CHAPTER 13

Recent Developments

This chapter focuses on relevant changes in the auditing standards of the Public Company Accounting Oversight Board (PCAOB) and the International Auditing Assurance Standards Board (IAASB) since the first edition of this book came out in 2015.

The PCAOB revised auditor reporting standards since 2015 that were not discussed in the prior edition. The equivalent IAASB standards came into effect at roughly the same time. This chapter addresses changes in the areas of:

• The auditor’s report
• Documentation of audit procedures
• Going concern related audit reports
• Internal controls over financial reports
• Engagement quality control
• Auditing accounting estimates

The Auditor’s Report

The PCAOB recently adopted different numbers for standards issued. For example, if we consider the auditor’s report AS 3, it is now AS 1215 The Auditor’s Report on an Audit of Financial Statements when the Auditor Expresses an Unqualified Opinion (applicable fiscal year December 15, 2020) and prior to that AU 700. This is a change in number only; the content appears to remain the same. The IAASB’s equivalent standard for auditor reporting is AS 700. Both the PCAOB and IAASB have a similar objective, namely, enhancing the auditor’s report. In essence, the goal is to provide greater transparency to investors and other financial statement users about audit-related matters. The PCAOB and IAASB approaches are intended to enhance the communication of matters in the auditor’s report that are likely to be of interest to users.

Going Concern Related Audit Reports

The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time not to exceed one year after the date of the financial statements being audited. The auditor considers the results of procedures performed relative to various audit objectives, which, when considered in the aggregate, indicate that there could be substantial doubt about the entity’s ability to continue as a going concern.

Going concern considerations differ slightly between U.S. auditing standards and international auditing standards. The PCAOB defines the going concern period as one year from the date of the fiscal year being audited. IAASB going concern period is at least one year, but not limited only to a year.

The auditor is not responsible for predicting future conditions or events. The absence of reference to substantial doubt about the firm’s continued existence should not be viewed as providing assurance of an entity’s ability to continue as a going concern.

The Auditor’s Report: PCAOB Required Amendments

The PCAOB’s statement AS 3101, Audit of Financial Statements when the Auditor Expresses an Unqualified Opinion. The auditor’s report requires discussion of what the auditor perceives to be important issues of concern based on the PCAOB’s standard. It is considered essential that, in the PCAOB’s terminology, certain important audit matters identified during the process leading to the issuance of the independent auditor’s report be communicated clearly. The PCAOB requires discussion of items that the auditor perceives to be important in the body of the auditor’s report and refers to these items as critical audit matters (CAM). A CAM is defined as any issue arising from the audit of the financial statements that should be communicated to the audit committee. In particular, this relates to accounts or disclosures that:

• Are material to the financial statements and
• Involve especially challenging, subjective, or complex judgment referred to as CAM.

The IAASB requires discussion of critical issues in an equivalent section entitled key audit matters (KAM) that is set out in ISA 701. Hence, one difference between the PCAOB and the IAASB is the title of the paragraph discussing important audit matters. It is called CAM by the PCAOB and KAM by the IAASB. A slight change is that the IAASB’s standards allow auditors to communicate KAM on a voluntary basis for entities other than listed entities in the absence of a requirement to do so.

Determining Whether a Matter Is a KAM/CAM

Key audit matters is required to be specific to the entity and the audit in order to provide relevant, meaningful information to users. Therefore, ISA recommends a judgment-based decision-making approach to help auditors determine which matters among those communicated should be included as KAM. This decision-making framework was developed to focus auditors’ attention on areas of the financial statements that involve management’s most significant or complex judgments. The framework for determining CAM under the PCAOB standard is similar to the IAASB’s ISA, except that the PCAOB does not prescribe any form of decision-making model. Instead, it relies on auditor judgment to determine which matters should be communicated to the audit committee.

