Rule 2-01, 17 CFR 210.2-01.
    \56\ See PCAOB Rule 3520, et seq.
---------------------------------------------------------------------------

    Commenters generally supported the required statement regarding 
auditor independence. Some said that the statement would reinforce 
financial statement users' understanding of the auditor's existing 
obligations to be independent and serve as a reminder to auditors of 
these obligations. Some commenters preferred a more definitive 
statement, such as stating that the auditor is in fact independent and 
in compliance with applicable independence rules. A few commenters 
questioned whether the statement will improve an investors' 
understanding of the auditor's independence responsibilities, yield any 
incremental benefits or insight to investors, or have any impact on 
auditor behavior. Some of these commenters pointed out that 
independence is already included in the title of the auditor's report 
and including an additional statement in the auditor's report is 
redundant and unnecessary.
    After consideration of comments, the statement regarding auditor 
independence is adopted as reproposed. The Board believes that the 
independence statement in the auditor's report will both enhance 
investors' and other financial statement users' understanding of the 
auditor's existing obligations to be independent, and serve as a 
reminder to auditors of these obligations. The statement regarding 
auditor independence is not intended to, and will not, affect auditor 
independence requirements under the securities laws, SEC rules, or 
PCAOB rules.
Requirements of Other Regulators and Standard Setters
    The IAASB requires that the auditor's report include a statement 
that the auditor is independent of the entity in accordance with the 
relevant ethical requirements relating to the audit and has fulfilled 
the auditor's other ethical responsibilities in accordance with these 
requirements.\57\ The EU requires a statement in the auditor's report 
that the auditor remained independent of the audited entity in 
conducting the audit.\58\ The FRC requires the auditor to state that 
the auditor is required to comply with the United Kingdom's ethical 
standards for auditors, which include requirements regarding auditor 
independence.\59\
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    \57\ See paragraph 28(c) of ISA 700.
    \58\ See requirements in 2(f) of Article 10, Audit Report, of 
Regulation (EU) No 537/2014.
    \59\ See paragraph 15 of UK ISA 700 (2013).
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Addressee
    Under the existing standard, the auditor's report may be addressed 
to the company whose financial statements are being audited, its board 
of directors, or stockholders.\60\ Under current practice, the 
auditor's report is generally addressed to one or more of the 
following: (1) The board of directors and stockholders/shareholders, or 
their equivalent for issuers that are not organized as corporations; 
(2) the plan administrator or plan participants for benefit plans; and 
(3) the directors or equity owners for brokers or dealers.\61\
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    \60\ See existing AS 3101.09.
    \61\ This information is based on a review by PCAOB staff of a 
random sample of 2014 fiscal year-end auditor's reports for issuers 
and brokers and dealers.
---------------------------------------------------------------------------

    To promote consistency in addressing the auditor's report to the 
company's investors, the reproposed standard included a requirement for 
the auditor's report to be addressed to the shareholders and the board 
of directors, or equivalents for companies not organized as 
corporations. The reproposed standard stated that the auditor's report 
may include additional addressees.
    Commenters generally supported the addressee requirement as 
reproposed stating that it is appropriate and will create consistency 
in practice. A commenter suggested limiting the required addressees to 
the shareowners of corporations or equivalents for companies not 
organized as corporations because investors are the key customers of 
the auditor's report. A few commenters stated that the auditor's report 
is intended for general use and the requirement for the auditor's 
report to be addressed to a specific party is not

[[Page 35411]]

necessary. A commenter expressed concern that retaining the option for 
the auditor's report to be addressed to third parties could 
inadvertently result in increased auditor liability and cost.
    In response to comments, and to promote greater uniformity in the 
addressees of the auditor's report, the Board is adopting the addressee 
requirement as reproposed. Since inclusion of additional addressees is 
voluntary, auditors could assess, based on the individual 
circumstances, whether or not to include additional addressees in the 
auditor's report. In addition, the Board believes that it is 
appropriate for the auditor's report to be addressed to the board of 
directors and not just to the shareholders, because of the role of the 
board of directors in the governance of the company.
Requirements of Other Regulators and Standard Setters
    The IAASB requires that the auditor's report be addressed as 
appropriate, based on the circumstances of the engagement.\62\ The EU 
does not specify the addressee of the auditor's report. The FRC 
requires that the auditor's report be addressed as required by the 
circumstances of the engagement.\63\ UK auditor's reports are typically 
addressed to either the members or the shareholders of the company.\64\
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    \62\ See paragraph 22 of ISA 700.
    \63\ See paragraph 13 of UK ISA 700 (2013).
    \64\ See paragraph A5 of UK ISA 700 (2013).
---------------------------------------------------------------------------

Other Enhancements to the Basic Elements
    The reproposal would have changed the language for certain elements 
in the existing auditor's report. These elements included:
     Financial statement notes--The identification of the 
financial statements, including the related notes and, if applicable, 
schedules, as part of the financial statements that were audited.\65\ 
Under the existing standard, the notes to the financial statements and 
the related schedules are not identified as part of the financial 
statements.
---------------------------------------------------------------------------

    \65\ The final standard uses the term ``financial statements'' 
to include all notes to the statements and all related schedules, as 
used under SEC rules that apply to issuers. See Regulation S-X 
Section 1-01(b), 17 CFR 210.1-01(b), which states in part, ``the 
term financial statements . . . shall be deemed to include all notes 
to the statements and all related schedules.'' The final standard 
will not apply to schedules included as supplemental information, as 
defined in AS 2701, Auditing Supplemental Information Accompanying 
Audited Financial Statements, because those schedules are not 
considered part of the financial statements. The auditor should 
continue to look to the requirements of AS 2701 for the auditor's 
reporting responsibilities regarding supplemental information 
accompanying audited financial statements.
---------------------------------------------------------------------------

     Error or fraud--A description of the auditor's 
responsibility to plan and perform the audit to obtain reasonable 
assurance about whether the financial statements are free of material 
misstatements, whether caused by error or fraud.\66\ The existing 
standard does not require the auditor's report to contain the phrase 
whether due to error or fraud.
---------------------------------------------------------------------------

    \66\ See paragraph .02 of AS 1001, Responsibilities and 
Functions of the Independent Auditor.
---------------------------------------------------------------------------

     Nature of the audit--The description of the nature of the 
audit reflected the auditor's responsibilities in a risk-based audit 
and aligned the description with the language in the Board's risk 
assessment standards, including:
     Performing procedures to assess the risks of material 
misstatement of the financial statements, whether due to error or 
fraud, and performing procedures that respond to those risks;
     Examining, on a test basis, appropriate evidence regarding 
the amounts and disclosures in the financial statements;
     Evaluating the accounting principles used and significant 
estimates made by management; and
     Evaluating the overall presentation of the financial 
statements.
    Commenters generally supported the reproposed language for these 
basic elements of the auditor's report. These elements are adopted as 
reproposed.
Additional Basic Elements Suggested by Commenters
    In addition to the changes proposed by the Board, commenters on the 
reproposal suggested additional elements to be included in the 
auditor's report.
    Several commenters suggested that the PCAOB consider additional 
standardized language in the auditor's report to describe the 
responsibilities of the auditor, management, and the audit committee. 
In doing so, some of these commenters suggested that the PCAOB consider 
additional language adopted by the IAASB, in order to promote 
consistency in reporting and to help users understand more fully the 
separate responsibilities of each of the parties with respect to the 
audited financial statements. In contrast, another commenter cautioned 
that a thorough description of everyone's roles and responsibilities 
would further add to repetitive boilerplate language. This commenter 
suggested instead that the auditor's report provide a cross reference 
to a more complete description of the roles and responsibilities of the 
auditor, management, and the audit committee. This commenter did not 
indicate where such cross-referenced material would appear. Given 
little interest from investors in such additional language during the 
Board's initial outreach and the risk that it would be boilerplate, the 
final standard does not include these additional elements.
    Two accounting firms suggested describing the meaning of reasonable 
assurance. The final standard requires a statement in the ``Basis for 
Opinion'' section of the auditor's report that the auditor ``plan and 
perform the audit to obtain reasonable assurance about whether the 
financial statements are free of material misstatement.'' The auditing 
standards describe reasonable assurance as a high level of assurance, 
although not absolute assurance.\67\ During the Board's initial 
outreach such additional language was considered, but there was no 
investor demand for it. As a result, the final standard does not expand 
the description of reasonable assurance in the auditor's report.
---------------------------------------------------------------------------

    \67\ Paragraph .10 of AS 1015, Due Professional Care in the 
Performance of Work.
---------------------------------------------------------------------------

    Some commenters also suggested that the auditor's report should 
include disclosure of the materiality measures used by auditors in 
planning the audit. These commenters asserted that it could help inform 
investors' proxy voting process for auditor ratification, as such 
disclosure could be a valuable supplement to an audit fee analysis and 
used to compare materiality over time to trends in restatements and 
adjustments. These commenters also observed that materiality 
disclosures are provided in the auditor's reports in the U.K. Other 
commenters from the Board's initial outreach stated that disclosing 
materiality levels in the auditor's report could have negative 
implications on audit quality by reducing the element of surprise 
necessary in an audit.\68\ One commenter opposed a disclosure of 
materiality on the basis that it may encourage disclosure of 
quantitative materiality levels and ignore qualitative aspects of 
materiality, which cannot be described in a meaningful way in the 
auditor's report. The Board has decided not to include this additional 
element in the auditor's report at this time because disclosure may 
reduce the element of surprise in the audit and overstate the 
importance of quantitative rather than qualitative factors in the 
auditor's overall consideration of materiality. However, the Board will 
monitor the implementation of the final standard, as

[[Page 35412]]

well as the developments of expanded auditor reporting in other 
jurisdictions, to determine if future enhancements to the auditor's 
report may be warranted in this area.
---------------------------------------------------------------------------

    \68\ See PCAOB Release No. 2011-003, Appendix C, for a detailed 
discussion of the staff's outreach regarding reporting materiality 
levels.
---------------------------------------------------------------------------

    Additionally, some commenters suggested that the auditor's report 
should define the auditor's responsibility for other information in 
documents containing audited financial statements so that financial 
statement users have a clear understanding. The Board's proposal 
included another new auditing standard, The Auditor's Responsibilities 
Regarding Other Information in Certain Documents Containing Audited 
Financial Statements and the Related Auditor's Report, regarding the 
auditor's responsibilities for other information outside the financial 
statements. The Board has not taken any further action since the 
proposal.
    A few commenters suggested including other elements, such as the 
date when the auditor completed fieldwork, a statement that the auditor 
looked for material fraud, disclosure when alternative dispute 
resolution clauses are included in engagement letters, and disclosure 
of reasons for change in the engagement partner prior to mandatory 
rotation. The final standard does not include these elements because 
the Board believes they would not add meaningfully to the information 
already provided in the final standard or the elements go beyond what 
was considered in this standard-setting project and, thus, the Board is 
not including these elements at this time.
Explanatory Language and Emphasis of a Matter
Explanatory Language Required by Other PCAOB Standards
    The reproposed standard, similar to the existing standard,\69\ 
provided a list of circumstances in which the auditor is required to 
add explanatory language to the auditor's report and included 
references to other PCAOB standards in which these circumstances and 
related reporting requirements are described. These circumstances 
included when there is substantial doubt about the company's ability to 
continue as a going concern and a restatement of previously issued 
financial statements, among others.
---------------------------------------------------------------------------

    \69\ See existing AS 3101.11.
---------------------------------------------------------------------------

    The list of circumstances from the Board's reproposal did not 
attract much comment, although one commenter affirmed support for 
including the list. Commenters on the Board's proposal supported 
providing a list in the standard of the circumstances that require 
explanatory language in the auditor's report on the basis that keeping 
this information in a single place would facilitate consistency in 
execution. The final standard includes the list of explanatory 
paragraphs and related references as reproposed.
    The reproposed standard included a requirement for the auditor to 
add explanatory language in cases where the company is required to 
report on ICFR but has determined that it is not required to obtain, 
and did not request the auditor to perform, an audit of ICFR.\70\ The 
reproposed standard included a reference to a new proposed requirement 
in AS 3105, Departures from Unqualified Opinions and Other Reporting 
Circumstances, for the auditor to add such explanatory language. Some 
commenters were supportive of the reproposed requirement, while one 
commenter did not believe such a requirement was necessary but did not 
object to its inclusion.
---------------------------------------------------------------------------

    \70\ This may be the case for companies that are subject to 
Section 404(a) of Sarbanes-Oxley, which mandates management ICFR 
reporting, but not Section 404(b), which mandates auditor ICFR 
reporting. Section 404(a) generally applies to companies that are 
subject to the reporting requirements of the Exchange Act, other 
than registered investment companies. Certain categories of 
companies that are subject to Section 404(a), such as nonaccelerated 
filers and emerging growth companies, are not subject to Section 
404(b).
---------------------------------------------------------------------------

    The Board also sought comment on whether the requirement to include 
an explanatory paragraph in the auditor's report when the auditor did 
not perform an audit of ICFR should apply not only if company's 
management is required to report on ICFR, but also if management is not 
required to report, such as for investment companies. Several 
commenters supported expanding the requirement to all instances in 
which the auditor is not engaged to opine on ICFR, and not limit it to 
only when management is required to report on ICFR.
    In the Board's view, it is appropriate to add explanatory language 
to the auditor's report when management has a reporting responsibility 
on ICFR but the auditor is not engaged to opine on ICFR, in order to 
clarify the auditor's responsibilities in this situation. For companies 
for which management is not required to report on ICFR, the Board does 
not believe that the auditor should have a separate reporting 
responsibility. Accordingly, the final standard retains the requirement 
as reproposed.\71\ The auditor may, however, choose to include such a 
paragraph in the auditor's report voluntarily.
---------------------------------------------------------------------------

    \71\ See amendments to AS 3105.59-.60.
---------------------------------------------------------------------------

    Interaction between critical audit matters and explanatory 
paragraphs. The reproposed standard clarified that critical audit 
matters are not a substitute for required explanatory paragraphs. 
However, there could be situations in which a matter meets the 
definition of a critical audit matter and also requires an explanatory 
paragraph, such as going concern. For these situations, the reproposal 
contemplated that both the explanatory paragraph and the required 
communication regarding the critical audit matter would be provided. 
The auditor could include the communication required for a critical 
audit matter in the explanatory paragraph, with a cross-reference in 
the critical audit matter section to the explanatory paragraph. 
Alternatively, the auditor could choose to provide both an explanatory 
paragraph and the critical audit matter communication separately in the 
auditor's report, with a cross-reference between the two sections.\72\ 
While the information reported in a critical audit matter may overlap 
with some of the information already provided in the explanatory 
paragraph, the critical audit matter would provide incremental 
information, such as how the matter was addressed in the audit.
---------------------------------------------------------------------------

    \72\ When both an explanatory paragraph and a critical audit 
matter communication are provided, the critical audit matter 
description should not include conditional language that would not 
be permissible in the explanatory paragraph. See footnote 5 of AS 
2415.
---------------------------------------------------------------------------

    Commenters were generally supportive of the interaction between the 
communication of critical audit matters and required explanatory 
paragraphs as described in the reproposed standard. Some alternative 
views, however, were expressed. One commenter thought that if a 
required explanatory paragraph is also a critical audit matter, 
disclosure in the auditor's report should be limited to one place in 
the auditor' report. The commenter suggested that the communication 
requirements for both a critical audit matter and an explanatory 
paragraph be reported in the critical audit matter section of the 
auditor's report with a cross reference in the explanatory paragraph 
section. Another commenter suggested that the PCAOB harmonize its 
approach with that of the IAASB, which requires a reference in the key 
audit matter section but waives the requirements to describe the key 
audit matter and how it was addressed during the audit. Finally, 
another commenter thought that critical audit matter communications 
should not be

[[Page 35413]]

permitted to be integrated with explanatory paragraphs, on the basis 
that explanatory paragraphs are about matters in the financial 
statements to which the auditor wants to draw the reader's attention 
and are not necessarily critical audit matters.
    The final standard retains the interaction between critical audit 
matters and explanatory paragraphs as reproposed. The approach provides 
flexibility on auditor disclosure, yet also ensures that the 
communication requirements are met.
Emphasis of a Matter
    The reproposed standard, similar to the existing standard, provided 
the ability for the auditor to add a paragraph to the auditor's report 
to emphasize a matter regarding the financial statements (``emphasis 
paragraph'').\73\ Emphasis paragraphs are not required, but may be used 
by auditors to draw the reader's attention to matters such as 
significant transactions with related parties and unusually important 
subsequent events.
---------------------------------------------------------------------------

    \73\ See existing AS 3101.19.
---------------------------------------------------------------------------

    The reproposed standard provided a list of potential matters that 
the auditor may emphasize in the auditor's report, although the auditor 
may also decide to emphasize other matters.
    Commenters were supportive of emphasis paragraphs as described in 
the reproposed standard and did not suggest any additional matters to 
be included in the list of potential emphasis paragraphs. The final 
standard includes emphasis paragraphs as reproposed.
    Interaction between critical audit matters and emphasis paragraphs. 
The reproposed standard stated that emphasis paragraphs are not a 
substitute for required critical audit matters. If a matter that the 
auditor considers emphasizing meets the definition of a critical audit 
matter, the auditor would provide the information required for critical 
audit matters, and would not be expected to include an emphasis 
paragraph in the auditor's report. Although this did not generate much 
comment, one commenter affirmed support for the interaction between 
critical audit matters and emphasis paragraphs. The final standard 
retains the interaction between critical audit matters and emphasis 
paragraphs as reproposed.
Requirements of Other Regulators and Standard Setters
    Under the requirements of other regulators and standard setters, 
there are no analogous explanatory paragraphs, except for reporting on 
going concern. The Board's reproposed approach is similar to the 
IAASB's approach to the interaction between a paragraph regarding the 
company's ability to continue as a going concern and key audit matters, 
although the underlying requirements for auditor reporting on going 
concern vary.\74\ Under the IAASB's approach, an emphasis of matter 
paragraph is not required for a matter that was determined to be a key 
audit matter.\75\ The EU and the FRC have separate requirements related 
to going concern reporting that do not specifically address the 
interaction with their expanded auditor reporting.\76\ The IAASB, FRC, 
and EU do not have requirements for reporting on ICFR.
---------------------------------------------------------------------------

