U.K Strikes on Auditor’s Report – Can U.S. Be Far Behind

The Financial Reporting Council (FRC) in the U.K. (think of the PCAOB/SEC in the U.S.) has proposed rules that will require auditors to provide commentary on the “risks of material misstatement” as well as how they applied the concept of materiality in the audit and how the audit scope responded to company risks.  These new requirements would be a huge departure from the current pass/fail auditor report model used by much of the world.

The PCAOB has also been looking at potential audit report modifications and had previously released a request for comments on potential changes to the report ranging from more information on how the audit was conducted to an auditor’s discussion and analysis.  The FRC proposal seems to be somewhere between these two extremes, but it would definitely seem to not be in alignment with the comments from most preparers in U.S. that said information about the company should come from the preparers not the auditors.

If the PCAOB decides to go down this path as well, I can see several significant issues from a preparer perspective.  First, in the U.S. management is required to provide an assessment of its system of internal controls to prevent material misstatements of the financial statements and the auditor then provides its opinion on that assessment.  If the auditor were then required to also comment on specific risks and what they did about them in the audit would this lead to either (1) questioning of managements assessment about the effectiveness of its internal controls or (2) management feeling compelled to specifically address their response to those risks as well in their report on internal controls.  And this doesn’t even address what might happen if management and the auditor have serious differences in opinion about what the risks really are in the first place.

I am also very concerned about the impact the required disclosure on how the concept of materiality was applied would have on the auditor’s evaluation of materiality.  Will auditors feel compelled to use lower than necessary materiality levels to prevent lawsuits that say if they had only used a slightly lower level of materiality problems that lead to the investor losses in the stock market would have been discovered?  If you don’t believe that would happen, then let me tell you about a recent development.

Previous to this audit cycle, most audit firms used a different dollar threshold of materiality for the income statement and the balance sheet.  I can hear the purest out there saying materiality is a qualitative measure, not a quantitative measure and they are correct, but when it comes down to it we have to measure whether potential misstatements are material so we have to quantify materiality in order to measure. The PCAOB decided that the auditing literature did not support separate materialities for the balance sheet and income statement so all of the auditing firms started using the lower of the two materiality measures for their evaluations.  This meant that many preparers had to change their controls to support a more precise measurement requirement – probably beyond the true cost-benefit trade off if materiality had been appropriately defined.

The point is that as firms lower materiality levels in defensive response to perceived threats, then the whole concept of materiality will be distorted as preparers find they must pay for more precise systems and controls then are necessary hurting the whole economy in the process.  So let’s hope cooler heads prevail in the U.S. and we don’t follow the U.K. lead in this case.

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