Requirements in Determining KAM/CAM

In determining whether a matter involves especially challenging, subjective, or complex issues, the PCAOB requires the auditor to consider the following specific audit factors either alone or in combination:

• The auditor’s assessment of the risks, especially significant risks arising from possible material misstatement;
• The degree of auditor judgment related to areas in the financial statements that involve the application of significant judgment or estimation by management, including estimates with significant material uncertainty;
• The degree of auditor subjectivity involved in applying audit procedures and evaluating the results of those procedures;
• The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed from outside of the engagement team.

In most audits, it is expected that the auditor will determine that at least one matter involved is an especially challenging, subjective, or complex auditor judgment (Paragraph 12 of the PCAOB standard AS 3101).

Because the determination of KAM/CAM relies on auditor judgment, both the IAASB and PCAOB set out specific requirements to assist auditors in documenting those important judgments. However, these requirements differ in terms of the matters for which such documentation is required. The IAASB standard requires documentation of the matters that required significant auditor attention and the rationale for the auditor’s determination as to whether each of these matters is a KAM and why. Under the PCAOB standard, for each matter that is communicated to the audit committee and is considered material to the financial statements, the auditor must document whether the matter was determined to be a CAM and why.

Communication of KAM/CAM

The PCAOB and IAASB require the communication of KAM/CAM only for the audit of the current period. Guidance in ISA 701 indicates that it may nevertheless be useful for the auditor to consider whether a KAM in the prior period continues to be a KAM in the audit of the current period. The PCAOB standard provides more detail and flexibility, noting that the auditor may communicate CAM relating to a prior period and includes examples of circumstances when this may be appropriate.

The PCAOB and IAASB require the auditor to communicate matters determined to be KAM/CAM. However, ISA 701 acknowledges that, in extremely rare circumstances, the auditor may decide that a matter that is determined to be KAM should not be communicated.

The IAASB and PCAOB preclude the communication of KAM/CAM when the auditor disclaims an opinion on the financial statements. The PCAOB does not permit communication of CAM when the auditor expresses an adverse opinion, whereas the IAASB requires the communication of KAM despite the adverse opinion.

Descriptions of KAM/CAM in the Auditor’s Report

Under the IAASB’s and PCAOB’s approaches, the description of a KAM/CAM is intended to provide a succinct and balanced explanation about the matter, which is tailored to the audit. This is meant to avoid standardized language and to reflect the specific circumstances of the matter, while limiting the use of highly technical accounting and auditing terms.

The IAASB notes that the level of detail in the description of each KAM is an issue of professional judgment. This may vary depending on the specific facts and circumstances of the particular engagement. Regarding the CAM, the PCAOB indicates that the descriptions should be at a level that users would understand and further notes that the objective is to provide a useful summary, not to detail every aspect of how the matter was addressed.

Required Descriptions in the Auditor’s Report

IAASB Standards. The description of a KAM is required to include a reference to the related disclosures, if any, in the financial statements and must address:

• Why the matter was considered to be highly significant to the audit and therefore determined to be a KAM; and
• How the matter was addressed in the audit (ISA 701 paragraph 13).

PCAOB Standards. For each CAM item communicated in the auditor’s report, the auditor must:

• Identify the critical audit matter;
• Describe the principal considerations that led the auditor to determine that it is 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.

The PCAOB provides more guidance for auditors on how to present the way that the matter was addressed in the audit, including: (1) a brief review of the procedures performed; (2) key aspects of the auditor’s response or approach; and (3) an indication of the outcome of the auditor’s procedures or key observations with respect to the matter.

Both approaches are clear that the communications in the auditor’s report about KAM/CAM should not imply that the auditor has not appropriately resolved forming an opinion on the financial statements or by offering a separate opinion with respect to the matter.

Illustrations of CAM and KAM

The PCAOB does not require provision of illustrative examples of CAM. By contrast, the IAASB requires the auditor to develop a limited number of KAM examples to illustrate how the requirements of ISA 701 may be applied. The IAASB notes that these are for illustrative purposes only, since KAM need to be tailored to the facts and circumstances of the individual audit engagements and the entity.