    \74\ See paragraph A1 of ISA 570, Going Concern, and paragraph 
15 of ISA 701.
    \75\ See paragraph 8 of ISA 706, Emphasis of Matter Paragraphs 
and Other Matter Paragraphs in the Independent Auditor's Report.
    \76\ See ISA (UK and Ireland) 570, Going Concern, and see 
Article 28, Audit Reporting, of Directive 2014/56/EU of the European 
Parliament and of the Council (Apr. 16, 2014).
---------------------------------------------------------------------------

Information About Certain Audit Participants
    On May 9, 2016, the SEC approved new rules and related amendments 
to the Board's auditing standards, including amendments to AS 3101, 
that will provide investors and other financial statement users with 
information about engagement partners and other accounting firms that 
participate in audits of issuers.\77\ Firms will be required to file 
Form AP with the PCAOB for each issuer audit, disclosing this 
information. In addition to filing Form AP, firms will also have the 
choice to include this information in the auditor's report.\78\ The 
final standard incorporates the adopted amendments to AS 3101 for 
situations in which the auditor decides to include information about 
certain audit participants in the auditor's report. The final standard 
requires the auditor to use an appropriate section title when providing 
this information in the auditor's report, but does not require a 
specific location in the auditor's report.
---------------------------------------------------------------------------

    \77\ See PCAOB Release No. 2015-008.
    \78\ When the auditor divides responsibility for the audit under 
AS 1205, Part of the Audit Performed by Other Independent Auditors, 
the auditor's report must acknowledge the involvement of the other 
auditor.
---------------------------------------------------------------------------

Requirements of Other Regulators and Standard Setters
    The IAASB requires the auditor to include the name of the 
engagement partner in the auditor's report for audits of listed 
entities.\79\ Under EU law, the engagement partner is required to sign 
the audit report in all EU countries, including the United Kingdom.\80\ 
Unlike disclosure of the engagement partner's name, disclosure of other 
accounting firms that participated in the audit is not required by the 
IAASB, FRC, or the EU.
---------------------------------------------------------------------------

    \79\ See paragraph 45 of ISA 700.
    \80\ Directive 2006/43/EC of the European Parliament and of the 
Council, Article 28, Audit Reporting (May 17, 2006).
---------------------------------------------------------------------------

Form of the Auditor's Report
    The reproposed standard required the ``Opinion on the Financial 
Statements'' section to be the first section of the auditor's report, 
immediately followed by the ``Basis for Opinion'' section. The 
reproposed standard did not specify an order for the remaining sections 
of the auditor's report, which would include explanatory paragraphs and 
critical audit matters. This approach allowed for consistency in the 
location of the opinion and basis for opinion sections, with 
flexibility for the other elements of the auditor's report. The 
reproposed standard also required titles for all sections of the 
auditor's report to provide consistency and assist users in identifying 
the individual sections of the auditor's report.
    Commenters were generally supportive of the proposed changes to the 
form of the auditor's report, because the changes will:
     Enhance the clarity and comparability of disclosures;
     Make it easier for investors to find the opinion since it 
will be listed first;
     Help facilitate a comparison between auditor's reports; 
and
     Allow for an appropriate level of flexibility and ease of 
use without being overly prescriptive.
    Some commenters suggested the PCAOB should be consistent with other 
standard setters in the ordering of section titles in the auditor's 
report. One commenter expressed concern that the ordering of the 
components of the opinion and the heading of the critical audit matter 
section of the report may be misunderstood to imply that critical audit 
matter communications are separate and distinct from the auditor's 
opinion, which could be misinterpreted as a piecemeal opinion. In light 
of the commenter support described above, the Board is adopting the 
form of the auditor's report as reproposed. As previously discussed, 
the final standard includes revised introductory language in the 
auditor's report to avoid the potential misperception that the 
communication of critical audit matters provides piecemeal opinions.

[[Page 35414]]

Requirements of Other Regulators and Standard Setters
    The reproposed approach with respect to the order of the sections 
of the auditor's report is generally consistent with that of the 
IAASB.\81\ The EU and FRC do not specify an order to the auditor's 
report.
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    \81\ See paragraphs 23-28 of ISA 700.
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Application to Other Audits Performed Under PCAOB Standards
    There are situations in which an auditor may be required by law or 
regulation, or voluntarily agrees, to perform an audit engagement in 
accordance with PCAOB standards for a company whose audit is not 
subject to PCAOB oversight.\82\ For example, SEC rules permit audits 
under PCAOB standards in connection with offerings under Regulation A 
and Regulation Crowdfunding.\83\ In these situations, certain elements 
of the auditor's report required under the final standard, such as the 
use of ``registered public accounting firm'' in the title or the 
statement regarding independence requirements, may not apply. 
Additional guidance for these situations will be provided.
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    \82\ Under the Sarbanes-Oxley Act, as amended by the Dodd-Frank 
Wall Street Reform and Consumer Protection Act, the PCAOB oversees 
the audits of ``issuers'' and brokers and dealers reporting under 
Exchange Act Rule 17a-5. See Sarbanes-Oxley Act Section 101. An 
``issuer'' under the Sarbanes-Oxley Act is an entity whose 
securities are registered under Section 12 of the Exchange Act, or 
that is required to file reports under Section 15(d) of the Exchange 
Act, or that files or has filed a Securities Act registration 
statement that has not yet become effective and that it has not 
withdrawn. See Sarbanes-Oxley Section 2(a).
    \83\ See Securities Act Form 1-A, Part F/S (b)(2) and 
(c)(1)(iii); Regulation Crowdfunding Rule 201(t) instruction 9, 17 
CFR 227.201(t).
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Amendments to Other PCAOB Standards
    The Board has adopted amendments to several of its existing 
auditing standards solely to conform to the final standard. The Board 
is not adopting any further changes to these existing auditing 
standards at this time, although the Board recognizes that some of the 
existing auditing standards, such as the redesignated standard AS 3105, 
may need further updating. The Board may consider proposing further 
changes to these standards under separate standard-setting projects.
AS 3105, Departures From Unqualified Opinions and Other Reporting 
Circumstances
    Existing AS 3101.10 and .20-.76 address departures from the 
auditor's unqualified opinion, such as a qualified opinion, an adverse 
opinion, or a disclaimer of opinion, and other reporting circumstances, 
such as reporting on comparative financial statements. These paragraphs 
are redesignated as AS 3105.\84\ Commenters who addressed this topic 
generally supported the reproposed amendments to AS 3105, including 
amending the example auditor's reports to conform with the example 
auditor's report in the final standard. The Board also received some 
comments suggesting further changes to AS 3105, such as updating 
descriptions of and references to accounting requirements that are no 
longer current \85\ and updating certain terminology (e.g., changing 
references from ``entity'' to ``company''). The Board may consider such 
updates as part of a separate standard-setting project.
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    \84\ AS 3101.01-.09 and .11-.19 are amended and restated as AS 
3101, The Auditor's Report on an Audit of Financial Statements When 
the Auditor Expresses an Unqualified Opinion.
    \85\ The Board has issued guidance regarding the status of 
outdated descriptions of and references to U.S. GAAP in PCAOB 
standards. See PCAOB, Staff Questions and Answers, References to 
Authoritative Accounting Guidance in PCAOB Standards (Sept. 2, 
2009). Among other things, this guidance provides that auditors 
should disregard descriptions of and references to accounting 
requirements in PCAOB standards that are inconsistent with the FASB 
Accounting Standards Codification (``ASC'').
---------------------------------------------------------------------------

    The Board has adopted final amendments to AS 3105 that are 
substantially similar to the reproposal. The amendments to AS 3105 are 
not intended to change the circumstances in which the auditor would 
depart from an unqualified opinion. The changes from the current 
standard will primarily: (1) Require the communication of critical 
audit matters in certain circumstances; (2) revise certain terminology 
to align with the final standard; and (3) amend the illustrative 
reports for the basic elements of the final standard and the required 
order of certain sections of the auditor's report.
    AS 3105 includes:
Communication of Critical Audit Matters in Reports Containing Other 
Than Unqualified Opinions
    a. Qualified opinion--Amendments to AS 3105 will require that when 
the auditor expresses a qualified opinion, the auditor's report also 
include communication of critical audit matters, if critical audit 
matter requirements apply.
    b. Adverse opinion--The existing requirements related to an adverse 
opinion are not amended to require the auditor to communicate critical 
audit matters. In the Board's view, the most important matter to 
investors and other financial statement users in such circumstances 
would be the reason for the adverse opinion.
    c. Disclaimer of opinion--The existing requirements related to a 
disclaimer of an opinion are not amended to require the auditor to 
communicate critical audit matters. In the Board's view, the most 
important matter to investors and other financial statement users in 
such circumstances would be the reason for the disclaimer of opinion.
Requirements of Other Regulators and Standard Setters
    Under the IAASB's approach, a matter giving rise to a qualified, 
adverse, or disclaimer of opinion is by nature a key audit matter.\86\ 
However, in such circumstances: (1) The matter should not be described 
in the key audit matter section of the auditor's report, (2) the 
auditor should report on the matter in accordance with applicable 
standards, and (3) the auditor should include a reference in the key 
audit matter section to the basis for modified opinion section where 
the matter is reported.\87\ The requirements to determine and 
communicate key audit matters, other than the matters giving rise to 
the modified opinion, would still apply when the auditor expresses a 
qualified or adverse opinion, but not when the auditor disclaims an 
opinion on the financial statements.\88\ The FRC and the EU do not 
include specific requirements for expanded auditor reporting when the 
auditor's report contains other than an unqualified opinion.
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    \86\ See paragraph 15 of ISA 701.
    \87\ Id.
    \88\ See paragraph A7 of ISA 701 and paragraph 29 of ISA 705, 
Modifications to the Opinion in the Independent Auditor's Report.
---------------------------------------------------------------------------

Other Amendments to PCAOB Standards
    The amendments to other PCAOB standards are substantially as 
reproposed. These include:
     AS 1220, Engagement Quality Review--amending to require 
the engagement quality reviewer to evaluate the engagement team's 
determination, communication, and documentation of critical audit 
matters;
     AS 1301, Communications with Audit Committees--amending to 
require the auditor to provide to and discuss with the audit committee 
a draft of the auditor's report;
     AS 2201, An Audit of Internal Control Over Financial 
Reporting That Is Integrated with An Audit of Financial Statements--
amending the example auditor's report to conform with the example 
auditor's report on the financial statements in the final standard;
     AS 2820, Evaluating Consistency of Financial Statements--
amending to

[[Page 35415]]

include the existing reporting requirements and illustrative 
explanatory language related to a change in accounting principle or a 
restatement that is currently in AS 3105; and
     AS 4105, Reviews of Interim Financial Information--
amending to include the basic elements of the final standard, where 
applicable.
    Conforming amendments were also made to every PCAOB standard that 
refers to the auditor's report. Commenters generally supported the 
amendments as reproposed.
    A commenter suggested revising AS 3305, Special Reports, to conform 
to the example auditor's report in the final standard. Since reports 
pursuant to AS 3305 are rarely filed with the SEC, as noted by this 
commenter, the Board does not believe these reports should be updated 
at this time. As described above, the Board may consider updating this 
standard as part of a separate standard-setting project.

D. Economic Considerations and Application to Audits of Emerging Growth 
Companies

    The Board is committed to analyzing the economic impacts of its 
standard setting. The following discussion addresses the potential 
economic impacts, including potential benefits and costs, considered by 
the Board. The Board has sought information relevant to economic 
consequences several times over the course of the rulemaking. 
Commenters provided views on a wide range of issues pertinent to 
economic considerations, including potential benefits and costs, but 
did not provide empirical data or quantified estimates of the costs or 
other potential impacts of the standard. The potential benefits and 
costs considered by the Board are inherently difficult to quantify, 
therefore the Board's economic discussion is primarily qualitative in 
nature.
    Commenters who discussed the economic analysis in the Board's 
reproposal provided a wide range of views. Some commenters pointed to 
academic research for the Board to consider in support of their views. 
One commenter asserted that the Board's release did not provide a true 
economic analysis of the pros and cons of mandating the reporting of 
critical audit matters, but only referenced academic studies on the 
purported benefits of such reporting. Another argued that the changes 
described in the reproposal would lead to a significant increase in 
costs, and that no compelling case had been made that the benefits 
would exceed the costs. The SEC's Investor Advocate said that the 
Board's economic analysis made a compelling case as to why the required 
reporting of critical audit matters would reduce informational 
asymmetries and add to the total mix of information available to 
investors.\89\ The Board has considered all comments received and has 
sought to develop an economic analysis that evaluates the potential 
benefits and costs of the final standard, as well as facilitates 
comparisons to alternative Board actions.
---------------------------------------------------------------------------

    \89\ See letter from Rick A. Fleming, Investor Advocate, SEC 
(Aug. 15, 2016) at 3, available on the Board's Web site in Docket 
034.
---------------------------------------------------------------------------

Need for the Rulemaking
Critical Audit Matters
    Generally, investors and other financial statement users know less 
about a company's financial performance than do others closer to the 
financial reporting process, particularly management. This information 
asymmetry \90\ can result in situations where capital is allocated 
suboptimally. The system of financial reporting in the United States, 
which requires periodic reporting of information, including annual 
financial statements, helps address the information asymmetry between 
investors and management. Board of directors and audit committee 
oversight of the financial reporting process can further reduce this 
information asymmetry by enhancing the quality of the information 
disclosed to the public. As part of this system, the audit of the 
financial statements also helps reduce the information asymmetry 
investors face by providing an independent opinion about whether the 
financial statements are presented fairly in all material respects.
---------------------------------------------------------------------------

    \90\ Economists often describe ``information asymmetry'' as an 
imbalance, where one party has more or better information than 
another party.
---------------------------------------------------------------------------

    Companies' operations continue to become more complex and global. 
In addition, over the last decade, there have been changes in the 
financial reporting frameworks relating to accounting estimates and an 
increasing use of fair value as a measurement attribute, together with 
new related disclosure requirements.\91\ These estimates and fair value 
measurements, which are important to a financial statement user's 
understanding of the company's financial position and results of 
operations, can be highly subjective, require significant judgment, and 
can result in increased measurement uncertainty in financial 
statements.\92\ The increased complexity of financial reporting, 
including the growing use of complex accounting estimates and fair 
value measurements, may contribute to the information asymmetry between 
investors and management, despite the fact that management is required 
to provide significant disclosures to investors and other financial 
statement users. Some commenters on the reproposal have stated that 
investors would find information provided by the auditor, an 
independent third party, particularly relevant in this setting.
---------------------------------------------------------------------------

    \91\ See PCAOB Staff Consultation Paper, Auditing Accounting 
Estimates and Fair Value Measurements (Aug. 19, 2014).
    \92\ See IAASB Project Proposal, Revision of ISA 540, Auditing 
Accounting Estimates, Including Fair Value Accounting Estimates, and 
Related Disclosures (Mar. 2016).
---------------------------------------------------------------------------

    As part of the audit, auditors often perform procedures involving 
challenging, subjective, or complex judgments, such as evaluating 
calculations or models, the impact of unusual transactions, and areas 
of significant risk. Although the auditor is required to communicate 
with the audit committee regarding such matters, the auditor's report 
has not been expanded to provide this information to investors and 
generally provides only a standardized pass/fail opinion. Because the 
auditor's report generally does not contain audit-specific information, 
it provides very little of the information the auditor knows about the 
company, its financial reporting, and the challenges of the audit. 
Given the increased complexity of financial reporting, which requires 
the auditor to evaluate complex calculations or models and make 
challenging or subjective judgments, the current form of the auditor's 
report does little to address the information asymmetry between 
investors and auditors.
    The Board believes that expanding the auditor's report to provide 
information about especially challenging, subjective, or complex 
auditor judgments will help investors and other financial statement 
users ``consume'' the information presented in management's financial 
statements more effectively. Stated in economic terms, in the Board's 
view, an expanded auditor's report will reduce the information 
asymmetry between investors and auditors, which should in turn reduce 
the information asymmetry between investors and management about the 
company's financial performance. Reducing information asymmetry about 
the company's financial reporting should lead to a more efficient 
allocation of capital.
    Some commenters supported the reporting of critical audit matters 
as a means of reducing the information asymmetry between investors and 
auditors. Other commenters disagreed with the Board's approach and

[[Page 35416]]

questioned whether the Board could or should attempt to reduce 
information asymmetry by requiring expanded auditor reporting. The 
Board believes that requiring expanded auditor reporting as a means of 
reducing the information asymmetry between investors and auditors is 
consistent with its statutory mandate to ``protect the interests of 
investors and further the public interest in the preparation of 
informative, accurate and independent audit reports.'' \93\ Investors 
are the intended beneficiaries of the audit, but investors do not 
receive information about specific work performed during the audit. The 
final standard seeks to enhance the form and content of the auditor's 
report to make it more relevant and informative to investors and other 
financial statement users.
---------------------------------------------------------------------------

