Critical Audit Matters: New Information in the Audit Report
The new reporting standard on auditing public company financial statements requires auditors to provide additional information that will yield a more informative and relevant audit report for financial statement users. The most significant change to the audit report is the inclusion of critical audit matters (CAMs). A CAM represents a material account or disclosure that was either challenging to audit or required the auditor to extend a high degree of subjective or complex judgment and has been communicated to the audit committee. The new standard will provide financial statement users with more visibility into these types of matters, clarifying how they were ultimately addressed during the audit.
Including CAMs in the audit report was required for audits of large accelerated filers with fiscal years ending on or after June 30, 2019 and is required for audits of other companies with fiscal years ending on or after December 15, 2020.
Although auditors are responsible for identifying and communicating CAMs, the inclusion of these items in the audit report provides management with both an opportunity to engage with auditors on these issues as well as a responsibility to address the matters through internal accounting and disclosure processes. Here are several steps management can take to prepare for and address the new standard.
Engage auditors early
It is never too early to discuss potential areas that can be identified and communicated as CAMs in the audit report. Early discussions with auditors will provide management with insight into the types of issues or the specific accounts and related processes that the audit team views as high risk, more complex, and judgmental. In many instances, these areas will be consistent with management’s own risk assessment. However, as most companies will be going through this process for the first time with their auditors, management should understand and confirm their thought process and rationale. This approach will allow management to consider the extent of documentation required for such items, evaluate whether the footnote disclosures associated with the CAMs provide the appropriate level of detail, and adequately prepare for the nature, timing, and extent of the audit procedures.
Maintain audit committee communications
The level of detail in the report regarding CAMs and the transparency regarding the auditor and management’s complex and judgmental accounts and estimates may be a surprise to some audit committee members. Early and ongoing dialogue between management, the auditors, and the audit committee is key to managing expectations and avoiding misunderstandings. Management should discuss the requirements of the standard and potential CAMs with the audit committee during audit planning and interim meetings. These discussions will keep the audit committee informed of the CAMs that may be included in the audit report, the status of the audit procedures in these areas, the potential need for incremental disclosures in the footnotes, and how management may respond to questions that arise from investors and analysts. Communication with the audit committee throughout the entire audit should also include discussion of any issues detected in accounts and disclosures related to CAMs and how management plans to resolve these in a timely manner.
Review draft CAM disclosures in audit report
Drafting CAMs can be challenging and time-consuming, usually requiring audit firm national office involvement. Therefore, management must work with the auditors to develop a process and timetable for reviewing CAM disclosures and discussing them with the audit committee. Management should be proactive in requesting drafts of the audit report to allow for adequate review for management and the audit committee prior to filing deadlines.
Get a benchmark understanding
The most common CAMs communicated since the standard became effective relate to goodwill and indefinite-lived intangible asset impairment, business combinations, revenue recognition, and income taxes (specifically tax contingencies). Companies that have these areas and transactions should prepare for these to be disclosed as CAMs in the audit report. Management should review previously issued public company audit reports containing CAMs to get a sense of the level of information and detail included. While the disclosures will vary across audit firms, by reviewing industry and peer company reports, management will be able to develop a frame of reference for the CAMs that may be most relevant to the company.
The inclusion of CAMs in the audit report represents a fundamental shift to providing greater transparency for challenging and complex accounts and disclosures that require significant audit effort. While the communication of CAMs is the responsibility of the auditor, management will be tasked with answering questions from financial statement users, investors, and analysts regarding CAMs in the audit report. To be prepared, management must work to understand the CAMs and align relevant footnote disclosures for consistency.