Other Differences in Auditor Reporting

Order of Presentation. Both the PCAOB and IAASB require the Opinion section to be presented first, followed by the Basis of Opinion section.

PCAOB: In the Basis of Opinion section, a statement is required indicating that the auditor is a public accounting firm registered with the PCAOB and must be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission (SEC) and the PCAOB.

IAASB: The Basis of Opinion section now requires an identification of ethical requirements and a statement indicating that the auditor is independent and has fulfilled the other ethical responsibilities in accordance with these requirements.

Modified Audit Opinions

PCAOB: When there is a departure from a modified opinion, the substantive reasons for the opinion should be included in one or more separate paragraphs immediately following the opinion paragraph of the auditor’s report. Additional information is also required to be included in these paragraphs in the case of an adverse opinion or a disclaimer of opinion. The use of a CAM cannot be a substitute for a modified opinion.

IAASB: When the auditor modifies the opinion, the basis for the modification is included in the Basis of Opinion section. A KAM cannot be a substitute for a modified opinion.

Statement of Responsibilities

PCAOB provides a description of the responsibilities of the auditor, management, and those charged with governance that are not as detailed under the PCAOB standard as they are under the IAASB standard.

These responsibilities are included in the Basis of Opinion section rather than as separate sections.

IAASB: Expanded descriptions are required with respect to:

• The responsibilities of management and those charged with governance;
• The responsibilities of auditors;
• The key features of an audit;

These are required in separate sections of the auditor’s report.

Engagement Partner

PCAOB: The audit firm is required to report the name of the engagement partner and information about the involvement of other accounting firms participating in the audit on PCAOB Form AP, Auditor Reporting of Certain Audit Participants. Auditors must use this form to disclose the names of the engagement partners who participated in their audits. The auditor may also include this information in the auditor’s report for an individual engagement, but is not required to do so. The relevant PCAOB is AS 3211 applicable on or after January 31, 2017 (engagement partners), and June 30, 2017 (accounting firms).

IAASB: By contrast, the name of the engagement partner is required to be included in the auditor’s report for audits of financial statements of listed entities under IAASB rules.

Audit Tenure

PCAOB: A statement indicating the year the auditor began serving consecutively as the company’s auditor is required to be included in the auditor’s report.

IAASB: There are no requirements regarding the disclosure of the auditor’s tenure.

Emphasis of Matter

In both PCAOB and IAASB standards, when there is a material uncertainty relating to the client as a going concern, even though the matter is a KAM/CAM by its nature, it is not included in the KAM/CAM section of the auditor’s report and the requirements relating to the description of KAM/CAM do not apply.

PCAOB: The PCAOB standard permits the inclusion of emphasis paragraphs, although there is no requirement to do so. However, these paragraphs may not serve as a substitute for CAM.

There is a continued requirement to include explanatory language or an explanatory paragraph in certain circumstances. CAM are not a substitute for required explanatory paragraphs. However, there could be situations in which a matter not only meets the definition of a CAM, but also requires an explanatory paragraph, such as a going concern issue. In these situations, both the explanatory paragraph and the CAM are required. However, the auditor may include the description of the matter in both the explanatory paragraph and the CAM section with a cross reference between them, or may include the required communication in the explanatory paragraph with a cross reference in the CAM section to the explanatory paragraph.

IAASB: Unlike the PCAOB standards, the IAASB introduces emphasis of matter (EOM) and other matter (OM) paragraphs. These paragraphs are unique to the IAASB. They may be required in certain circumstances; otherwise, they are permitted at the auditor’s discretion. If ISA 701 applies, and a matter cannot be determined as a KAM, it may be communicated as an EOM or OM. However, when ISA requires an EOM or OM paragraph and the matter is also a KAM, it is communicated in both sections.