    \93\ Section 101(a) of Sarbanes-Oxley.
---------------------------------------------------------------------------

Increasing the Informativeness of the Auditor's Report To Address 
Information Asymmetry
    The communication of critical audit matters will reduce the 
information asymmetry between investors and auditors by informing 
investors and other financial statement users about areas of the audit 
that required especially challenging, subjective, or complex auditor 
judgment, including the principal considerations for determining the 
matters and how the matters were addressed in the audit. The Board 
believes that auditor reporting of critical audit matters will provide 
investors with audit-specific information that should facilitate their 
analysis of the financial statements and other related disclosures. The 
communication of critical audit matters in the auditor's report should 
also help investors and analysts who are interested in doing so to 
engage management and the audit committee with targeted questions about 
these issues.\94\ Ultimately, while not every critical audit matter 
will be useful for every investor, broadly, the Board believes that 
having the auditor provide investors and other financial statements 
users with additional information about especially challenging, 
subjective, or complex auditor judgments should help reduce the 
information asymmetry that exists between investors and management by 
providing additional insights on the financial statements.
---------------------------------------------------------------------------

    \94\ The FRC observes that, in some instances, investors have 
begun to use the information provided in the expanded auditor's 
reports in the U.K. to engage with audit committees. See FRC, 
Extended Auditor's Reports, A Further Review of Experience (Jan. 
2016) (``FRC 2016 Report'').
---------------------------------------------------------------------------

    The communication of critical audit matters should also assist 
investors in assessing the credibility of the financial statements and, 
in at least some instances, audit quality.\95\ For example, the 
description of how the auditor addressed the critical audit matter will 
help investors understand the types of issues that the auditor grappled 
with in addressing these challenging, subjective, or complex areas of 
the audit, which should allow a deeper and more nuanced understanding 
of the related financial statement accounts and disclosures. 
Furthermore, investors have consistently stated that having the auditor 
rather than the company, provide this type of information would be of 
added value to investment decision making.\96\ Commenting on the 
reproposal, the SEC's Investor Advocate noted that investors want to 
hear directly from the auditor and that this point is confirmed by 
surveys of professional investors, as well as by certain academic 
research.\97\ This commenter agreed with the premise in the reproposal 
that, because the auditor is required to be independent, information 
provided by the auditor may be viewed by investors as having greater 
credibility than information provided by management alone.
---------------------------------------------------------------------------

    \95\ It is often not possible to observe the difference between 
financial reporting quality and audit quality. An academic study 
conceptually models the path through which the financial reporting 
and audit processes result in audited financial reporting outcomes. 
The authors postulate that although audit quality and pre-audit 
financial reporting quality are distinct constructs, the two 
processes are often inseparable in terms of observable financial 
reporting outcomes in archival research. See Lisa Milici Gaynor, 
Andrea Seaton Kelton, Molly Mercer, and Teri Lombardi Yohn, 
Understanding the Relation between Financial Reporting Quality and 
Audit Quality, 35 Auditing: A Journal of Practice & Theory 1, 1-22 
(2016).
    \96\ See IAG 2011 survey and CFA survey and poll results.
    \97\ See letter from Rick A. Fleming, Investor Advocate, SEC 
(Aug. 15, 2016) at 3, available on the Board's Web site in Docket 
034 (citing Brant E. Christensen, Steven M. Glover, and Christopher 
J. Wolfe, Do Critical Audit Matter Paragraphs in the Audit Report 
Change Nonprofessional Investors' Decision to Invest? 33 Auditing: A 
Journal of Practice & Theory 71, 71-93 (2014)).
---------------------------------------------------------------------------

    Reporting of critical audit matters should provide insights that 
will add to the mix of information that could be used in investors' 
capital allocation decisions, for example, by:
     Highlighting the aspects of the financial statement audit 
that the auditor found to be especially challenging, subjective, or 
complex;
     Enabling comparison of these aspects of the audit across 
companies, for example audits of companies within the same industry; 
and
     Enabling comparison of these aspects of the audit for the 
same company over time.
    Many companies commenting on the reproposal argued that the 
reporting of critical audit matters would not increase the 
informativeness of the auditor's report. For example, several of these 
commenters claimed that the reporting of critical audit matters would 
simply duplicate management disclosure without adding additional 
information, or that critical audit matters would not provide value-
relevant information. Other commenters asserted that the reporting of 
critical audit matters would result in the auditor's report becoming a 
lengthy list of boilerplate disclosures, which would contribute to 
disclosure overload or run contrary to the SEC's disclosure 
effectiveness initiative. Several commenters said that critical audit 
matters could confuse investors if the information in the auditor's 
report was duplicative of management's disclosures but was presented in 
a different manner, or if the critical audit matter presented 
information without appropriate context.
    By contrast, investor commenters overwhelmingly agreed that the 
communication of critical audit matters would make the auditor's report 
more informative. One commenter said that, although critical audit 
matters in themselves would not provide investors with all the 
information needed in the face of growing financial complexity, 
critical audit matters would add to the total mix of information 
available to investors, and would contribute to their ability to 
analyze companies, form a multifaceted understanding of them, and make 
informed investment decisions. Another commenter noted that, in 
jurisdictions where the expanded auditor's report is available, it is 
one of the earliest elements of the company's annual report that they 
read because it typically highlights the more judgmental elements of 
the company's accounting, which often provides insights that form a 
basis for discussions with management.
Mandated Rather Than Voluntary Reporting
    Auditors have not developed a practice of providing information in 
the auditor's report beyond what is required, even though investors 
have consistently requested that the auditor's report become more 
informative. Current standards provide a framework for auditors to 
provide limited additional information through emphasis paragraphs,\98\ 
but in general these only point to a disclosure in the company's 
financial statements without providing any additional description of

[[Page 35417]]

the matter and, as noted below, emphasis paragraphs are infrequent in 
practice. Auditor reporting about matters significant to the audit is 
not prohibited in an emphasis paragraph, but current standards do not 
encourage auditors to include such information in their report and do 
not provide a framework for doing so.
---------------------------------------------------------------------------

    \98\ See existing AS 3101.19.
---------------------------------------------------------------------------

    There are many other potential reasons why auditors are not 
providing information voluntarily in the auditor's report, whether 
about the financial statements or the audit. For example, the 
historical model of management disclosing information and the auditor 
attesting to the information may lead companies to resist voluntary 
additional reporting by the auditor, either through emphasis paragraphs 
or with respect to information about the audit, which the auditor would 
be better positioned to communicate than management. Further, auditors 
may believe that providing additional information could potentially 
expose them to liability or that doing so could be interpreted as a 
disclaimer of opinion or a partial opinion as to the identified 
matters. Finally, in general, there may be disincentives to voluntary 
reporting if the disclosing party is not able to fully capture the 
benefits of the disclosures,\99\ and parties may also exhibit a bias 
toward the status quo.\100\ All of these factors disincentivize 
auditors from voluntarily providing further information about the 
audit, even if investors and other financial statement users would 
respond favorably to receiving additional information.
---------------------------------------------------------------------------

    \99\ Academic research finds that there are certain situations 
in which disclosure may be socially optimal but not privately 
optimal. Auditors and companies may resist voluntary expanded 
auditor reporting because of concerns that certain types of 
spillover effects (or externalities) may create a competitive 
disadvantage. For a summary of this line of research, see Luigi 
Zingales, The Future of Securities Regulation, 47 Journal of 
Accounting Research 391, 394-395 (2009). Professor Zingales is the 
founding director of the PCAOB's Center for Economic Analysis, now 
known as the Office of Economic and Risk Analysis. The research 
cited above was published before he joined the PCAOB.
    \100\ Research in behavioral economics suggests that when facing 
a set of decisions, individuals are more likely to stick to the 
known outcome (status quo) than would be expected based on the 
theory of rational decision making under uncertainty. There are a 
variety of reasons why individuals may choose the status quo outcome 
in lieu of an unknown outcome, including aversion to the uncertainty 
inherent in moving from the status quo to another option. See 
William Samuelson and Richard Zeckhauser, Status Quo Bias in 
Decision Making, 1 Journal of Risk and Uncertainty 7, 7-59 (1988).
---------------------------------------------------------------------------

    The Board believes that the required reporting of critical audit 
matters will promote more complete and consistent disclosure of audit-
specific information to financial statement users who may be interested 
in it.\101\ Mandatory disclosure can also improve the allocative 
efficiency of capital markets by decreasing the costs associated with 
gathering information, or by providing market participants with 
information that otherwise would have been difficult or impossible for 
them to gather.\102\
---------------------------------------------------------------------------

    \101\ Academic research on disclosure explores these types of 
positive externalities, as well as certain negative externalities. 
See, e.g., Ronald A. Dye, Mandatory versus Voluntary Disclosures: 
The Cases of Financial and Real Externalities, 65 The Accounting 
Review 1, 1-24 (1990); or Anat R. Admati and Paul Pfleiderer, 
Forcing Firms to Talk: Financial Disclosure Regulation and 
Externalities, 13 The Review of Financial Studies 479, 479-519 
(2000).
    \102\ See, e.g., John C. Coffee, Jr., Market Failure and the 
Economic Case for a Mandatory Disclosure System, 70 Virginia Law 
Review 717, 717-753 (1984).
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The final standard requires auditors to disclose in the auditor's 
report the number of years they have served consecutively as the 
auditor for the company. Although some commenters dispute the value of 
this information, investor commenters have indicated that the length of 
the relationship between the auditor and the company would be a useful 
data point. The growing trend toward voluntary disclosure of this 
information by companies suggests that increasing numbers of companies 
believe that the market finds the disclosure useful.\103\ Further, 
there is a line of academic research suggesting that there is an 
association between auditor tenure and increases or decreases in audit 
quality.\104\
---------------------------------------------------------------------------

    \103\ See Center for Audit Quality and Audit Analytics, 2016 
Audit Committee Transparency Barometer (Nov. 2016). See also Ernst & 
Young, Audit Committee Reporting to Shareholders 2016 (Sept. 2016).
    \104\ See below for a discussion of academic research regarding 
auditor tenure.
---------------------------------------------------------------------------

    Although investors may be able to determine auditor tenure by, for 
example, reviewing past auditor's reports, for many companies the 
information is not readily available even through a manual search 
process. Furthermore, while some companies voluntarily provide 
information about auditor tenure in the proxy statement, many do not. 
Many companies are also not subject to the proxy rules (for example, 
most investment companies, foreign private issuers, and many companies 
whose securities are not listed on a national securities exchange). In 
cases where the information is provided voluntarily, it is not provided 
in a consistent location. The Board believes that these issues create 
unnecessary search costs for investors who wish to evaluate information 
about auditor tenure. Mandatory disclosure of auditor tenure in the 
auditor's report will provide a consistent location for this 
information and will reduce search costs relative to the current 
baseline for investors who are interested in auditor tenure, especially 
in the case of companies that do not voluntarily provide such 
information or for which the information is not available through the 
EDGAR system. Mandatory disclosure of auditor tenure in the auditor's 
report may also be more likely to encourage further discussion of 
auditor tenure by management and the audit committee and potential 
disclosure in company filings.
    The existing auditor's report also does not describe important 
aspects of the auditor's responsibilities under existing auditing 
standards, such as the auditor's responsibility to detect material 
misstatements, whether due to error or fraud; the auditor's 
responsibility for the notes to the financial statements; and the 
auditor independence requirement. This may contribute to misperceptions 
by investors and other financial statement users about the auditor's 
role and responsibilities, including with respect to these matters. 
Academic research suggests that there are a number of ways in which 
investor perceptions of the role and responsibilities of the auditor 
may diverge from what current professional standards require.\105\ In 
addition, the existing standards do not require a uniform approach to 
basic content, such as the addressee of the report and the form of the 
auditor's report, which may increase the time and costs of processing 
the information in the auditor's report. The final standard contains 
provisions requiring the basic elements in the auditor's report to be 
presented more uniformly.
---------------------------------------------------------------------------

    \105\ See, e.g., Bryan K. Church, Shawn M. Davis, and Susan A. 
McCracken, The Auditor's Reporting Model: A Literature Overview and 
Research Synthesis, 22 Accounting Horizons 69, 69-90 (2008); Glen L. 
Gray, Jerry L. Turner, Paul J. Coram, and Theodore J. Mock, 
Perceptions and Misperceptions Regarding the Unqualified Auditor's 
Report by Financial Statement Preparers, Users, and Auditors, 25 
Accounting Horizons 659, 675-676 (2011); or Theodore J. Mock, Jean 
B[eacute]dard, Paul J. Coram, Shawn M. Davis, Reza Espahbodi, and 
Rick C. Warne, The Audit Reporting Model: Current Research Synthesis 
and Implications, 32 Auditing: A Journal of Practice & Theory 323, 
323-351 (2013).
---------------------------------------------------------------------------

    Commenters generally supported the reproposed changes to these 
basic elements of the auditor's report. Some commenters noted that the 
enhanced descriptions of the auditor's responsibility to detect 
material misstatements would clarify the auditor's responsibilities for 
financial

[[Page 35418]]

statement users, other commenters offered suggestions for refinement, 
such as aligning the requirements to the IAASB model or amending the 
description to more clearly define the auditor's role within the 
context of the financial reporting regulatory framework.
    Commenters also generally supported including a statement on the 
auditor's independence requirement. For example, some commenters stated 
that adding a statement by the auditor on their independence would 
reinforce investors' understanding of the auditor's requirement to 
remain independent and objective in expressing the audit opinion. Other 
commenters said that the enhanced description of the independence 
requirement could provide a meaningful reminder of the importance of 
auditor independence. However, other commenters said that the enhanced 
description of auditor independence was either unnecessary, or would 
not have a significant impact on auditor behavior. Based on broad 
commenter support, the Board is adopting these additional improvements 
to the auditor's report as reproposed.
Baseline
Critical Audit Matters
    The auditor's report in the United States today generally consists 
of three paragraphs that include limited audit-specific information. 
The existing auditor's report identifies the company's financial 
statements that were audited, provides a standardized description about 
the nature of an audit, and provides an opinion on whether the 
company's financial statements are fairly presented, in all material 
respects, in conformity with the applicable financial reporting 
framework. The auditor's report is often described as a pass/fail model 
because the report only conveys the auditor's opinion on whether the 
financial statements are fairly presented (pass) or not (fail) and 
typically provides limited information about the nature of the work on 
which the opinion is based.
    The Board's current standards also require that the auditor add 
explanatory paragraphs to the auditor's report under specific 
circumstances, such as when there is substantial doubt about the 
company's ability to continue as a going concern or a restatement of 
previously issued financial statements. When included, these paragraphs 
generally consist of standardized language that provides limited audit-
specific information.
    The auditor may also, at his or her discretion, include emphasis 
paragraphs in the auditor's report to emphasize a matter regarding the 
financial statements. Generally, an emphasis paragraph only points to a 
disclosure in the company's financial statements without providing any 
additional description. Under current practice, emphasis paragraphs are 
infrequent.\106\ Auditors may also, at their discretion, include 
language in the auditor's report indicating that they were not engaged 
to examine management's assertion about the effectiveness of internal 
control over financial reporting.\107\
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    \106\ In the audit reports of approximately 6,350 issuers with 
fiscal year 2014 filings, PCAOB staff identified audit reports 
containing explanatory paragraphs to emphasize matters in the 
financial statements in approximately 2 percent of the filings.
    \107\ See paragraph .10 of AI 20, Other Information in Documents 
Containing Audited Financial Statements: Auditing Interpretations of 
AS 2710.
---------------------------------------------------------------------------

    Academic research confirms the view of the Board and many 
commenters that the current form of the auditor's report conveys little 
of the audit-specific information obtained and evaluated by the 
auditor.\108\ Academic research also finds that investors and other 
financial statement users refer to the existing auditor's report only 
to determine whether the opinion is unqualified because it does not 
provide much additional informational value about a particular 
audit.\109\ These findings align with the consistent call from 
investors, over the course of the Board's rulemaking process, for a 
more informative auditor's report.\110\
---------------------------------------------------------------------------

    \108\ See Church et al., The Auditor's Reporting Model: A 
Literature Overview and Research Synthesis 69-90.
    \109\ See Gray et al., Perceptions and Misperceptions Regarding 
the Unqualified Auditor's Report by Financial Statement Preparers, 
Users, and Auditors 659-684; Mock et al., The Audit Reporting Model: 
Current Research Synthesis and Implications 323-351.
    \110\ Academic research has found that, in some instances, the 
inclusion of explanatory language in the auditor's report may 
provide investors with additional value-relevant information. A 
recent academic study suggests that auditor's reports containing 
certain types of explanatory paragraphs required under existing 
standards may provide information about the likelihood that 
financial statements will be subsequently restated. The authors 
argue that the inclusion of such an explanatory paragraph in the 
auditor's report can provide a signal to investors about the risk of 
misstatement of the company's financial statements. See Keith 
Czerney, Jaime J. Schmidt, and Anne M. Thompson, Does Auditor 
Explanatory Language in Unqualified Audit Reports Indicate Increased 
Financial Misstatement Risk? 89 The Accounting Review 2115, 2115-
2149 (2014).
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Additional Improvements to the Auditor's Report
    The existing auditor's report is not required to have a specified 
addressee but it may be addressed to the company whose financial 
statements are being audited, its board of directors, or 
stockholders.\111\ Under current practice, the auditor's report is 
generally addressed to one or more of the following: (1) The board of 
directors and stockholders/shareholders, or their equivalent for 
issuers that are not organized as corporations; (2) the plan 
administrator or plan participants for benefit plans; and (3) the 
directors or equity owners for brokers or dealers.\112\
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    \111\ See existing AS 3101.09.
    \112\ This information is based on a review by PCAOB staff of a 
random sample of 2014 fiscal year-end auditor's reports for issuers, 
benefit plans, and brokers and dealers.
---------------------------------------------------------------------------

