Changes to the Independent Auditors’ Report are on the Horizon

On June 1, 2017, the Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and Related Amendments (AS 3103). If you are not a public filer, like most investment managers running alternative investment funds, you are probably asking yourself why you should care about this. The answer is that this new reporting standard seems to be the trend recently and could possibly affect non-registered investment funds in the future. Several other jurisdictions including the International Auditing and Assurance Standards Board, the EU, and the UK Financial Reporting Council have all adopted similar standards and requirements. Will the AICPA be next?

The intent of the new auditing standard is to make the independent auditor’s report more informative and relevant to investors and other users of the financial statements by adding in additional information regarding the conduct of the audit. SEC approval of AS 3103 is still pending, but the PCAOB anticipates that some of the changes required by the new standard will be in effect for audits ending on or after December 15, 2017 (items 1, 2 and 4 below), while other aspects will be phased in over a three-year period, depending on the type of filer (item 3 below).

There is some speculation in the accounting world that if the SEC likes these new standards, they could be applied to the “audit provision” exemption of the Custody Rule, which many Registered Investment Advisers use in order to satisfy the Custody Rule. The audit provision allows an investment adviser to comply with the surprise examination requirement of the Custody Rule for Pooled Investment Vehicles (PIV) managed by the adviser if it has the PIV audited annually by an independent public accountant registered with and subject to inspection by the PCAOB. The financial statements must be presented in accordance with U.S. GAAP (or IFRS with a reconciliation to U.S. GAAP), and the audit must be conducted under U.S. auditing standards, among other requirements.

Key Changes to the Auditor’s Report

The new standard retains the pass/fail opinion of the auditor’s report, but contains significant changes, including:

1. Standardized ordering and inclusion of the section headers, with the opinion section appearing first.
2. Enhanced descriptions of the auditor’s role and responsibilities, including a statement regarding independence requirements.
3. Communication of critical audit matters (CAMS).
4. Disclosure of audit firm tenure – the year in which the auditor began serving consecutively as the entity’s auditor.

Overview of Critical Audit Matters and Auditor Reporting

The most significant change is the requirement to disclose critical audit matters (CAMS). A CAM is defined 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.” CAMS will be identified and described in a separate section of the auditor’s report titled “Critical Audit Matters” and will be followed by language stating that the CAMS do not alter the auditor’s opinion on the financial statements and that the auditor is not providing a separate opinion on the CAMS or the accounts or disclosures to which they relate. In addition, the auditor must: 1) identify the CAM, 2) describe the principal considerations that led the auditor to determine that the matter is a CAM, 3) describe how the CAM was addressed, and 4) refer the reader to the relevant financial statement accounts or disclosures that relate to the CAM.

CAM Considerations

This type of information has not previously been reported to financial statement users, and there are concerns that audit firms will vary on the number of CAMS identified and the extent of the information included in the auditors’ report, potentially leading to investor confusion. The PCAOB explained that the CAM definition is grounded in the “auditor’s expertise and judgment, which is directly responsive to investor requests for information,” but the Board did include a nonexclusive list of factors to help the auditor with its determination of a CAM. The PCAOB is expecting that, for most audits, the auditor would identify at least one CAM, if not more. However, if no CAMS are identified, the auditor would be required to make a statement to that effect in the auditor’s report.

There is also concern that auditors may be in the position of communicating information about an entity that is not required to be communicated externally, such as “significant deficiencies” and “material weaknesses” in internal control that are only required to be communicated to management and the audit committee. The PCAOB explains in the standard that, through the definition of a CAM, it is attempting to strike a balance between investor demands for more information about the audit and potential unintended consequences associated with providing this information. The standard goes further to explain that while the auditor is required to describe the principal considerations that were used to determine if an item is a CAM, they can do it in general terms and do not have to use the terminology of significant deficiency or material weakness, but rather explain what the control issue is. However, it is easy to see that issuing this type of information could cause new troubles for the entities being audited and be a reason for strong concern.

CAMS for Alternative Investment Entities

Based on the nature of a CAM, any matters discussed in the Required Communications Between the Auditor and Those Charged With Governance letter received at the conclusion of each audit might be considered a CAM. (In accordance with auditing standards, auditors are required to communicate certain matters related to the conduct of the audit to ensure that those charged with governance receive additional information regarding the scope and results of the audit that may assist them in overseeing the financial reporting and disclosure process, for which management is responsible). Matters including changes in critical accounting policies, such as a change in revenue recognition; sensitive and significant accounting estimates, such as valuation of Level 3 non-marketable investments; significant difficulties encountered during the audit; uncorrected and corrected financial statement misstatements, including audit adjustments and impact to financial statements for uncorrected misstatements; disagreement with management; and internal control related matters, such as lack of segregation of duties or financial statement oversight, may end up being described in the audit opinion. Currently, readers of the financial statements would not have access to some of these matters and would be unaware of their existence.

Audit Firm Tenure Considerations

The other change to the opinion that is causing some worry is the disclosure of audit firm tenure. Some critics are worried that there could be a perceived connection between the audit quality and tenure, which could be an incorrect perception. This could give rise to increased investor queries regarding the audit firms and the quality of audits, especially if there is a change in auditor.

Conclusion

Although these changes to the audit report will currently affect only public filers, if the accounting rules for non-public entities follow suit, non-registered investment funds will be impacted and need to consider any potential ramifications. There are sure to be many more questions raised and discussions held between entities, their current and potential investors, and other users of the financial statements once these changes are rolled out. Will this lead to more clarity or confusion in financial reporting? Time will tell.