The Auditor’s Report: Is “Pass/Fail’” Enough?

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In August, the Public Company Accounting Oversight Board (“PCAOB”) issued a proposal that calls for enhanced communication from Auditors—in addition to the traditional Pass/Fail opinion—in Audit Reports (PCAOB Release No. 2013-005).  If this proposal is approved, it would be the first significant change to the audit report in more than 70 years, according to PCAOB Chairman James Doty.  The proposed changes are based on the premise that investors and financial statement users want more information from auditors, and these changes would represent a huge landscape change for the audit profession.

The proposal is open for public comment until December 11.  In addition to the traditional pass/fail opinion (also known as a “clean” or “qualified” opinion), the proposal would require auditors to report on matters addressed during the audit that:
•    Involved the most difficult, subjective, or complex auditor judgments;
•    Posed the most difficulty to the auditor in obtaining sufficient appropriate evidence; or
•    Posed the most difficulty to the auditor in forming an opinion on the financial statements.

As it exists today, the auditor’s report identifies the financial statements that were audited, describes the nature of an audit, and presents the auditor’s opinion as to whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in accordance with Generally Accepted Accounting Principles (“GAAP”).   This type of auditor’s report is commonly described as a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).

Much of the investing community 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 any other informational value about the particular audit.  It is believed that the auditors have unique and relevant insight based on their audits and that the auditors should provide information about their insights in the auditor’s report to make the reports more relevant and useful.

The implications to our practice are readily apparent.  If public companies auditors are required to communicate “Critical Audit Matters” in their reports, there will be more material to second-guess them on if the company they are auditing takes a fall.  The more that an auditor discloses to the investing public, in our litigious environment, the more risk (exposure) the auditor will have.  In addition, the disclosure of these critical judgment areas has the potential of giving the Plaintiff’s bar a road map to pursue Management and the Board if it turns out that the final decisions  made were, in the plaintiffs’ opinion, unreasonable viewed in hindsight.