    The current auditor's report also includes the report title, the 
date, and the name and location of the accounting firm's office issuing 
the report. The auditor is not currently required to disclose in the 
auditor's report the number of years it has served as auditor for the 
company. However, as noted earlier, many larger companies have begun 
voluntarily disclosing auditor tenure in the proxy statement.
    Currently, the title of the auditor's report, ``Report of 
Independent Registered Public Accounting Firm,'' provides the only 
indication of the auditor's independence.
Benefits
Critical Audit Matters
    Economic theory commonly attributes two benefits to mandatory 
disclosure. First, the disclosure of previously unknown, value-relevant 
information directly benefits the market because it allows market 
participants to make better-informed decisions. Second, the disclosure 
of such information may indirectly benefit the market because some 
parties may change their behavior in positive ways after information is 
disclosed.
Direct Benefit: More Informative and Useful Auditor's Report
    The Board believes that auditor communication of critical audit 
matters will reduce the information asymmetry between investors and 
auditors, which should in turn reduce the information asymmetry between 
investors and management about the company's financial performance. 
Some commenters on the reproposal agreed that the information provided 
in critical audit matters would be used by various types of investors 
in a number of different ways that are consistent with the framework 
outlined in the reproposal:
     Informing--Identification of the matters arising from the 
audit that the auditor considered especially challenging, subjective, 
or complex,

[[Page 35419]]

together with a description of how the auditor addressed those matters, 
which should provide valuable information. For example, some commenters 
said that:
     Critical audit matters would add to the total mix of 
information available to investors, and would contribute to their 
ability to analyze companies and make investment decisions;
     Investors would use critical audit matters in the same way 
that they use any other financial disclosure; critical audit matters 
would add an additional perspective to management's disclosures;
     Insights on critical audit matters may be relevant in 
analyzing and pricing risks in capital valuation and allocation;
     Critical audit matters would inform investor models of 
company financial performance;
     Critical audit matters would augment and add more 
dimension to the information provided by the financial statements and 
the critical accounting policies and estimates; and
     The communication of critical audit matters would lower 
the cost of acquiring information for financial statement users.
     Framing--Critical audit matters should provide investors 
with a new perspective on the financial statements and focus their 
attention on the related financial statement accounts and disclosures, 
which should facilitate their analysis of the financial statements, and 
help them assess financial performance, for example by highlighting 
potentially relevant information or by reducing the costs to process or 
search for the information. For example, some commenters said that:
     Critical audit matters would focus investors' attention on 
key financial reporting issues and identify areas that deserve more 
attention;
     In jurisdictions where expanded auditor reporting is 
available, it focuses users' attention on issues that would be 
pertinent to understanding a company as a long-term investor; and
     Information in critical audit matters would contribute to 
investor understanding and consumption of information in the financial 
statements.
     Monitoring--The ability to identify and evaluate the 
matters identified as critical audit matters should also help investors 
and analysts engage management with targeted questions about these 
issues and support investor decisions on ratification of the auditor. 
For example, some commenters said that:
     Critical audit matters would facilitate the ability of 
investors to monitor management's and the board of director's 
stewardship of the company by highlighting accounting and auditing 
issues and other matters that investors may wish to emphasize in their 
engagement with management; and
     Critical audit matters would provide important information 
on how the auditor has addressed an issue, which investors can use in 
evaluating the rigor of the audit and making proxy voting decisions, 
including ratification of the audit committee's choice of external 
auditor.
    Critical audit matters may be used by different types of investors 
in different ways. For example, retail investors (or others who may act 
on their behalf, such as analysts, credit rating agencies, or the 
financial press) may use the additional information to help them 
identify and analyze important aspects of the financial statements. 
Larger investors, on the other hand, may also use critical audit 
matters as a basis for engagement with management.
    The communication of critical audit matters aims to provide 
investors and financial statement users with specific information about 
the audit of a company's financial statements. Some commenters were 
concerned, however, that the communication of critical audit matters 
could lead to a reduction in comparability of auditor's reports. 
Although differences in critical audit matters from period to period 
and across companies may make auditor's reports less uniform, to the 
extent the information provided is useful in evaluating the financial 
performance, highlighting these differences should contribute to the 
overall mix of information. Further, some commenters on the proposal 
said that investors are interested in information that is specific to 
the audit of a company's financial statements, and therefore, would 
expect differences in auditor's reports across companies and reporting 
periods. Investors also have indicated that they are accustomed to 
analyzing company-specific information, such as information in 
financial statements or MD&A that is specific to a company or a 
reporting period.
    A body of academic research regarding the possible effects of 
expanded auditor reporting is emerging.\113\ The Board has been 
monitoring this research with a view towards assessing its potential 
relevance to this rulemaking. The Board is mindful of several issues 
that limit the extent to which this research can inform its decision 
making. Much of this research is unpublished and at a relatively early 
stage. The current conclusions may be subject to multiple 
interpretations and it is possible that results from this research may 
be revised during the peer review process. Moreover, it may be 
difficult to generalize results outside the context of specific 
studies. For example, in considering the implications of academic 
studies based on data from other jurisdictions, differences between the 
Board's final standard and the requirements in other jurisdictions must 
be taken into account. In addition, specific characteristics of the 
U.S.-issuer audit market may make it difficult to generalize 
observations made in other markets because of differences in baseline 
conditions (for example, market efficiency, affected parties, policy 
choices, legal environment, and regulatory oversight). As to 
experimental research in particular, it should be noted that the 
experimental setting may not provide study participants with 
information that is representative of the information environment in 
which market participants actually operate; for instance, if new 
information appeared more salient to study participants than it would 
to a market participant, the impact of expanded auditor reporting would 
be overstated in an experimental setting. In addition, some of these 
studies were conducted based on earlier versions of rule text that 
differs from the final standard, which may affect the extent to which 
the results can inform the Board in evaluating potential effects of the 
final standard.
---------------------------------------------------------------------------

    \113\ For a review of relevant academic research, see Jean 
B[eacute]dard, Paul Coram, Reza Espahbodi, and Theodore J. Mock, 
Does Recent Academic Research Support Changes to Audit Reporting 
Standards? 30 Accounting Horizons 255, 255-275 (2016).
---------------------------------------------------------------------------

    As discussed in more detail in the economic analysis contained in 
the reproposal, the results from early research analyzing the 
informational value of expanded auditor reporting are 
inconclusive.\114\ Some studies found that expanded auditor reporting 
could provide investors with new and useful information, while other 
studies found that the benefits attributable to expanded auditor 
reporting were not statistically significant, but that it could produce 
unintended consequences. These limited findings may be due to the fact 
that the results of the studies represent averages for large samples of 
companies. On average, investors may already have access to a variety 
of information sources (such as annual reports, news media, and analyst

[[Page 35420]]

research reports) which may contain similar information about a 
company. However, expanded auditor reporting may be relatively more 
informative for companies where alternative sources of information are 
less available (e.g., those companies with less analyst coverage).
---------------------------------------------------------------------------

    \114\ See PCAOB Release No. 2016-003, Section VI.C.1.a.
---------------------------------------------------------------------------

    In response to the reproposal, two commenters submitted studies 
suggesting that expanded auditor reporting has increased the 
informative value of the auditor's report. One experimental study 
tested the communicative value of expanded auditor reporting by 
analyzing how key audit matters affected investment professionals' 
assessment of a company's business economics, as well as their 
confidence in making that assessment.\115\ The authors found that 
specific informational content of the key audit matter affected the 
study participants' perceived level of trust associated with the 
auditor's report, which then affected the perceived level of trust 
associated with the financial statements and their assessment of the 
company's business economics. Another study analyzed whether the 
communicative value of auditor's reports changed following the 
implementation of expanded auditor reporting in the United 
Kingdom.\116\ The author found that the readability of auditor's 
reports increased in the post-implementation period, and that the use 
of negative and uncertain words in expanded auditor's reports captured 
more client-specific audit risk.\117\ In addition, the author found 
limited evidence that the dispersion of analysts' EPS forecasts 
decreased following the implementation of expanded auditor reporting, 
suggesting an improved information environment. The author argued that 
expanded auditor reporting was successful at increasing the 
communicative value of the auditor's report, and that analyst behavior 
changed accordingly. In contrast, another recent experimental study 
found that including critical audit matters reduced the readability of 
the auditor's report but did not incrementally inform nonprofessional 
investors' valuation judgments. However, the study suggested that the 
reporting of a critical audit matter lowers nonprofessional investors' 
perceptions of management's credibility when earnings just meet 
analysts' expectations. The study was designed and implemented using 
the definition of critical audit matters and related reporting 
requirements from the Board's proposal, which differ from the final 
standard.\118\
---------------------------------------------------------------------------

    \115\ See Annette Koehler, Nicole Ratzinger-Sakel, and Jochen 
Theis, Does the Reporting of Key Audit Matters Affect the Auditor's 
Report's Communicative Value? Experimental Evidence from Investment 
Professionals (working paper submitted as comment letter No. 18, 
available on the Board's Web site in Docket 034).
    \116\ See Kecia Williams Smith, Tell Me More: A Content Analysis 
of Expanded Auditor Reporting in the United Kingdom (working paper 
submitted as comment letter No. 71, available on the Board's Web 
site in Docket 034).
    \117\ The author uses several measures designed to assess the 
readability of texts which, the study notes, have been used in 
several other published academic studies addressing the readability 
of financial disclosure. See id. at 5.
    \118\ See Brian Carver and Brad Trinkle, Nonprofessional 
Investors' Reactions to the PCAOB's Proposed Changes to the Standard 
Audit Report (March 2017) (working paper, available in Social 
Science Research Network).
---------------------------------------------------------------------------

    In addition, in reviewing the experience of expanded auditor 
reporting in the United Kingdom, the FRC observed that investors 
greatly value the information provided in expanded auditor 
reporting.\119\ This view is confirmed by UK investors that commented 
on the reproposal. The FRC noted that, in the two years following the 
implementation of the new requirements, an association of investment 
managers has recognized in an annual awards ceremony those specific 
auditor's reports found to be most clear and most innovative in 
providing insight into the audit of the company's financial 
statements.\120\ In addition, the FRC notes that users of the new 
auditor's reports identified certain descriptions of risks that they 
found to be more useful--such as descriptions that are specific to the 
entity being audited. Further, the FRC report noted that, in the second 
year of implementation, a much greater proportion of risks were set out 
in a more meaningful and transparent way.\121\ As noted above, the 
FRC's requirements for expanded auditor reporting are different from 
the final standard, and the baseline legal and regulatory environment 
is not the same as in the United States. Nevertheless, the Board 
believes that there are sufficient similarities for the UK experience 
to be generally informative in its decision-making.
---------------------------------------------------------------------------

    \119\ See FRC 2016 Report.
    \120\ See FRC, March 2015--Extended Auditor's Reports, A Review 
of Experience in the First Year; and FRC 2016 Report.
    \121\ Id.
---------------------------------------------------------------------------

    While it is too early for the body of academic research on expanded 
auditor reporting to provide a conclusive answer, investors commenting 
during the Board's standard-setting process have consistently affirmed 
the usefulness of expanded auditor reporting and the FRC's observations 
on the early experience of investors in the United Kingdom are 
consistent with this view. Accordingly, the Board believes that auditor 
communication of critical audit matters will add to the mix of 
information that investors can use.
Indirect Benefit: Improved Audit and Financial Reporting Quality
    In general, information asymmetry can lead to situations in which 
an agent (such as an auditor) takes actions that do not coincide with 
the best interests of the principal (such as an investor), if the 
agent's incentives are misaligned.\122\ This type of problem is the 
result of the inability of the principal to observe or monitor the 
agent's behavior, which also inhibits the principal's ability to 
identify and reward optimal behavior, or punish sub-optimal behavior. 
Economic theory posits that the disclosure of information can have 
indirect effects that lead to changes in behavior.\123\ In the context 
of expanded auditor reporting, the additional information provided in 
the auditor's report could be beneficial to investors by providing more 
information about the audit, which could affect their voting decisions. 
To the extent that this could influence the terms of the auditor's 
engagement, academic research suggests ``any additional information 
about the agent's action, however imperfect, can be used to improve the 
welfare of both the principal and the agent.'' \124\
---------------------------------------------------------------------------

    \122\ Economists use principal-agent theory to analyze 
situations where one party (the principal) hires another party (the 
agent) to perform certain tasks and decision-making ability is 
delegated to the agent. For a general discussion of principal-agent 
theory, see, e.g., Michael C. Jensen and William H. Meckling, Theory 
of the Firm: Managerial Behavior, Agency Costs and Ownership 
Structure, 3 Journal of Financial Economics 305, 305-360 (1976), or 
Bengt Holmstrom, Moral Hazard and Observability, 10 The Bell Journal 
of Economics 74, 74-91 (1979).
    \123\ See, e.g., George Loewenstein, Cass R. Sunstein, and 
Russell Golman, Disclosure: Psychology Changes Everything, 6 Annual 
Review of Economics 391, 391-419 (2014).
    \124\ See Holmstrom, Moral Hazard and Observability at 75.
---------------------------------------------------------------------------

    This suggests that making aspects of the audit more visible to 
investors through the communication of critical audit matters should 
provide some auditors, management, and audit committees with additional 
incentives to change their behavior in ways that may enhance audit 
quality and ultimately financial reporting quality. For instance, the 
communication of critical audit matters could lead:
     Auditors to focus more closely on the matters identified 
as critical audit matters;
     Audit committees to focus more closely on the matters 
identified as critical audit matters and to engage the

[[Page 35421]]

auditor and management about the adequacy of the related disclosures; 
and
     Management to improve the quality of their disclosures 
because they know that investors and the auditor will be scrutinizing 
more closely the matters identified as critical audit matters.
    The communication of critical audit matters could lead auditors to 
increase their focus on the matters identified in the auditor's report 
as critical audit matters. As suggested by commenters, the 
communication of critical audit matters could further incentivize 
auditors to demonstrate the level of professional skepticism necessary 
for high quality audits in the areas of the critical audit matters. 
Other commenters stated that the reporting of critical audit matters 
could result in increased audit quality. For example, auditors could 
feel that the potentially heightened scrutiny of the matters identified 
as critical audit matters may warrant additional effort to satisfy 
themselves that they have obtained an appropriate amount of audit 
evidence to support their opinion.
    The communication of critical audit matters could also heighten 
management's attention to the relevant areas of financial statements 
and related disclosures. Several commenters stated that the reporting 
of critical audit matters would lead management to improve the quality 
of their disclosures or adopt more widely accepted financial reporting 
approaches in these areas.\125\
---------------------------------------------------------------------------

    \125\ To substantiate this point, one commenter cited a memo 
prepared for the clients of an international law firm that noted 
management should consider revising or supplementing their own 
disclosures relating to issues raised in expanded auditor's reports 
to ensure that the totality of disclosures around the issue are 
complete and accurate. See Sullivan & Cromwell LLP, Audit Reports, 
PCAOB Releases Reproposal of Amendments to Its Audit Report Standard 
(May 25, 2016).
---------------------------------------------------------------------------

    An experimental study analyzed the joint effect of expanded auditor 
reporting and audit committee oversight on management disclosure 
choices.\126\ The author found that the study participants, who were 
currently serving as public company financial executives, chose to 
provide the greatest level of disclosure when they knew that the 
auditor's report would provide a more detailed description of the 
accounting estimate, and the audit committee exhibited strong 
oversight. The author argued that, similar to what other academic 
research has found regarding the resolution of audit adjustments, 
information presented in critical audit matters would be the outcome of 
a negotiation process between the auditor and management.
---------------------------------------------------------------------------

    \126\ See Stephen H. Fuller, The Effect of Auditor Reporting 
Choice and Audit Committee Oversight Strength on Management 
Financial Disclosure Decisions (working paper submitted as comment 
letter No. 49, available on the Board's Web site in Docket 034).
---------------------------------------------------------------------------

    Increased management attention to the related aspects of the 
financial statement accounts and disclosures described in the critical 
audit matters should, at least in some cases, lead to an incremental 
increase in the quality of the information presented. Academic research 
has shown that increased quality of information could result in a 
reduction in the average cost of capital.\127\
---------------------------------------------------------------------------

    \127\ See, e.g., Richard A. Lambert, Christian Leuz, and Robert 
E. Verrecchia, Information Asymmetry, Information Precision, and the 
Cost of Capital, 16 Review of Finance 1, 1-29 (2012). Professor Leuz 
is an economic advisor at the PCAOB. The research cited above was 
published before he joined the PCAOB.
---------------------------------------------------------------------------