Documentation of Audit Procedures

AS 1215 deals with documentation of audit procedures with the objective of improving audit quality and enhancing public confidence in the quality of auditing. Prior to AS 1215 the relevant Standard was AU 230. In between temporarily the relevant standard was AS 3. AS 1215 requires that auditors support the conclusions in their reports with documentation. The documentation, also referred to as “working papers” or “work papers,” is required by PCAOB AS 1215 paragraph 3.

The main objective of audit documentation is to support the basis for the conclusions in the auditor’s report. Audit documentation aids in the planning, performance, and supervision of the audit engagement. Audit documentation provides interested parties with written evidence explaining and elaborating on the supporting evidence. It also provides a basis for reviewing the quality of the work with evidence supporting the auditor’s significant conclusions.

Audit documentation is usually required:

• To provide a record of actual work performed;
• To provide assurance that the auditor accomplishes the planned objectives;
• To aid supervisors, managers, engagement partners, engagement quality reviewers, PCAOB inspectors, and other relevant parties interested in the audit;
• To improve audit effectiveness and efficiency by reducing time-consuming and possibly inaccurate oral explanations of what was done (or not done).

In summary, AS 1215 requires that audit documentation contain sufficient information to enable an experienced auditor, who has no previous connection with the engagement, to understand the work that was performed, the name of the person(s) who performed it, the date it was completed, and the conclusions reached. This should be summarized in an engagement letter prior to commencement of the audit.

The PCAOB also added paragraphs to the final standard to explain the importance and associated responsibility of performing the work and adequately documenting all work that was performed. Paragraph 7 provides a list of factors that the auditor should consider in determining the nature and extent of documentation. These factors should be considered by both the auditor in preparing the documentation and the reviewer in evaluating the documentation.

Paragraph 9 of this standard AS 1215 addresses the issue of whether sufficient, appropriate evidence was obtained and whether an appropriate audit conclusion was reached. After the documentation completion date, if there is a lack of appropriate documentation, the auditor is required to demonstrate whether, in fact, the procedures were performed, the evidence was obtained, and appropriate conclusions were reached. In this and similar contexts, it is noted that oral explanation alone does not constitute persuasive other evidence. However, oral evidence may be used to clarify other written evidence.

Paragraph 39 notes that the standard AS 1215 would require an auditor to retain audit documentation for seven years after completion of the engagement, which is the minimum period permitted under AS 1215.

The IAASB’s discussion of these issues is generally similar, although there are a few key differences between the IAASB and PCAOB content. For example, the PCAOB auditing standards require auditors to obtain an engagement letter before they start audit work. There is no such requirement under ISA. PCAOB standards requires the audit work to be retained for seven years.

The PCAOB standard includes two important dates for the preparation of the audit, which are not in IAASB with respect to documentation:

• The report release date
• The documentation completion date

Prior to the report release date, the PCAOB states that the auditor must have completed all necessary auditing procedures, including clearing review notes and providing support for all final conclusions. In addition, the auditor must have obtained sufficient evidence to support the representations in the auditor’s reports before the report release date.

After the report release date and prior to the documentation completion date, the auditor has 45 calendar days in which to assemble the documentation.

Internal Control over Financial Reporting

The auditor’s objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company’s internal control over financial reporting. This is needed because a company’s internal control cannot be considered effective if one or more material control weaknesses exist. To create a basis for forming an opinion about the effectiveness of the firm’s internal controls, the auditor must plan and perform the internal control audit in order to obtain sufficient, appropriate evidence to provide reasonable assurance about whether one or more material weaknesses exist as of the date specified in management’s assessment.

Internal control over financial reporting is another difference between PCAOB and IAASB. The Sarbanes Oxley Act (SOX) of 2002 requires that company management have internal controls in place that are sufficient to prevent or to detect and correct any material misstatement. Management must also provide their assertion as to whether they have effective internal controls over financial reporting in place, and this SOX of 2002, Section 404, report should accompany the audit report. ISA do not have these requirements explicitly expressed in its standards.

