Why Critical Audit Matters Are So Critical

Remarks as prepared for delivery

Good afternoon and thank you, Bill [Calder], and thank you to my fellow panelists for allowing me the opportunity to share a few thoughts and perspectives.

I am delighted to be speaking at the 42nd Annual SEC and Financial Reporting Conference, and even more pleased to be doing so here on USC’s magnificent campus. For over four decades, this has been a premier event for interaction across the financial reporting ecosystem. I am honored to be participating in a panel with such esteemed company, and look forward to the exchange of ideas and dialogue.

Before I proceed further, please know that all of my remarks this afternoon reflect my individual views as a Board Member, and do not necessarily reflect the views of the full Board, my fellow Board Members, or the PCAOB’s excellent staff.

When I have the opportunity to speak at institutes of higher learning, I like to do a little learning myself on the namesakes. In this case, Elaine and Kenneth Leventhal were captivating research subjects. For one, they met in an accounting class. For another, they started their own accounting firm days after they married in 1949, operating out of their rented apartment. From these humble beginnings, Kenneth Leventhal & Co. grew to be the ninth largest accounting firm in the country when it merged with Ernst and Young in 1995.¹

The Leventhals’ fondness for accounting actually began at UCLA, but they switched their allegiance to USC when their son enrolled in the 1970s. Since 1996, the school of accounting has borne their name.

I was reflecting on the Leventhals’ story yesterday, when I hosted our second 2024 PCAOB Forum for Auditors of Small Businesses and Broker-Dealers. Audit firms come in all sizes, and no matter their size, they play a critical gatekeeper role in protecting investors and helping our capital markets to flourish. Diversity in nature is crucial for ecological health; the same holds true in the financial reporting ecosystem.

At the hearings before the passage of the Sarbanes-Oxley Act, Lee J. Seidler, the Deputy Chairman of the Cohen Commission, declared, “The last line of defense of fair financial reporting is a well-trained, informed auditor exercising independent judgment.”² He is right. Our capital markets are the envy of the world, and investors feel confident entrusting their hard-earned money to them, because of the high-quality financial reporting and the audits underlying them.

The auditing profession is resilient, vibrant, and noble. I feel privileged to count myself a member of it and to use the lessons of my past auditing experience to inform decisions that I make as a Board Member.

I plan to cover two topics during these remarks. First, I will offer a brief overview of the PCAOB’s current rulemaking agenda and progress made, before turning to the question of Critical Audit Matters, or CAMs.

Overview of the Rulemaking Agenda

“The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors.”³ I look forward to sharing more about our work during the panel discussion, but let me highlight our ambitious rulemaking agenda and some recent developments there. As noted in the PCAOB’s 2022-2026 Strategic Plan, “Effective auditing, attestation, quality control, ethics, and independence standards advance audit quality and are foundational to the PCAOB’s execution of its mission to protect investors.” Our expert staff is working to make sure our standards and rules are fit for purpose, and they have made enormous progress.

Last month, we adopted two new standards, QC 1000, A Firm’s System of Quality Control, and AS 1000, General Responsibilities of the Auditor in Conducting an Audit. The month before, we issued two proposals relating to Firm and Engagement Metrics – previously known as Audit Quality Indicators – and Firm Reporting. And, our standard-setting research agenda includes Communication of CAMs.

State of CAMs

Moving now to CAMs, I speak frequently about the importance of transparency – both from the standpoint of investors, firms, audit committees, and other stakeholders having a clear view of the PCAOB’s activities and areas of focus, as well as from the standpoint of capital market participants, who want, and frankly, need more insight into the audit process. CAMs are integral to investors gaining an enhanced understanding of the audits that are performed for their benefit. I am concerned that generally, too few CAMs are being reported, and their disclosures are not providing the intended transparency.

Reported CAMs should help to bridge the information gap that exists between investors and public companies, which, in turn, allows investors to better assess risks associated with the company and ultimately make more sound investment decisions. A 2020 research paper provided an example I find compelling:

A crude analogy [to an audit without sufficient CAMs] would be a doctor’s summary that the patient is “fairly healthy” after an annual checkup. We do not know whether the patient suffers from hypertension that is under control, has diabetes which is managed, or has other symptoms or a family history that [merit follow-up]. If over 98% of patients receive the “fairly healthy” designation, health insurers cannot use [this summary] to determine their risk or formulate a business strategy.⁴

As consumers of information, whether as patients or as investors, you would not accept that response from your doctor. You should expect more from your auditor as well.