    In addition, the communication of critical audit matters may 
enhance the audit committee's oversight efforts by providing an 
additional incentive for the audit committee to engage with the auditor 
and management about the matters identified as critical audit matters 
and the adequacy of the company's related disclosures. Although some 
commenters stated that the required communication of critical audit 
matters would ``chill'' communications between the auditor and the 
audit committee, others said that it would enhance communications 
between these parties. Further, it should be noted that the final 
standard does not change the Board's existing requirements on audit 
committee communications, other than requiring the auditor to provide 
the audit committee with a draft of the auditor's report.
    To the extent changes in the behavior of auditors, audit 
committees, and management occur, they could lead to an incremental 
increase in audit quality and financial reporting quality, which should 
increase investors' confidence in the reliability of the financial 
statements. Some commenters stated that a more transparent and 
informative auditor's report could heighten user confidence in the 
audit and the audited financial statements. Academic research suggests 
that an increase in investor confidence should decrease the average 
cost of capital.\128\ As discussed in the economic analysis of the 
reproposal, some empirical studies conducted in other jurisdictions 
provide evidence that expanded auditor reporting increased audit 
quality, while other studies found that it did not have a measurable 
effect on audit quality.\129\ The Board is not aware of any empirical 
studies indicating that expanded auditor reporting had a negative 
effect on audit quality.
---------------------------------------------------------------------------

    \128\ See Luigi Guiso, Paola Sapienza, and Luigi Zingales, 
Trusting the Stock Market, 63 The Journal of Finance 2557, 2557-2600 
(2008). Professor Zingales is the Founding Director of the PCAOB's 
Center for Economic Analysis, now known as the Office of Economic 
and Risk Analysis. The research cited here was published before he 
joined the PCAOB.
    \129\ See PCAOB Release No. 2016-003, Section VI.C.1.b, 
footnotes 154-156 and accompanying text.
---------------------------------------------------------------------------

Indirect Benefit: Differentiation Among Auditor's Reports
    If investors and other financial statement users perceive and 
respond to differences in the quality and usefulness of the information 
communicated by auditors regarding critical audit matters, expanded 
auditor reporting should serve as a potential means of greater 
differentiation among accounting firms and engagement partners.\130\ 
One commenter stated that the reporting of critical audit matters would 
allow auditors to differentiate themselves, and that this 
differentiation would provide useful information to investors and other 
financial statement users. If expanded auditor reporting allows 
investors to differentiate among accounting firms and engagement 
partners, it should provide a more nuanced signal of audit quality and 
financial reporting reliability.
---------------------------------------------------------------------------

    \130\ On May 9, 2016, the SEC approved new rules and related 
amendments to the Board's auditing standards, including amendments 
to AS 3101, that will provide investors and other financial 
statement users with information about engagement partners and other 
accounting firms that participate in audits of issuers. See PCAOB 
Release No. 2015-008.
---------------------------------------------------------------------------

    The FRC report also noted that there are clear differences among 
accounting firms in the approaches taken to implement the 
requirements.\131\ For example, one firm went beyond the FRC's 
requirements by including audit findings for the risks of material 
misstatement in the majority of its auditor's reports in the second 
year of implementation, which other firms did far less frequently. The 
FRC's observations may suggest that accounting firms took different 
approaches to expanded auditor reporting as a means of distinguishing 
themselves based on the quality and usefulness of the information 
provided in their auditor's reports. Furthermore, as discussed in the 
economic analysis of the reproposal, an academic study argued that 
investors found the auditor's reports issued by some accounting firms 
to be more useful than others.\132\ One commenter specifically noted 
that mandatory auditor rotation was introduced in the UK at the same 
time

[[Page 35422]]

as expanded auditor reporting, and that this may have provided 
accounting firms with motivation to differentiate themselves.
---------------------------------------------------------------------------

    \131\ See FRC 2016 report.
    \132\ See PCAOB Release No. 2016-003, Section VI.C.1.b, footnote 
161 and accompanying text.
---------------------------------------------------------------------------

    In addition to relying on the audit committee (which, at least for 
exchange-listed companies, is charged with overseeing the external 
auditor), in the absence of differentiation based on the auditor's 
report, users of financial statements may rely on proxies such as the 
reputation of the accounting firm issuing the auditor's report, 
aggregated measures of auditor expertise (for example, dollar value of 
issuer market capitalization audited or audit fees charged), or 
information about the geographic location of the office where the 
auditor's report was signed as signals for audit quality. Academic 
research finds, however, that these are imperfect signals of audit 
quality.\133\
---------------------------------------------------------------------------

    \133\ See, e.g., Jere R. Francis, A Framework for Understanding 
and Researching Audit Quality, 30 Auditing: A Journal of Practice & 
Theory 125, 125-152 (2011) and Mark DeFond and Jieying Zhang, A 
Review of Archival Auditing Research, 58 Journal of Accounting and 
Economics 275, 275-326 (2014).
---------------------------------------------------------------------------

    The identification and description of critical audit matters should 
permit differentiation among auditor's reports based on investor 
perceptions of their informativeness and usefulness. In some instances 
it may also provide a signal of audit quality. Because the 
determination and communication of critical audit matters may reflect a 
variety of considerations, however, critical audit matters may not bear 
directly on audit quality. For example, the choice of which critical 
audit matters to communicate or how to describe them may reflect 
considerations such as the company's business environment and financial 
reporting choices, accounting firm methodology, engagement partner 
characteristics, and legal advice. Thus, a more detailed description of 
critical audit matters may not necessarily reflect a higher quality 
audit than a less informative description of such matters.
    Nevertheless, informative descriptions of how the audit addressed 
critical audit matters should provide insight into the extent and 
appropriateness of the auditor's work. Moreover, it is possible that 
thoughtful, audit-specific, and useful critical audit matters (or, 
conversely, generic and uninformative critical audit matters) could 
affect investor perceptions of the auditor's work and willingness to 
provide useful information. As a result, the communication of critical 
audit matters, potentially in conjunction with disclosures regarding 
the identity of the engagement partner and other accounting firms that 
participated in the audit,\134\ and other relevant information should 
enable differentiation among engagement partners and accounting firms 
on that basis.
---------------------------------------------------------------------------

    \134\ See PCAOB Release No. 2015-008.
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The final standard will introduce new requirements regarding 
auditor tenure, the addressee of the auditor's report, and statements 
in the auditor's report related to auditor independence and the 
auditor's responsibility for reporting on ICFR.\135\ In addition, the 
final standard contains other changes to the form of the auditor's 
report, which are intended to improve and clarify the language for 
certain elements, such as statements related to the auditor's 
responsibilities regarding the notes to the financial statements, and 
to promote a consistent presentation of this information across 
auditor's reports.
---------------------------------------------------------------------------

    \135\ In circumstances where management is required to report on 
ICFR but the auditor is not and has not performed an audit of ICFR, 
the final standard requires a statement to that effect in the 
auditor's report.
---------------------------------------------------------------------------

    Investor commenters have consistently supported disclosing tenure 
in the auditor's report. In the Board's view, which is consistent with 
the views of some commenters,\136\ disclosing information about auditor 
tenure in the auditor's report will provide a consistent location for 
this information and decrease the search costs, relative to the current 
environment of voluntary reporting, for some investors and other 
financial statement users who are interested in this information.
---------------------------------------------------------------------------

    \136\ See below for a discussion of academic research regarding 
auditor tenure.
---------------------------------------------------------------------------

    The statement regarding the auditor's existing obligation to be 
independent of the company is intended to enhance investors' and other 
financial statement users' understanding about the auditor's 
obligations related to independence and to serve as a reminder to 
auditors of these obligations. By requiring the auditor's report to be 
addressed to certain parties, the Board will be promoting uniformity in 
the addressees of the auditor's report.
    Commenters were generally supportive of the reproposed changes to 
the form of the auditor's report. For example, some commenters stated 
these enhancements would make the auditor's report easier to read and 
would facilitate comparisons between auditor's reports for different 
companies by providing a consistent format.
Costs and Potential Unintended Consequences
Costs
    Commenters on the reproposal raised concerns that the rule would 
impose various types of costs, but generally did not quantify those 
costs. Even those that, at an earlier stage of the rulemaking, 
conducted limited implementation testing of the proposal were unable to 
provide a quantified cost estimate. Given lack of data, the Board is 
unable to quantify costs, but provides a qualitative cost analysis.
    As an additional means of assessing potential cost implications of 
the final standard, PCAOB staff has reviewed data from the first year 
of implementation of expanded auditor reporting in the United 
Kingdom.\137\ As discussed below, staff analyzed a variety of data 
points that may be associated with potential costs, including audit 
fees, days required to issue the auditor's report, and the content of 
the expanded auditor's report. It should be noted that it may be 
difficult to generalize observations from the UK experience. For 
example, the reporting and documentation requirements relating to 
expanded auditor's reports in the United Kingdom differ from those in 
the final standard, the baseline legal environments are different, and 
the UK requirements apply only to companies with a premium listing on 
the London Stock Exchange and not, for example, to smaller companies 
that list on London's AIM market.
---------------------------------------------------------------------------

    \137\ See PCAOB, White Paper on the Auditor's Reports of Certain 
UK Companies that Comply with International Auditing Standard (UK 
and Ireland) 700 (``PCAOB White Paper'') (May 2016), available on 
the Board's Web site in Docket 034.
---------------------------------------------------------------------------

Critical Audit Matters
    The Board anticipates that the final requirements regarding 
critical audit matters will have potential cost implications for 
auditors and companies, including their audit committees. Such costs 
will likely relate to additional time to prepare and review auditor's 
reports, including discussions with management and audit committees, as 
well as legal costs for review of the information provided in the 
critical audit matters. In addition, auditors may choose to perform 
more audit procedures related to areas reported as critical audit 
matters (even though performance requirements have not changed in those 
areas), with cost implications for both auditors and companies.
    For auditors, costs might represent both one-time costs and 
recurring costs. One-time costs could be incurred as a

[[Page 35423]]

result of: (1) Updating accounting firm audit and quality control 
methodologies to reflect the new reporting requirements; and (2) 
developing and conducting training of accounting firm personnel on the 
new reporting requirements. When updating methodologies, some 
accounting firms will likely also develop new quality control processes 
related to additional review or consultation on the determination, 
communication, and documentation of critical audit matters. One 
commenter suggested that the initial implementation costs could place a 
significant and possibly disproportionate burden on smaller accounting 
firms.
    Recurring costs will primarily reflect additional effort expended 
in individual audits. The final standard does not impose new 
performance requirements other than the determination, communication, 
and documentation of critical audit matters, which will be based on 
work the auditor has already performed. However, there will be some 
additional recurring costs associated with drafting descriptions of 
critical audit matters and related documentation. It is likely that 
senior members of the engagement teams, such as partners and senior 
managers, will be involved in determining the critical audit matters 
and developing the language to be included in the auditor's report. In 
addition, reviews by others, such as the engagement quality reviewer 
and national office, will also result in recurring costs. Additional 
time might also be incurred by the auditor as a result of discussions 
with management or the audit committee regarding critical audit 
matters.
    Companies, including audit committees, will likely also incur both 
one-time and recurring costs as a result of the final standard. One-
time costs could be incurred, for example, in educating audit committee 
members about the requirements of the new standard and in developing 
management and audit committee processes for the review of draft 
descriptions of critical audit matters and the related interaction with 
auditors. Recurring costs will include the costs associated with 
carrying out those processes, as well as any increase in audit fees 
associated with the new reporting requirements or legal fees stemming 
from a review of critical audit matter communications.
    If the drafting and review of critical audit matter reporting takes 
place towards the end of the audit, there will also be an opportunity 
cost associated with the time constraints on the parties involved 
(including, for example, management, the engagement partner, the audit 
committee, and the auditor's and company's respective legal counsel). 
The end of the audit is a busy period in which multiple issues may need 
to be resolved before the auditor's report can be issued. At the same 
time, companies and management may also be in the process of finalizing 
the annual report. Time spent drafting and reviewing the communication 
of critical audit matters could occur at the same time as other 
important work in the financial reporting and audit process, and would 
likely involve senior management that command relatively high annual 
salaries or experienced auditors and lawyers with relatively high 
hourly billing rates. In addition, the communication of critical audit 
matters could lead to changes in management's disclosures, which may 
result in more effort and cost in the financial reporting process.
    Several commenters on the reproposal claimed that the required 
reporting of critical audit matters would lead to increased audit fees, 
but none provided data or estimates regarding the magnitude of the 
increases they expected. Commenters on the proposal had differing views 
about the likely magnitude of direct costs associated with auditor 
reporting of critical audit matters. Some commenters said that there 
would not be material additional costs for communication of critical 
audit matters, as these matters would already have been communicated to 
the audit committee. This may suggest that a substantial amount of the 
work required to communicate critical audit matters would already have 
been completed earlier in the audit.
    One commenter argued that the changes described in the reproposal 
would lead to a significant increase in costs, and that no compelling 
case had been made that the benefits would exceed the costs. Some 
commenters noted that investors would be expected to ultimately bear 
the cost of the audit, and these commenters have voiced strong support 
for expanded auditor reporting since the project's inception. This 
suggests that they consider the benefits of expanded auditor reporting 
to justify the costs, and would support additional fees for additional 
useful information.
    Audit fees do not fully reflect the cost of implementing expanded 
auditor reporting to the extent that accounting firms choose to absorb 
those additional costs and because audit fees do not reflect the impact 
of any additional demand on management's time associated with expanded 
auditor reporting. Subject to those limitations, in its review of the 
implementation of expanded auditor reporting in the United Kingdom, the 
PCAOB staff did not find evidence of statistically significant 
increases in audit fees following the first year of expanded auditor 
reporting.\138\ For 53 percent of the companies analyzed, audit fees 
for the year of implementation remained the same or decreased as 
compared to the prior year's audit fees. Audit fees increased for the 
remaining companies. The PCAOB staff found that the average change in 
audit fees was an increase of approximately 5 percent, roughly 
consistent with the findings of academic research described in the 
economic analysis in the reproposal. However, the staff found that the 
median change in audit fees was zero. Collectively, these results seem 
to suggest that outlier companies with relatively large increases in 
audit fees drove the result for the average change in audit fees. It 
should be noted that the PCAOB staff's review did not analyze whether 
other factors, such as inflation, changes in the economic environment 
and corporate risk, corporate acquisitions, or the implementation of 
other regulatory changes, contributed to the documented increase in 
audit fees.
---------------------------------------------------------------------------

    \138\ Id.
---------------------------------------------------------------------------

    One commenter on the reproposal noted that the caveats described 
above are important because the inability to fully gauge the costs of 
expanded auditor reporting could lead the Board to underestimate the 
costs associated with the rule, which may bear disproportionately on 
smaller companies and their auditors. Another commenter also asserted 
that the costs of expanded auditor reporting are likely to be 
disproportionately borne by smaller companies because the reproposed 
rule had, in their estimation, limited scalability. The Board believes 
that the complexity and costs associated with determining, documenting, 
and communicating critical audit matters should generally depend on the 
nature and complexity of the audit. This would in turn depend on the 
complexity of the operations and accounting and control systems of the 
company.
Additional Improvements to the Auditor's Report
    The changes adopted to the basic elements of the auditor's report 
do not represent a significant departure from the reproposal. Some of 
the enhanced basic elements will have cost implications for auditors, 
although these costs are not expected to be significant. One-time costs 
will primarily relate to updating methodology and training and

[[Page 35424]]

the initial determination of the first year the auditor began serving 
consecutively as the company's auditor. Based on comments received, it 
does not appear that the changes adopted to the basic elements will 
impose significant recurring costs, because the year in which tenure 
began will not change and the other amendments involve standardized 
language that, once implemented, will be the same or very similar 
across different auditor's reports every year.
Potential Unintended Consequences
Time Needed To Issue the Auditor's Report
    As a result of the additional effort required to determine, 
communicate, and document critical audit matters, some commenters said 
that it would take auditors longer to issue their reports. On this 
point, the PCAOB staff study did not find evidence that compliance with 
the United Kingdom's expanded auditor reporting requirements delayed 
the issuance of auditor's reports in the first year of implementation. 
Based on the study, for companies that had three years of financial 
statements, a new form auditor's report was issued, on average, in 63 
days from the company's fiscal year end date in the year of 
implementation, as compared to 64 days in the prior year and 65 days 
two years earlier. Further, academic research cited in the economic 
analysis of the reproposal similarly did not find that the UK reporting 
requirements led to delays in financial reporting.\139\
---------------------------------------------------------------------------

    \139\ See PCAOB Release No. 2016-003, section VI.D.2.a, footnote 
169 and accompanying text.
---------------------------------------------------------------------------

Number and Content of Critical Audit Matters
    Some commenters indicated an expectation that the auditor's report 
would include a long list of critical audit matters or that auditors 
would have incentives to communicate an overly long list of critical 
audit matters. For example, some commenters said that this would occur 
because the auditor would be motivated to communicate as much as 
possible in an effort to mitigate any future liability for unidentified 
critical audit matters, or as a means to avoid potential consequences 
of being second-guessed by regulators or others. Other commenters 
asserted that such a development could make the auditor's report overly 
long, contributing to disclosure overload and conflicting with the 
SEC's disclosure effectiveness project. Other commenters indicated that 
expanded auditor reporting could lead to boilerplate language that 
would diminish the expected value of the critical audit matters and 
obscure the clarity of the auditor's opinion. If auditors fail to 
provide audit-specific information, the communication of critical audit 
matters will not decrease information asymmetry about the audit, and 
may obscure other important information included in the auditor's 
report and the audited financial statements.
    The final requirements aim to provide investors with the auditor's 
unique perspective on the areas of the audit that involved the 
auditor's especially challenging, subjective, or complex judgments. 
Limiting critical audit matters to these areas should mitigate the 
extent to which expanded auditor reporting could become standardized. 
Focusing on auditor judgment should limit the extent to which expanded 
auditor reporting could become duplicative of management's reporting. 
Also, while some commenters argued that liability concerns would 
increase the number of critical audit matters auditors communicate, 
others suggested that liability concerns would minimize the additional 
statements auditors make.
    The PCAOB staff study did not find evidence that expanded auditor 
reporting in the United Kingdom resulted in a very large number of risk 
topics or none at all in the first year of implementation.\140\ On 
average, the auditor's reports in the first year of implementation 
included descriptions of four risk topics, with total risk topics 
ranging from one to eight. Additionally, the descriptions of the risks 
of material misstatement in the auditor's reports in the first year of 
implementation were not presented in standardized language, but 
included variations in content length, description, and presentation. 
The most frequently described risk topics related to revenue 
recognition, tax, and goodwill and intangible assets. The FRC report on 
the first two years of expanded auditor reporting in the United Kingdom 
finds a similar range and average number of risk topics disclosed in 
both the first and second year of implementation.\141\ The FRC report 
also finds disclosure of similar risk topics in the second year of 
implementation of expanded auditor reporting in the United 
Kingdom.\142\
---------------------------------------------------------------------------