Risk Assessment

Risk assessment is another important audit procedure where IAASB and PCAOB standards differ. Under IAASB, auditors should assess how companies respond to these risks. PCAOB auditors are required to assess the risk of material misstatements based on each company and its operating environment.

The IAASB has proposed to update its standard on audit risk assessments to take into account the developments arising from Information Technology (IT) (ISA 315). This is important because IT has become the medium through which a significant amount of audit evidence is obtained. It has become increasingly important for auditors to understand an entity’s IT system, including how the integrity of the information is maintained.

As a result, the IAASB has suggested a number of changes to the auditor’s consideration of IT when obtaining an understanding of the entity’s system of internal control. These include:

• Matters to be understood in relation to the IT environment, including the IT applications, IT infrastructure, and IT processes;
• Examples of matters within the IT environment that would likely be relevant for determining the IT applications and other aspects of the IT environment that are relevant to the audit.

According to the IAASB, the most significant proposed enhancements to ISA 315 addressing the entity’s use of IT are in the requirements for the information system and communication component, and the identification of controls relevant to the audit.

Use of Another Auditor to Audit Foreign Subsidiaries

The use of another auditor specifically to audit a foreign subsidiary is another issue where the PCAOB and ISA differ in their guidelines. Under PCAOB standards, AU 543 auditors have the option to mention the use of the other auditor. By contrast, IAASB standards do not allow the main auditor to mention the use of other auditors. Thus under IAASB, the primary auditor must take full responsibility, even though they might have used another auditor for part of the audit. To clarify ISA are IAASB standards not the organization issuing the standards. PCAOB is the standard issuing organization, not the standards themselves (e.g., AS 1215). We have to be consistent and careful.

Engagement Quality Control

One common issue for both the PCAOB and the IAASB is the concept of engagement quality control (EQC). Both the PCAOB and IAASB require the EQC reviewer to make a judgment on the communication and the documentation of KAM/CAM. However, the approach of the IAASB and the PCAOB are slightly different. The PCAOB requires the EQC reviewer to evaluate the engagement team’s communication and documentation of CAM. Under the IAASB’s standards, the EQC reviewer is required to perform an evaluation of the conclusions reached in formulating the auditor’s report and consider whether the proposed auditor’s report is appropriate and the relevant working papers material explains that such conclusions include various matters relating to KAM. Both the PCAOB and IAASB require the auditor to provide the audit committee with a draft of the auditor’s report and to discuss it with them. In addition, the IAASB requires:

• An explanation in the auditor’s report of how the concept of materiality was applied in the audit;
• A summary of the audit scope in the audit report;
• In circumstances where there is no material uncertainty related to going concern, a determination of whether a KAM related to a going concern issue exists and should be communicated in the auditor’s report.

Auditing Accounting Estimates

The new PCAOB standard for auditing accounting estimates, including fair value measurements, differs from the current requirements in several important ways. Among other things, the standard:

• Better integrates the requirements for auditing accounting estimates with the PCAOB’s assessment standards;
• Places greater emphasis on the auditor’s consideration of potential management bias in accounting estimates; and
• Introduces specific requirements for evaluating pricing information received from a third party, such as a pricing service, a broker or a dealer.

The new and amended standards for using the work of specialists strengthen the requirements for the auditor’s evaluation of the specialists’ work. For specialists engaged or employed by the audit firm, the expanded requirements explicitly include:

• Evaluating the reasonableness of all significant assumptions used by the specialist, whether developed by management or the specialist;
• Evaluating whether the methods used by the specialist are appropriate under the circumstances;
• Testing the accuracy and completeness of company-produced data used by the specialist; and
• Evaluating the relevance and reliability of data from external sources that are used by the specialist.

These new and amended standards strengthen the requirements for auditing management’s accounting estimates and the auditor’s use of the work of specialists, including company specialists. The new standard on auditing accounting estimates is an initiative by the PCAOB that differentiates IAASB and PCAOB rules for auditors.