Let me take a moment to summarize the current requirements for reporting CAMs. As background, the PCAOB adopted AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, in June 2017. The standard included changes to inform investors and other financial statement users about significant matters in the audit and how they were addressed.

Under this standard, a CAM is defined as any matter arising from the audit that was or should have been communicated to the audit committee and that relates to material matters involving especially challenging, subjective, or complex auditor judgment. This phrase, “Especially challenging, subjective, or complex auditor judgment,” is assessed in the context of the many judgments the auditor makes as part of the audit. The standard uses the word “especially,” instead of “most” as originally proposed, to convey more clearly that there could be multiple CAMs and that matters are assessed on a relative basis within the specific audit.⁵

The essence of the standard is to communicate to investors the things from the audit that “kept the auditor up at night.” When the standard was adopted, the expectation was that, in most audits to which the CAM requirements apply, there would be at least one CAM.⁶

The reality, however, is that few CAMs are disclosed in audit opinions and the trend seems to be continuing. As an example, think of the five companies with the largest U.S. market capitalization: Microsoft, Apple, Nvidia, Alphabet, and Amazon. These are global companies with millions of employees, and an average annual revenue of approximately $320 billion;⁷ these are the companies that are leading with the technologies of the future. Now, take a moment to think about how many CAMs, combined, the auditors of these international titans included in their most recent audit reports.

The answer may surprise you. Six. Not six for each company; six in total.

Research tells the story of a disturbing and consistent trend of fewer CAMs disclosed each year since the requirement became effective in 2019. In 2019 the average Large Accelerated Filer audit report contained 1.69 CAMs. By 2022, that number was down to 1.38. The average number of CAMs in the U.S. overall in 2022 was 1.3.⁸

Let me provide an illustrative example of an area, one of many, where my expectation of the number of CAMs is greater than the reality. North American merger and acquisition activity hit a record in 2021, both in terms of the number and value of transactions. Yet audit opinions included CAMS characterized as business combinations only 745 times in 2021. While my calculation may not include the most precise information or the data with the highest correlation, nonetheless, this represents only 2.4 percent of the approximately 30,000 deals.⁹

I am confident most people in this room or online have first-hand experience with the challenging, subjective, and complex nature of a significant proportion of business combinations. And, I question why so few related CAMs were disclosed in 2021 audit reports.

Outside of the U.S., the International Auditing and Assurance Standards Board (IAASB) adopted a different and broader definition of “key audit matters,” or “KAMs.” Overall, non-U.S. filers report 28 percent more CAMs in each opinion than U.S. filers.¹⁰ The contents of KAMs versus CAMs also differ. Recent academic studies have evaluated CAMs and KAMs for companies listed both in the U.S. and Europe, noting KAMs are more informative than CAMs.¹¹ These studies covered the same companies audited by the same audit firm, but reporting under two different frameworks. Why wouldn’t the disclosures be more similar?

In response to the reality of the number of CAMs being disclosed and the difference in perceived quality between KAMs and CAMs, the PCAOB has added a research project on the communication of CAMs. This project seeks to understand why there continues to be a decrease in the average number of CAMs reported in the auditor’s report over time and whether there is a need for additional guidance, changes to PCAOB standards, or other regulatory action to improve such reporting, including the nature of the information disclosed.

In addition, the PCAOB’s Investor Advisory Group has an initiative to identify CAMs that are exemplifying the value they can provide to investors. To the extent you have seen a robust, descriptive CAM in the last reporting cycle, this is an opportunity to showcase that disclosure. The Investor Advisory Group is accepting submissions of decision useful CAMs or KAMs from 2023 audit reports. Three submissions will be selected and analyzed in an Investor Advisory Group report later this year.¹² The IAG requests submissions by June 30.

Conclusion

Let me close by sharing an observation from former PCAOB Chairman Jim Doty, who I had the honor to work with. He had this to say about CAMs and their relationship to transparency:

In today’s complex economy, . . . investors in our public capital markets want a better understanding of the judgments that go into an auditor’s opinion – not a recitation of the standard procedures that apply to any audit, but the specific judgments that were most critical to the auditor in arriving at the opinion.¹³

I look forward to the outcome of the research project and, in the meantime, encourage firms to reassert their commitment to the identification and reporting of CAMs.

Thank you for allowing me to provide a few thoughts and I look forward to the panel discussion.