    \140\ See PCAOB White Paper.
    \141\ See FRC 2016 Report.
    \142\ Id.
---------------------------------------------------------------------------

    Further, the FRC found that, in the second year of expanded auditor 
reporting in the United Kingdom, the discussion of risks has improved 
relative to the first year of implementation and that the majority of 
auditor's reports provided discussion of risks that were more tailored 
to the company under audit, thus avoiding generic or standardized 
wording.\143\ These findings suggest that, thus far, expanded auditor 
reporting has not become standardized in the United Kingdom.\144\
---------------------------------------------------------------------------

    \143\ Id.
    \144\ The Board finds the UK experience instructive, although it 
is, of course, possible that differences between the UK and U.S. 
litigation and regulatory environments may influence the extent to 
which these findings would generalize to the U.S. market.
---------------------------------------------------------------------------

Effects of Increased Attention to Critical Audit Matters
    The communication of critical audit matters could lead auditors, 
company management, and the audit committee to spend additional time 
and resources on reviewing the adequacy of the work performed on the 
related financial statement accounts and disclosures. While this could 
lead to an incremental improvement in audit and financial reporting 
quality for the identified critical audit matters, it is also possible 
that there may be increased costs for auditors as a result of the 
requirements. For example, even though the final standard does not 
mandate the performance of additional audit procedures other than with 
respect to communication of critical audit matters, it is possible that 
some auditors may perform additional procedures. If that occurs, the 
associated costs may be passed on--in whole, in part, or not at all--to 
companies and their investors in the form of higher audit fees. 
Further, increased procedures may also require additional time from the 
company's management to deal with such procedures. Some commenters 
suggested that the increased attention on certain matters could also 
lead to a related decrease in audit and financial reporting quality if 
other material aspects of the financial statements and disclosures 
receive less attention.
    Some commenters argued that including critical audit matters in the 
auditor's report would impair the relationship between auditors and 
management or auditors and the audit committee. Other commenters 
suggested that the required reporting of critical audit matters would 
inhibit communication among the auditor, management, and the audit 
committee because of concerns about what would be publicly communicated 
in the auditor's report. One commenter also suggested that auditors may 
include additional matters in audit committee communications out of 
concern that an

[[Page 35425]]

omission could lead to regulatory sanctions or liability. Other 
commenters have said that it would enhance communication among the 
participants in the financial reporting process.
    An experimental study analyzed how the strength of audit committee 
oversight of the financial reporting process varied with the presence 
of sophisticated investors and knowledge of forthcoming expanded 
auditor reporting.\145\ The author found that study participants, most 
of whom were experienced audit committee members, asked fewer probing 
questions if they knew that the auditor would be providing a discussion 
of the significant accounting estimate in the auditor's report. The 
author argued that by asking fewer probing questions audit committee 
members subconsciously insulated themselves from potential challenges 
mounted by investors regarding the appropriateness of the company's 
financial reporting. The Board is not aware of evidence this has 
occurred in the jurisdictions that have adopted expanded auditor 
reporting. Moreover, it may be difficult in an experimental setting to 
recreate the actual legal responsibility and potential liability that 
audit committee members face, which may limit the extent to which the 
experimental results would generalize to actual behavior in real-world 
settings.
---------------------------------------------------------------------------

    \145\ Yoon Ju Kang, Are Audit Committees More Challenging Given 
a Sophisticated Investor Base? Does the Answer Change Given 
Anticipation of Additional Mandatory Audit Report Disclosure? 
(working paper submitted as comment letter No. 17, available on the 
Board's Web site in Docket 034).
---------------------------------------------------------------------------

    Similarly, as described in the economic analysis of the reproposal 
and asserted by at least one commenter, management may have an 
incentive to withhold information from the auditor in order to prevent 
an issue from being described in the auditor's report. It seems 
unlikely, however, that management would or could withhold information 
from the auditor on the most critical issues in the audit because it 
could result in a scope limitation. On the contrary, it may be just as 
likely that management would communicate more information to the 
auditor as a means of demonstrating that an issue is not challenging, 
subjective, or complex, and, therefore, would not need to be described 
in the auditor's report.
    Under the final standard, critical audit matters are determined 
from the matters communicated or required to be communicated to the 
audit committee. As noted earlier, with respect to any matters already 
required to be communicated to the audit committee, there should not be 
a chilling effect or reduced communications to the audit committee. 
Therefore, it would seem that any chilling effect would relate to 
matters that are not explicitly required to be communicated to the 
audit committee, although, as previously described, given the breadth 
of current communication requirements, the Board believes there will 
likely be few communications affected by that possibility.
Potential Impact on Management Disclosure
    Several commenters stated that the communication of critical audit 
matters would give auditors leverage to encourage disclosure of 
information by management. While some commenters asserted that this 
would be beneficial, others claimed it would be an unintended negative 
consequence of requiring the communication of critical audit matters. 
Several commenters characterized this as inappropriately expanding the 
role of the auditor in the financial reporting process, while 
undermining the role of management and the audit committee. In their 
view, this would be especially problematic if the final standard 
permitted the auditor to communicate information that was not otherwise 
required to be disclosed (for example, because it did not meet a 
specified threshold for disclosure, such as a significant deficiency in 
internal control over financial reporting). Commenters claimed that 
auditor communication of this ``original information'' would cause a 
number of unintended consequences, including significant costs, 
disclosure of confidential or competitively sensitive information, and 
potentially misleading or incomplete information.
    Investors and other commenters pointed out that, although expanded 
auditor reporting would give the auditor additional leverage over 
management's disclosure choices, this could result in improvements in 
the usability of financial statements and increases in financial 
reporting quality. One of these commenters cited academic research 
noting that, in current practice, disclosure is already guided by an 
iterative process between management and the auditor. This commenter 
reasoned that concerns regarding ``original information'' were 
misplaced because the iterative process would reduce the likelihood 
that the auditor would be a source of original information since 
critical audit matters would likely overlap with increased management 
disclosure.
    Another commenter pointed out that auditors would not have 
incentives to interpret the Board's rule to require disclosure of 
original information in most situations. For example, concerns about 
the limitations of their knowledge and expertise, potential liability 
implications, and friction in the relationship with the company are 
likely to discourage auditors from going beyond management disclosures. 
Nevertheless, the final standard contemplates that the auditor will do 
so only when it is necessary to describe the principal considerations 
that led the auditor to determine that a matter was especially 
challenging, subjective, or complex and how the matter was addressed in 
the audit. The Board believes that this provision is needed in order to 
ensure that the fact that management did not provide a disclosure would 
not prevent the auditor from communicating a critical audit matter.
    Although the communication of critical audit matters may lead to 
changes in the incentives for the auditor, company management, and the 
audit committee to communicate with each other, initial anecdotal 
evidence from the Board's outreach activities suggests that the 
implementation of expanded auditor reporting in the United Kingdom has 
not chilled such communications.
Changes in Perceived Assurance on the Auditor's Report, Including 
Perceptions of Auditor Liability
    The communication of critical audit matters could have liability 
implications for auditors. In addition, because the communication of 
critical audit matters requires auditors to discuss aspects of the 
audit that they found to be especially challenging, subjective, or 
complex, it is possible that some investors and financial statement 
users may misconstrue the communications to mean that auditors were 
unable to obtain reasonable assurance about the matters identified as 
critical audit matters. Some commenters have said that the 
communication of critical audit matters could lead to changes in the 
way investors and financial statements users perceive the level of 
assurance provided by the auditor on matters identified as critical 
audit matters, including that it could undermine the basic pass/fail 
opinion. This could lead investors to erroneously conclude that there 
is a problem with the audit either in the areas identified in critical 
audit matters or other areas, or that auditors are providing separate 
assurance about the presentation of the financial statements, which may 
have implications for perceptions of auditor responsibility in the 
event of an audit failure.

[[Page 35426]]

    As discussed in the economic analysis of the reproposal, several 
academic papers analyze certain risks associated with communicating 
critical audit matters, including perception of auditor 
responsibility.\146\ If the communication of critical audit matters 
were to lead to a reduction in perceived auditor responsibility, as is 
suggested by some academic research, and this in turn reduced auditor 
liability, it is possible that auditors may feel that less audit work 
is needed on the matters identified as critical audit matters, which 
could adversely affect audit quality (although the Board's other 
auditing standards, reinforced through firm quality control and Board 
inspections and enforcement activity, should provide a disincentive for 
auditors to decrease the amount or quality of audit work performed). It 
is difficult to draw generalizable conclusions based on the findings of 
these studies. In part, this is because their results vary and are 
sometimes contradictory, with some studies finding that expanded 
auditor reporting increases perceived auditor responsibility and others 
finding that it decreases perceived auditor responsibility. This may 
suggest that the results are sensitive to the experimental design and 
the context in which information is presented to study participants. In 
addition, it is not clear how the findings would correlate with changes 
in auditor behavior, because perceptions of auditor responsibility may 
be a poor proxy for actual auditor responsibility or liability.
---------------------------------------------------------------------------

    \146\ See PCAOB Release No. 2016-003, Section VI.D.2.d, 
footnotes 182-186 and accompanying text.
---------------------------------------------------------------------------

    To address the risk that the communication of critical audit 
matters could result in the perception of separate assurance, the final 
standard requires the following statement in the auditor's report:

    The communication of critical audit matters does not alter in 
any way [the auditor's] opinion on the financial statements, taken 
as a whole, and [the auditor is not] by communicating the critical 
audit matters . . . providing separate opinions on the critical 
audit matters or on the accounts or disclosures to which they 
relate.

The purpose of this statement is to make clear that the communication 
of critical audit matters in an auditor's report should not be 
interpreted as altering the level of assurance on any aspect of the 
audit report, including the identified critical audit matters. In this 
regard, the Board also notes the view of some commenters that critical 
audit matters are likely to be used by institutional investors that are 
unlikely to misinterpret the information.
Auditor Tenure
    Many commenters stated that information regarding the auditor's 
tenure included in the auditor's report could result in inappropriate 
and inconsistent assumptions about correlations between auditor tenure 
and/or independence and audit quality. Academic research on the 
relationship of tenure to audit quality has varied conclusions. For 
instance, some academic research indicates that engagements with short-
term tenure are relatively riskier or that audit quality is improved 
when auditors have time to gain expertise in the company under audit 
and in the related industry.\147\ Other academic research suggests 
that, at least prior to 2001, both short tenure (less than five years) 
and long tenure (greater than fifteen years) can have detrimental 
effects on audit quality.\148\ Still other academic research indicates 
that investors are more likely to vote against, or abstain from, 
auditor ratification as auditor tenure increases, which may suggest 
that investors view long-term auditor-company relationships as 
adversely affecting audit quality.\149\
---------------------------------------------------------------------------

    \147\ See, e.g., Joseph V. Carcello and Albert L. Nagy, Audit 
Firm Tenure and Fraudulent Financial Reporting, 23 Auditing: A 
Journal of Practice & Theory 55, 55-69 (2004) and Timothy B. Bell, 
Monika Causholli, and W. Robert Knechel, Audit Firm Tenure, Non-
Audit Services, and Internal Assessments of Audit Quality, 53 
Journal of Accounting Research 461, 461-509 (2015).
    \148\ See, e.g., Larry R. Davis, Billy S. Soo, and Gregory M. 
Trompeter, Auditor Tenure and the Ability to Meet or Beat Earnings 
Forecasts, 26 Contemporary Accounting Research 517, 517-548 (2009).
    \149\ See, e.g., Mai Dao, Suchismita Mishra, and K. Raghunandan, 
Auditor Tenure and Shareholder Ratification of the Auditor, 22 
Accounting Horizons 297, 297-314 (2008).
---------------------------------------------------------------------------

    The disclosure of auditor tenure is intended to add to the mix of 
information that investors can use. However, commenters other than 
investors did not support disclosure of auditor tenure in the auditor's 
report on the basis that such disclosure would not provide value to 
investors or could result in false conclusions about correlations 
between auditor tenure and audit quality or between auditor tenure and 
auditor independence. Many of these commenters recommended that, if the 
Board determined to require disclosure of auditor tenure, it should be 
disclosed in Form AP rather than in the auditor's report as a means of 
avoiding these inferences.
Alternatives Considered, Including Policy Choices Under the Final 
Standard
    After considering the comments received, the Board is adopting a 
new auditor reporting standard, AS 3101 and related amendments to its 
standards. The final standard retains the pass/fail model while 
expanding auditor reporting to include the communication of critical 
audit matters. Investor commenters have consistently asked for 
additional information in the auditor's report to make it more 
informative about the audit of the company's financial statements.
    As described below, the Board has considered a number of 
alternative approaches to achieve the potential benefits of enhanced 
auditor reporting.
Alternatives Raised by Commenters
Only Cross-Reference to Management's Disclosures
    Some commenters suggested that, instead of communicating critical 
audit matters as reproposed, auditors should only identify the critical 
audit matters and provide a cross-reference to management disclosures 
(i.e., not describe the principal considerations that led the auditor 
to determine a matter is a critical audit matter or how it was 
addressed in the audit), or refer to or list critical accounting 
policies and estimates as disclosed by management. The Board believes 
that communicating the principal considerations that led the auditor to 
determine that a matter is a critical audit matter and how it was 
addressed in the audit will provide useful information beyond simply 
referencing existing management disclosure, and is more responsive to 
investor requests for more information from the auditor's perspective.
Auditor Association With Other Company Disclosures
    Other commenters suggested more specific auditor assurance on 
particular management disclosures, such as inclusion of a statement in 
the auditor's report that the audit included evaluation of the 
accounting policies and significant estimates, with a cross-reference 
to management's disclosures, or a statement of auditor concurrence with 
the critical accounting policies and estimates of the company. One 
commenter suggested that audit committees should disclose critical 
audit matters with a corresponding confirmation from the independent 
auditor.
    Several commenters on the proposal also suggested that the Board 
should consider auditor association with, or attestation on, portions 
of MD&A, specifically management's critical accounting policies and 
estimates, as an alternative to expanded auditor reporting. These 
commenters have

[[Page 35427]]

argued that such an association could increase the quality and 
reliability of the information subject to the procedures.
    Some commenters on the concept release, including investors, said 
that they were not supportive of separate assurance by the auditor on 
information outside of the financial statements as an alternative to 
expanded auditor reporting, primarily because the related auditor 
reporting would have appeared in a standardized form and would not 
provide audit-specific information. Requiring such reporting might 
necessitate action by the SEC, as well as the PCAOB, to implement, 
including new SEC rules regarding management reporting and auditor 
attestation. In addition to reporting requirements, the PCAOB might 
have to develop new performance requirements and auditors would be 
required to undertake additional audit work in order to provide 
attestation in these areas.
    Based on concerns about the complexity of such an approach, as well 
as the comments received as to its limited benefits, the Board 
determined not to pursue auditor association with portions of MD&A as 
an alternative to expanded auditor reporting at this time. The Board 
believes that this approach would fail to deliver the audit-specific 
information requested by investors, while also raising potential 
concerns about separate assurance on the identified matters.
No Change to Auditor Reporting Requirements
    The Board considered whether changes to the existing auditor 
reporting requirements were needed. Auditor reporting under the current 
model has been criticized by many commenters as providing limited 
information. Auditors have not voluntarily provided more information in 
the auditor's report in response to investors' requests. A number of 
factors described above, such as potential costs and uncertainties 
related to voluntary auditor reporting and the potential for auditor 
status quo bias, may explain why voluntary reporting would not be 
expected to become prevalent. These factors suggest that voluntary 
reporting, with or without guidance to encourage it, could also create 
uncertainty about the content of auditor's reports because auditors 
would be able to choose whether to provide information about the audit, 
what information to provide, and the form in which to provide it. On 
that basis, the Board believes that standard setting is appropriate.
Consideration of Analogous Requirements of Other Regulators and 
Standard Setters
    In developing the final standard, the Board took into account the 
requirements for expanded auditor reporting of other regulators and 
standard setters, such as the IAASB, the FRC, and the EU. Changes to 
the auditor's report that other regulators and standard setters have 
adopted include some commonality, such as communicating information 
about audit-specific matters in the auditor's report. Several 
commenters suggested that the Board align its requirements for expanded 
auditor reporting more closely with the requirements of the IAASB to 
provide more consistent global auditor reporting requirements.
    However, the Board recognizes that the regulatory environments in 
other jurisdictions are different from the United States, requiring the 
Board to address unique U.S. requirements and characteristics in its 
standard-setting projects. Because the Board's standards have the force 
of law, the Board aims to make them as clear and easy to apply as it 
can. For example, the factors that the auditor considers in determining 
whether a matter involved especially challenging, subjective, or 
complex auditor judgment are included in the standard; by contrast, 
while the IAASB approach includes similar factors, they appear in the 
application and other explanatory material.
    In addition, there are differences between requirements and 
terminology of the Board's auditing standards and those of other 
regulators and standard setters that may cause inconsistent 
application, even if the Board were to adopt the approach of another 
standard setter. For example, the Board's requirements for 
communications to the audit committee are not identical to the 
analogous requirements of the IAASB. Therefore, although both critical 
audit matters and the IAASB's key audit matters are derived from such 
communications, the matters ultimately discussed with the audit 
committee under each framework would not necessarily be the same, which 
could result in differences in which matters are reported even if the 
language in the auditor reporting standards were identical. Also, the 
component of the definition of critical audit matter in the final 
standard, namely ``matters that involve especially challenging, 
subjective, or complex auditor judgment'' grounds the definition in the 
auditor's expertise and judgment. Although the processes of identifying 
these matters vary across jurisdictions, there are commonalities in the 
underlying criteria regarding matters to be communicated and the 
communication requirements, such that expanded auditor reporting could 
result in the communication of many of the same matters under the 
various approaches.
Auditor Assessment and Descriptions of Certain Financial Statement 
Areas
    Several commenters on the concept release suggested that investors 
would be most interested in auditor reporting on the categories of 
information identified by investor respondents to the 2011 survey 
conducted by a working group of the IAG: (1) Significant management 
estimates and judgments made in preparing the financial statements and 
the auditor's assessment of them; (2) areas of high financial statement 
and audit risk; (3) unusual transactions, restatements, and other 
significant changes in the financial statements; and (4) the quality, 
not just the acceptability, of the company's accounting practices and 
policies.\150\ This request was reiterated by several commenters on the 
proposal, who continued to believe that this approach would provide the 
information investors want most. In a similar vein, other commenters on 
the reproposal have requested that the auditor provide a ``grade'' on 
management's significant accounting estimates and judgments.
---------------------------------------------------------------------------

    \150\ See IAG 2011 survey.
---------------------------------------------------------------------------

    The Board believes that the final critical audit matter definition 
will likely cover many of the topic areas requested by investors. For 
example, the auditor may communicate critical audit matters related to 
significant management estimates and judgments, highlight areas of high 
financial statement and audit risk, and discuss significant unusual 
transactions. However, the auditor will not be required to report on 
its assessment of management's significant estimates and judgments or 
on the quality (as opposed to merely the acceptability), of the 
company's accounting practices and policies or of the financial 
statements as a whole.
    The final standard seeks to strike an appropriate balance between 
the value of the information being provided and the costs of providing 
it. Requiring auditors to report their qualitative assessments in a 
manner that appears very precise (for example, describing an estimate 
as ``conservative'' or ``aggressive'' or assigning the financial 
statements an ``A'' or a ``B'') may impose significantly greater costs 
and unintended consequences than the

[[Page 35428]]

principles-based reporting of critical audit matters. For example, 
although the reporting of qualitative assessments would appear to be 
precise, these qualitative assessments are likely to be applied 
inconsistently because there is no framework for such assessments and 
the determinations are inherently subjective. In addition, such 
assessments may heighten concerns related to the perceived level of 
assurance provided by the audit or the perception that separate 
assurance is being provided as to the assessed areas. Also, the 
reporting of such qualitative assessments may subject auditors and 
companies to additional litigation risk beyond what may result from the 
principles-based reporting of critical audit matters because the 
apparent precision of the reporting may facilitate plaintiffs' claims.
Policy Choices
Definition of Critical Audit Matters
    The Board considered a variety of possible approaches to the 
definition of critical audit matters suggested by commenters. See above 
for a discussion of the Board's considerations of the final standard.
Communication of Critical Audit Matters
    The Board considered a variety of possible approaches to the 
communication requirements for critical audit matters. See above for a 
discussion of the Board's considerations of the final standard.
Auditor Tenure
    The final standard retains the reproposed requirement to include a 
statement in the auditor's report about auditor tenure.
    In the reproposal, the Board solicited comment on whether 
disclosure of auditor tenure should be made on Form AP instead of in 
the auditor's report. Form AP was developed as a means to address 
commenter concerns about the potential liability implications of naming 
persons in the auditor's report. Because the disclosure of auditor 
tenure does not have the same potential liability consequences, such an 
approach is unnecessary in this case. In addition, some commenters 
preferred tenure disclosure on Form AP because of a concern that 
disclosure in the auditor's report could result in inappropriate 
inferences about correlations between auditor tenure and audit quality, 
or between auditor tenure and auditor independence. The Board is not 
persuaded by such concerns. Further, the final standard allows the 
auditor flexibility in the location of the auditor tenure disclosure in 
the auditor's report.
    The Board determined that disclosure will be better achieved 
through the auditor's report because the information will be more 
readily accessible upon the filing with the SEC of a document 
containing audited financial statements and poses lower search costs, 
particularly for those investors who may prefer to have the information 
provided in the auditor's primary means of communication. In addition, 
disclosing tenure in the auditor's report will make information 
available earlier to investors, which may assist in their voting on 
auditor ratification. However, disclosing auditor tenure in the 
auditor's report rather than Form AP could result in higher costs to 
investors that wish to accumulate tenure data for a large number of 
companies or compare data across companies because these investors will 
have to acquire tenure data from each company's auditor's report 
separately or from a data aggregator.
Additional Improvements to the Auditor's Report
    The final standard includes a number of requirements that will 
enhance the standardized content of the auditor's report by clarifying 
the auditor's role and responsibilities related to the audit of the 
financial statements. These include, for example, statements regarding 
auditor independence requirements and the addition of the phrase 
``whether due to error or fraud,'' when describing the auditor's 
responsibility under PCAOB standards to obtain reasonable assurance 
about whether the financial statements are free of material 
misstatements. In addition, the final standard includes requirements 
intended to promote uniformity in the form of the auditor's report. 
These include requirements as to the addressee, a specific order of 
certain sections of the auditor's report, and required section 
headings.
    Many commenters generally supported these enhancements and 
suggested that such enhancements will increase the usability of the 
auditor's report by improving financial statement users' understanding 
of the auditor's responsibilities, reducing search costs for 
information in the auditor's report, and facilitating comparisons 
across auditor's reports.
Applicability of Critical Audit Matter Requirements
Brokers and Dealers, Investment Companies, and Benefit Plans
    The reproposed standard did not require communication of critical 
audit matters for audits of brokers and dealers reporting under 
Exchange Act Rule 17a-5, investment companies other than business 
development companies (``BDCs''), and benefit plans. The reproposing 
release described the Board's rationale, including economic 
considerations, for such exclusions from the critical audit matter 
requirements and noted that auditors of these entities would not be 
precluded from including critical audit matters in the auditor's report 
voluntarily.
    Commenters generally supported these exclusions, pointing to the 
same or similar reasons to those described by the Board in the 
reproposing release. Some commenters asserted that the communication of 
critical audit matters should apply to all companies. One commenter 
supported voluntary communication of critical audit matters for the 
exempted entities. Another commenter disagreed with providing auditors 
the ability to voluntarily communicate critical audit matters for 
brokers and dealers and investment companies. This commenter also 
suggested that all broker-dealers, including broker-dealers that are 
issuers, should be excluded from the requirement.
    After considering the comments received and evaluating benefits and 
costs, the final standard excludes the audits of brokers and dealers 
that are reporting under Exchange Act Rule 17a-5, investment companies 
other than BDCs, and benefit plans, from the critical audit matter 
requirements as reproposed.\151\ Auditors of these entities may choose 
to include critical audit matters in the auditor's report voluntarily.
---------------------------------------------------------------------------

    \151\ The other requirements of the final standard will be 
applicable to audits of these entities.
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    The Board's rationales for these exclusions are described below.
Brokers and Dealers Reporting Under Exchange Act Rule 17a-5
    Pursuant to Exchange Act Rule 17a-5, the annual reports that 
brokers and dealers file with the SEC are public, except that if the 
statement of financial condition in the financial report is bound 
separately from the balance of the annual report, the balance of the 
annual report is deemed confidential and nonpublic.\152\ In this 
situation, the

[[Page 35429]]

auditor would generally issue two separate auditor's reports that would 
have different content: (1) An auditor's report on the statement of 
financial condition that would be available to the public and (2) an 
auditor's report on the complete financial report that, except as 
provided in paragraph (c)(2)(iv) of Exchange Act Rule 17a-5, would be 
confidential and not available to the public.\153\ Research by the 
PCAOB's Office of Economic and Risk Analysis (``ERA'') \154\ indicates 
that, for approximately half of brokers and dealers, the complete 
financial report and the related auditor's report are confidential and 
not available to the public.
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    \152\ See Exchange Act Rule 17a-5(e), 17 CFR 240.17a-5(e).
    \153\ See also Exchange Act Rule 17a-5(c)(2), 17 CFR 240.17a-
5(c)(2), regarding audited statements required to be provided to 
customers.
    \154\ ERA's research was conducted on brokers and dealers who 
filed financial statements through May 15, 2015, for fiscal years 
ended during 2014 that included audit reports issued by firms 
registered with the PCAOB.
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    In 2013, the Board adopted new standards related to brokers and 
dealers that enhanced the auditor's performance and reporting 
responsibilities for financial statement audits, as well as engagements 
on compliance and exemption reports of brokers and dealers.\155\
---------------------------------------------------------------------------

    \155\ See Attestation Standards for Engagements Related to 
Broker and Dealer Compliance or Exemption Reports Required by the 
U.S. Securities and Exchange Commission and Related Amendments to 
PCAOB Standards, PCAOB Release No. 2013-007 (Oct. 10, 2013) and 
Auditing Standard No. 17, Auditing Supplemental Information 
Accompanying Audited Financial Statements and Related Amendments to 
PCAOB Standards, PCAOB Release No. 2013-008 (Oct. 10, 2013).
---------------------------------------------------------------------------

    Some commenters on the proposal asserted that the value of 
reporting critical audit matters for brokers and dealers would be 
significantly limited by the closely held nature of brokers and 
dealers; the limited number of users of their financial statements; and 
the fact that, in many cases, only the statement of financial condition 
is available publicly. Some commenters also recognized that both the 
SEC and PCAOB recently updated their rules to further enhance reporting 
by brokers and dealers and their auditors.
    Research by ERA indicates that currently there are no brokers or 
dealers that are issuers. Rather, brokers and dealers are often owned 
by a holding company, an individual, or a group of individuals that 
holds a controlling interest. The owners of brokers and dealers are 
generally part of the management of the entity and therefore would have 
direct access to the auditor. Given that, in many cases, there is much 
less separation of ownership and control in brokers and dealers than in 
issuers, the communication of critical audit matters would provide 
little information about the audit that would otherwise be unobtainable 
by investors.
    Although there may be circumstances in which other financial 
statement users may benefit from reduced information asymmetry about 
the audits of brokers and dealers, certain aspects of broker and dealer 
financial reporting may limit the benefits of requiring the 
communication of critical audit matters. For example, while other 
financial statement users, such as customers of brokers and dealers, 
may benefit from increased information about the audit, the ability for 
brokers and dealers to file certain financial statements and schedules 
confidentially would require the auditor to identify and communicate 
critical audit matters that apply only to the publicly available 
statement of financial condition. This may reduce the value of 
communicating critical audit matters for brokers and dealers relative 
to issuers. Moreover, customers of brokers and dealers may be 
interested in the overall financial position of the broker or dealer 
but may not benefit from audit-specific information in the same way as 
investors in an issuer.
    The communication of critical audit matters may also impose 
additional costs on the auditors of brokers and dealers relative to the 
auditors of other types of companies, as they would have to identify 
critical audit matters that apply exclusively to the publicly available 
financial information, which may be difficult in some situations.
    After consideration of the ownership and reporting characteristics 
of brokers and dealers, the comments received on the proposal and 
reproposal, and the Board's recent standard-setting activities related 
to brokers and dealers, the Board does not believe that reporting of 
critical audit matters for brokers and dealers will provide meaningful 
information in the same way as for issuers. Therefore, the 
communication of critical audit matters is not required for audits of 
brokers and dealers reporting under Exchange Act Rule 17a-5. If a 
broker or dealer were an issuer required to file audited financial 
statements under Section 13 or 15(d) of the Exchange Act, the 
requirements would apply.
Investment Companies
    The Investment Company Act generally defines an investment company 
as any issuer that is engaged primarily in the business of investing, 
reinvesting, or trading in securities.\156 \Most investment companies 
registered under the Investment Company Act are required to file with 
the SEC annual reports on Form N-CSR containing audited financial 
statements.\157\ The Investment Company Act includes specific 
requirements for investment companies, intended to reduce investors' 
risks, in areas such as an investment company's portfolio 
diversification, liquidity, leverage, and custody of securities.\158\
---------------------------------------------------------------------------

    \156\ See Section 3(a)(1) of the Investment Company Act.
    \157\ See SEC Rules under Section 30(e) of the Investment 
Company Act.
    \158\ See, e.g., Sections 12, 13, and 17 of the Investment 
Company Act.
---------------------------------------------------------------------------

    In an SEC rulemaking, the SEC observed that commenters believed the 
key information that investors use in deciding to invest in an 
investment company includes an investment company's investment 
objectives, strategies, risks, costs, and performance.\159 \The 
disclosure of information about these items appears in the annual 
prospectus that investment companies provide to current and future 
investors.\160 \Changes to investment objectives and strategies require 
shareholder approval or disclosure.\161\
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    \159\ See SEC, Enhanced Disclosure and New Prospectus Delivery 
Option for Registered Open-End Management Investment Companies, 
Securities Act Release No. 8998, 74 FR 4546 (Jan. 26, 2009). See 
also Investment Company Institute, Understanding Investor 
Preferences for Mutual Fund Information (Aug. 2006) at 2-3.
    \160\ See SEC Rules under Section 30(e) of the Investment 
Company Act.
    \161\ See Sections 8(b) and 13(a)(3) of the Investment Company 
Act and Investment Company Act Rule 8b-16.
---------------------------------------------------------------------------

    Several commenters on the proposal noted that an investor's 
decision to invest in an investment company is primarily based on the 
investment objectives, risks, performance, and fees, and critical audit 
matters are not expected to provide information about these items and 
therefore would not be relevant. These and other commenters generally 
stated that investment companies are designed for the sole purpose of 
trading in and holding investments and auditor judgment would arise 
primarily with respect to valuation of investments, which would tend to 
be repeated as a critical audit matter. One of these commenters noted 
that, since the strategies of investment companies do not change 
significantly over time, the critical audit matters identified could 
become standardized from one reporting period to the next and also 
across funds with similar objectives.
    Even though the disclosures required under the Investment Company 
Act and

[[Page 35430]]

other federal securities laws provide investors with useful 
information, they may not fully substitute for the communication of 
critical audit matters. The required communication of critical audit 
matters contemplates that auditors would provide investors with audit-
specific information, which is unlikely to appear in the disclosures 
provided by management. In addition, some academic research documented 
a difference in the perceived usefulness and reliability of information 
depending on the location of the disclosure and whether it was 
disclosed by management or by the independent auditor.\162\This 
academic research suggests that the auditor's communication of 
information similar to critical audit matters may provide value to 
investors because it comes from the auditor, even if the same 
information is disclosed by management in the experimental design of 
the study.
---------------------------------------------------------------------------

    \162\ See, e.g., Christensen et al., Do Critical Audit Matter 
Paragraphs in the Audit Report Change Nonprofessional Investors' 
Decision to Invest?
---------------------------------------------------------------------------

    The benefits of providing critical audit matters, however, may be 
smaller for investment companies, other than BDCs, relative to other 
types of companies because of their purpose and structure. Unlike 
companies whose business models can change over time, investment 
companies have specific investment mandates that are disclosed in the 
prospectus and rarely change. This creates the potential for critical 
audit matters of investment companies to become excessively repetitive, 
making them uninformative.
    There may also be additional costs of applying critical audit 
matter requirements to audits of investment companies, other than BDCs, 
as compared to audits of other types of companies. For example, in some 
cases, annual shareholder reports of affiliated investment companies 
with the same fiscal year-end might be filed with the SEC in one 
document, which generally contains a single auditor's report that 
covers multiple audited investment companies. In these situations, 
communicating critical audit matters specific to each investment 
company may require the auditor to prepare separate auditor's reports. 
This could increase costs for these types of investment companies.
    After consideration of the purpose and reporting characteristics of 
investment companies and the comments received on the proposal and 
reproposal, the Board has determined not to require the communication 
of critical audit matters for audits of most investment companies, 
although they will apply to audits of investment companies regulated as 
BDCs.\163\ Unlike the audits of many other investment companies, 
auditing the valuation of BDCs' investments generally involves 
complexity and auditor judgments due to the nature of the BDCs' 
portfolios. Also, because of the more diverse operations of BDCs, such 
as providing managerial assistance and involvement with more complex 
debt and equity instruments than other investment companies, 
communication of critical audit matters in a BDC audit could be more 
informative to investors. Additionally, BDCs follow a reporting regime 
under the Exchange Act that is more closely aligned with that of 
companies to which the Board is applying the requirements for critical 
audit matters. For these reasons, the Board believes it is appropriate 
for audits of BDCs to be subject to critical audit matter requirements.
---------------------------------------------------------------------------

    \163\ See Section 54 of the Investment Company Act.
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Benefit Plans
    Benefit plans that purchase and hold securities of the plan sponsor 
using participants' contributions are generally required to file with 
the SEC an annual report on Form 11-K \164\ that includes the benefit 
plan's audited financial statements and the related auditor's 
report.\165\ The audit of the financial statements included in a filing 
on Form 11-K is performed in accordance with the standards of the 
PCAOB. Benefit plans are also generally subject to the financial 
reporting requirements of the Employee Retirement Income Security Act 
of 1974 (``ERISA''), including the U.S. Department of Labor's (``DOL'') 
rules and regulations for disclosure under ERISA.\166\
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    \164\ See Section 15(d) of the Exchange Act.
    \165\ A benefit plan's audited financial statements may also be 
included as part of the annual report of the issuer sponsoring the 
benefit plan. See Exchange Act Rule 15d-21, CFR 240.15d-21.
    \166\ ERISA Section 103(a)(3)(A) requires a plan administrator 
to engage an independent auditor to conduct an examination of the 
plan's financial statements and required schedules in accordance 
with generally accepted auditing standards. See 29 CFR 2520.103-1. 
Benefit plans subject to ERISA also file with the DOL an annual 
report on Form 5500, including audited financial statements and an 
auditor's report. See also FASB ASC 960-10-05-6.
---------------------------------------------------------------------------

    Participation in a benefit plan is limited to eligible employees of 
the plan sponsor. Each plan participant in a defined contribution 
benefit plan is responsible for selecting, from the investment options 
made available by the plan sponsor, the specific investments in which 
the participant's funds are invested.
    Employee stock benefit plans are generally less complex than other 
types of companies because they are designed for the sole purpose of 
holding the plan's investments for the participants' benefit. A plan's 
financial statements reflect summary information about the plan's 
assets and liabilities by aggregating the balances of all plan 
participants. However, only the individual account statements that plan 
participants receive periodically provide information specific to each 
participant's investments.
    Several commenters on the proposal suggested excluding audits of 
benefit plans from the requirement for reporting critical audit matters 
due to the unique characteristics of these entities and their 
differences from other types of companies. For example, some commenters 
indicated that benefit plans are designed for a specific purpose and, 
as a result, would likely have similar critical audit matters from one 
reporting period to the next. Other commenters noted that benefit plans 
are inherently less complex and entail fewer estimates and judgments.
    The communication of critical audit matters could provide 
information about any complex issues that were identified during the 
audit and how the auditor addressed them. However, since a benefit 
plan's assets and liabilities aggregate the balances of all plan 
participants, the financial statements or related critical audit 
matters would not provide actionable information about a plan 
participant's specific investment. Further, given the nature of benefit 
plans, there is a chance that the same critical audit matters would be 
communicated each year. For example, the valuation of investments is 
likely to be the most complex area in the audit of a benefit plan and 
therefore may be a critical audit matter in each reporting period, 
making the information less useful.
    After consideration of the structure and reporting characteristics 
of benefit plans and the comments received on the proposal and 
reproposal, the Board has determined not to require the communication 
of critical audit matters for audits of benefit plans.
Smaller Companies
    The reproposal sought comment on whether the critical audit matter 
requirements should not apply to audits of other types of companies, in 
addition to the exempted entities discussed above. Some commenters 
asserted that the communication of critical audit matters should apply 
to all companies. Other commenters recommended that the Board give 
consideration to not applying the critical audit matter requirements to 
audits of smaller

[[Page 35431]]

reporting companies \167\ and nonaccelerated filers \168\ due to their 
smaller size and because, in the commenters' view, communication of 
critical audit matters would not provide sufficient benefits for these 
companies to justify the costs.
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    \167\ In general, a ``smaller reporting company'' means an 
issuer with less than $75 million in public float or zero public 
float and annual revenues of less than $50 million during the most 
recently completed fiscal year for which audited financial 
statements are available. See Exchange Act Rule 12b-2, 17 CFR 
240.12b-2. Smaller reporting companies currently make up 
approximately 42 percent of Form 10-K filers. The SEC recently 
proposed changes to the definition of smaller reporting companies, 
which would increase the percentage of smaller reporting companies 
to approximately 52 percent of Form 10-K filers. See SEC, Amendments 
to Smaller Reporting Company Definition, Release No. 33-10107 (June 
27, 2016), 81 FR 43130 (July 1, 2016).
    \168\ Nonaccelerated filers are not defined in SEC rules but are 
generally understood to be companies that do not meet the definition 
of large accelerated filer or accelerated filer.
---------------------------------------------------------------------------

    Academic research suggests that smaller companies have a higher 
degree of information asymmetry relative to the broader population of 
companies. Although the degree of information asymmetry surrounding a 
particular issuer is unobservable, researchers have developed a number 
of proxies that are thought to be correlated with information 
asymmetry, including small issuer size, lower analyst coverage, larger 
insider holdings, and higher research and development costs.\169\ To 
the extent that a smaller company can be characterized as exhibiting 
one or more of these properties, this may suggest that it has a greater 
degree of information asymmetry relative to the broader population of 
companies. This would suggest that there is a higher likelihood that 
critical audit matters could provide new information about a smaller 
company than a large one for which there already exists a variety of 
information sources (such as annual reports, news media, and analyst 
research reports).
---------------------------------------------------------------------------

    \169\ See, e.g., David Aboody, and Baruch Lev, Information 
Asymmetry, R&D, and Insider Gains, 55 The Journal of Finance 2747, 
2747-2766 (2000), Michael J. Brennan and Avanidhar Subrahmanyam, 
Investment Analysis and Price Formation in Securities Markets, 38 
Journal of Financial Economics 361, 361-381 (1995), Varadarajan V. 
Chari, Ravi Jagannathan, and Aharon R. Ofer, Seasonalities in 
Security Returns: The Case of Earnings Announcements, 21 Journal of 
Financial Economics 101, 101-121 (1988), and Raymond Chiang, and 
P.C. Venkatesh, Insider Holdings and Perceptions of Information 
Asymmetry: A note, 43 The Journal of Finance 1041, 1041-1048 (1988).
---------------------------------------------------------------------------

    After consideration of comments, academic research, and data 
regarding the number of such companies, the final standard does not 
exclude smaller companies from the critical audit matter requirements. 
However, as discussed below, the Board has determined that it is 
appropriate to give auditors of smaller companies additional time to 
implement the new requirements. If approved by the SEC, auditors of 
companies that are not large accelerated filers will have an additional 
18 months to implement the requirements for critical audit matters and 
will be able to benefit from the experiences of auditors of larger 
companies.
Requirements of Other Regulators and Standard Setters
    Under the IAASB's standard, the communication of key audit matters 
applies to listed entities.\170\ The EU requirements apply to audits of 
PIEs, including listed companies, credit institutions, and insurance 
companies.\171\ The FRC 2013 requirements apply to auditor's reports 
for entities that apply the UK Corporate Governance Code.\172\
---------------------------------------------------------------------------

    \170\ See paragraph 5 of ISA 701.
    \171\ See requirements in 1 of Article 2, Audit Report of 
Regulation (EU) No 537/2014.
    \172\ These include companies with a premium listing of equity 
shares on the London Stock Exchange regardless of whether they are 
incorporated in the U.K. or elsewhere.
---------------------------------------------------------------------------

Considerations for Audits of Emerging Growth Companies
    Section 104 of the Jumpstart Our Business Startups (``JOBS'') Act 
imposes certain limitations with respect to application of the Board's 
standards to audits of EGCs, as defined in Section 3(a)(80) of the 
Exchange Act. Section 104 provides that ``[a]ny rules of the Board 
requiring . . . a supplement to the auditor's report in which the 
auditor would be required to provide additional information about the 
audit and the financial statements of the issuer (auditor discussion 
and analysis) shall not apply to an audit of an emerging growth company 
. . .'' \173\ Auditor discussion and analysis (``AD&A'') does not exist 
in auditing standards. The idea was introduced in the concept release, 
which described AD&A as one of several conceptual alternatives for 
changing the auditor's reporting model.\174\
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    \173\ See Public Law 112-106 (Apr. 5, 2012). See Section 
103(a)(3)(C) of Sarbanes-Oxley, as added by Section 104 of the JOBS 
Act.
    \174\ See PCAOB Release No. 2011-003 (June 21, 2011) at 2 
(describing one alternative as ``a supplement to the auditor's 
report in which the auditor would be required to provide additional 
information about the audit and the company's financial statements 
(an `Auditor's Discussion and Analysis') ''). Section IV.A., 
Auditor's Discussion and Analysis, of the proposal further described 
AD&A and related comments received on the concept release.
---------------------------------------------------------------------------

    Section 104 of the JOBS Act further provides that any additional 
rules adopted by the Board subsequent to April 5, 2012, do not apply to 
the audits of EGCs unless the SEC ``determines that the application of 
such additional requirements is necessary or appropriate in the public 
interest, after considering the protection of investors, and whether 
the action will promote efficiency, competition, and capital 
formation.'' \175\ As a result of the JOBS Act, the final standard and 
amendments are subject to an evaluation as to whether they could, and 
if so, should be applicable to the audits of EGCs.
---------------------------------------------------------------------------

    \175\ See Section 103(a)(3)(C) of Sarbanes-Oxley.
---------------------------------------------------------------------------

Critical Audit Matters
    The reproposal solicited comment on the application of critical 
audit matter requirements to the audits of EGCs. Commenters on this 
issue generally favored applying the standard to audits of EGCs, 
primarily because investors in these companies would benefit from the 
additional information communicated in the auditor's report in the same 
way that investors in larger companies would. Two commenters 
recommended that the critical audit matter requirements not apply to 
audits of EGCs because there would not be sufficient benefits to 
justify the costs.
    Three commenters addressed the legal question of whether the JOBS 
Act provision on AD&A would prohibit the Board from applying critical 
audit matter requirements to audits of EGCs. Two of these commenters 
suggested that this would be prohibited, on the basis that critical 
audit matters ``appear substantively similar to'' \176\ or ``closely 
resemble'' \177\AD&A. The SEC's Investor Advocate stated that, from a 
policy perspective, critical audit matter requirements should apply to 
audits of EGCs, and recommended that the PCAOB adopt the standard for 
policy reasons and let the SEC determine the legal question.\178\ This 
commenter also recommended that, ``to prepare for any outcome of the 
SEC's determination,'' the PCAOB should encourage auditors, on a 
voluntary basis, to include critical audit matter communications in the 
auditor's reports on EGCs.'' \179\
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    \176\ See letter from the U.S. Chamber of Commerce, Center for 
Capital Markets Competitiveness (Aug. 15, 2016) at 10, available on 
the Board's Web site in Docket 034.
    \177\ See letter from Robert N. Waxman (Aug. 15, 2016) at 24, 
available on the Board's Web site in Docket 034.
    \178\ See letter from Rick A. Fleming, Investor Advocate, SEC 
(Aug. 15, 2016) at 5-6, available on the Board's Web site in Docket 
034 (noting that ``the SEC will need to make a legal determination 
on whether such a requirement with respect to the audits of EGCs 
would accord with certain provisions of'' the JOBS Act).
    \179\ 179 Id. at 6.
---------------------------------------------------------------------------

    The requirements for critical audit matters share characteristics 
with two of

[[Page 35432]]

the alternative approaches described in the concept release: Required 
and expanded explanatory paragraphs and AD&A. Similar to critical audit 
matters, required and expanded explanatory paragraphs involved 
additional paragraphs in the auditor's report that would have 
highlighted areas of critical importance to the financial statements, 
with auditor comment on key audit procedures and a reference to 
relevant financial statement accounts and disclosure. AD&A, by 
contrast, envisioned a supplemental report in addition to the auditor's 
report that could cover a broad range of issues, including the 
auditor's views regarding the company's financial statements, material 
matters as to which the auditor believed disclosure could be enhanced, 
and areas where management could have applied different accounting or 
disclosure approaches.
    However, critical audit matters go beyond the content of a required 
and expanded explanatory paragraph by including a discussion of the 
principal reasons the auditor determined that a matter was a critical 
audit matter. Further, although this is not required, critical audit 
matters could potentially include a discussion of auditor findings. 
These additional elements may make critical audit matters resemble AD&A 
in some respects. This potential similarity, together with the fact 
that there has been no authoritative interpretation of Section 104 of 
the JOBS Act, creates some uncertainty as to whether it is legally 
permissible for critical audit matter requirements to be mandated for 
EGC audits. In view of this uncertainty, the Board has determined not 
to apply the requirements regarding critical audit matters to audits of 
EGCs at this time.
    As with other audits where critical audit matter requirements do 
not apply, voluntary application is permissible. EGCs and their 
auditors can consider whether investors would benefit from additional 
information about the audit from the auditor's point of view.
Additional Improvements to the Auditor's Report
    The additional improvements to the auditor's report contained in 
the final standard and amendments do not raise concerns under the AD&A 
provisions of the JOBS Act, but instead fall within the category of 
``additional rules'' that may not be applied to audits of EGCs unless 
the SEC determines that doing so ``is necessary or appropriate in the 
public interest, after considering the protection of investors, and 
whether the action will promote efficiency, competition, and capital 
formation.'' The Board is providing this analysis to assist the SEC in 
making this determination.
    To inform consideration of the application of auditing standards to 
audits of EGCs, the staff has also published a white paper that 
provides general information about characteristics of EGCs.\180\ The 
data on EGCs outlined in the white paper remains generally consistent 
with the data discussed in the reproposal. A majority of EGCs continue 
to be smaller public companies that are generally new to the SEC 
reporting process. This suggests that there is less information 
available to investors regarding such companies (a higher degree of 
information asymmetry) relative to the broader population of public 
companies because, in general, investors are less informed about 
companies that are smaller and newer. For example, smaller companies 
have very little, if any, analyst coverage which reduces the amount of 
information made available to financial statement users and therefore 
makes markets less efficient.\181\
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    \180\ See White Paper on Characteristics of Emerging Growth 
Companies as of November 15, 2016 (Mar. 28, 2017), available on the 
Board's Web site in Docket 034.
    \181\ See SEC, Final Report of the Advisory Committee on Smaller 
Public Companies to the U.S. Securities and Exchange Commission 
(Apr. 23, 2006) at 73.
---------------------------------------------------------------------------

    The reproposal solicited comment on whether the elements of the 
reproposed standard and amendments other than the requirements for 
critical audit matters should apply to the audits of EGCs. As noted 
above, one commenter supported application of the entire standard and 
amendments to EGCs (without differentiating between critical audit 
matters and other elements), and one commenter opposed application of 
the entire standard and amendments. In addition, one commenter 
supported applying some of the reproposed improvements to the auditor's 
report to audits of EGCs (the requirement as to addressee and the 
clarifications of existing auditor responsibilities, as well as a 
modified version of the statement regarding auditor independence), but 
generally opposed the other aspects of the reproposal for both EGCs and 
other companies.
    As described above, the additional improvements to the auditor's 
report are intended to provide a consistent location and decrease 
search costs with respect to information about auditor tenure, enhance 
users' understanding of the auditor's role, make the auditor's report 
easier to read and facilitate comparison across companies by making the 
format consistent. As described above, the costs associated with these 
changes are not expected to be significant and are primarily one-time, 
rather than recurring, costs.
    For the reasons explained above, the Board believes that the 
additional improvements to the auditor's report contained in the final 
standard and amendments are in the public interest and, after 
considering the protection of investors and the promotion of 
efficiency, competition, and capital formation, recommends that the 
final standard and amendments should apply to audits of EGCs. 
Accordingly, the Board recommends that the SEC determine that it is 
necessary or appropriate in the public interest, after considering the 
protection of investors and whether the action will promote efficiency, 
competition, and capital formation, to apply the final standard and 
amendments, other than the provisions relating to critical audit 
matters, to audits of EGCs. The Board stands ready to assist the SEC in 
considering any comments the SEC receives on these matters during the 
SEC's public comment process.

III. Date of Effectiveness of the Proposed Rules and Timing for 
Commission Action

    Pursuant to Section 19(b)(2)(A)(ii) of the Exchange Act, and based 
on its determination that an extension of the period set forth in 
Section 19(b)(2)(A)(i) of the Exchange Act is appropriate in light of 
the PCAOB's request that the Commission, pursuant to Section 
103(a)(3)(C) of the Sarbanes-Oxley Act, determine that the proposed 
rules, other than the provisions relating to critical audit matters, 
apply to audits of emerging growth companies, as defined in Section 
3(a)(80) of the Exchange Act, the Commission has determined to extend 
to October 26, 2017 the date by which the Commission should take action 
on the proposed rules.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed 
rules are consistent with the requirements of Title I of the Act. 
Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/pcaob.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number PCAOB-2017-01 on the subject line.

[[Page 35433]]

Paper Comments

     Send paper comments in triplicate to Brent J. Fields, 
Secretary, Securities and Exchange Commission, 100 F Street NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number PCAOB-2017-01. This file 
number should be included on the subject line if email is used. To help 
the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/pcaob.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rules that are filed 
with the Commission, and all written communications relating to the 
proposed rules between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for Web site viewing and printing in 
the Commission's Public Reference Room, on official business days 
between the hours of 10:00 a.m. and 3:00 p.m. Copies of such filing 
will also be available for inspection and copying at the principal 
office of the PCAOB. All comments received will be posted without 
charge; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number PCAOB-
2017-01 and should be submitted on or before August 18, 2017.

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    \182\ 17 CFR 200.30-11(b)(1) and (3).

    For the Commission, by the Office of the Chief Accountant, by 
delegated authority.\182\
Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-15718 Filed 7-27-17; 8:45 am]
BILLING CODE 8011-01-P