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BoardMatters Quarterly, September 2011 - The constant in global financial reporting: change - EY - United States

BoardMatters Quarterly, September 2011The constant in global financial reporting: change

Questions for the board and audit committee to consider

  • How would the auditor reporting alternatives in the PCAOB’s concept release affect the information that the audit committee currently receives from the auditors?
  • What are the audit committee’s procedures to monitor auditor independence and audit quality in the current environment?
  • What are the audit committee’s and full board’s views on mandatory firm rotation as discussed in the PCAOB concept release? Will the audit committee provide comments to the PCAOB?
  • Given the delay in the revenue recognition and leases projects, when will the audit committee and company management address the effects of applying the revised proposals?
  • What are management’s views of the IFRS transition approach outlined by the SEC staff compared to a mandatory, date-certain adoption or an optional adoption of IFRS?

Planning early gives audit committees and companies the opportunity to provide input to shape the changes and be better prepared for the uncertainties that lie ahead.

Potential changes to the US auditing environment

The Public Company Accounting Oversight Board (PCAOB) Chairman, James R. Doty, has indicated in a series of recent speeches that the PCAOB is increasing its focus on auditor oversight. In June and August 2011, the PCAOB issued concept releases on the auditor’s reporting model and auditor independence, respectively.

As indicated in a recent speech by Mr. Doty, the concept releases are intended “to foster broad debate and research about ways to enhance both the relevance and credibility of audits, and to provide the investing public a better understanding of what an audit is through enhanced transparency.”1

Both of these concept releases seek comment on potential changes that could directly affect the audit committee’s oversight of the auditor and a company’s financial reporting. Therefore, boards and audit committees are encouraged to carefully study the issues raised and the potential changes contemplated in the releases, and then consider providing input to the PCAOB.

While the PCAOB has stressed that it intends to retain the current pass-fail opinion, it presents various alternatives that it says could increase the transparency and relevance of the auditor’s report, including an Auditor’s Discussion and Analysis, expanded use of emphasis paragraphs, having the auditor report on information outside of the financial statements and clarifying certain language in the auditor’s report.

For example, the Auditor’s Discussion and Analysis could supplement the current auditor’s report with documentation that may address:

  • Areas of risk in the entity’s financial reporting and the auditor’s response to those risks
  • The quality of the entity’s accounting policies and practices
  • The auditor’s views on significant judgments and estimates made in preparing the financial statements
  • Difficult or contentious issues
  • Auditor independence matters

In its August concept release on auditor independence and audit firm rotation, the PCAOB notes that provisions of the Sarbanes-Oxley Act of 2002 have improved audit quality. But the PCAOB also believes that there continue to be instances of auditors failing to approach the audit with the required level of independence, objectivity and professional skepticism.

Mandatory audit firm rotation debate

As a result, the concept release seeks comments on possible ways to enhance auditor independence, objectivity and professional skepticism, including mandatory audit firm rotation and other alternatives.

Proponents of mandatory audit firm rotation argue that setting a limit on the term of an audit firm’s relationship with a company would potentially allow the auditor to better withstand pressures from management. Opponents say mandatory audit firm rotation could lower audit quality by eliminating the auditor’s institutional knowledge of the company and its industry.

The PCAOB recognizes in the concept release that mandatory audit firm rotation would represent a significant change in practice and could impose significant costs and disruptions. The release identifies a number of issues, in addition to those noted above, that would have to be considered.

 Questions for the board and audit committee to consider

Europe discusses changes to the audit environment … and auditors

In October 2010, the European Commission (EC) released its green paper, Audit Policy: Lessons from the Crisis. The green paper raises many questions about the audit profession, similar to those raised by the PCAOB in its recent releases.

These questions have important implications, not just for the audit profession but also for management, audit committees and investors in Europe and around the world. Some of the ideas discussed in the green paper, even if they were confined to the European Union (EU), would nevertheless have a global effect because many businesses have operations in Europe that would be affected if the proposals were implemented.

While all of the issues addressed in the green paper deserve careful consideration, a few are of particular concern for audit committees due to their potential to impair, not enhance, audit quality. These include:

  • Whether there is an unnecessary concentration in the four major audit firms that decreases audit quality
  • The possible prohibition of non-audit services
  • Mandatory audit firm rotation and joint audits

Taking time with convergence

Turning to the ongoing changes in global accounting standards, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) decided to formally expose their proposals on revenue recognition and leases for comment for a second time because they have made significant changes to the models since the original Exposure Drafts. Final standards could be issued in the second half of 2012.

Although the Boards have not yet decided on an effective date, it does not appear that the new guidance would be effective before 1 January 2015, given that the new guidance will likely require retrospective application to the earliest periods presented.

SEC discusses IFRS with investors, smaller registrants and regulators

At a US Securities and Exchange Commission (SEC) roundtable on 7 July 2011, investors, representatives of smaller public companies and regulators discussed the possible incorporation of International Financial Reporting Standards (IFRS) into the US financial reporting system. The SEC staff is gathering feedback from constituents as part of its 2010 Work Plan to help the commissioners decide whether or not to incorporate IFRS into the financial reporting system for US issuers, and if so, how and when.

The investors participating at the roundtable generally supported the pursuit of a single set of high-quality, globally accepted accounting standards, with some expressing direct support for the phased-in approach that the SEC described in its May 2011 paper. Other participants preferred an approach that would provide for full adoption of IFRS. There was mixed support for providing US issuers with an option to fully adopt IFRS.

Participants representing smaller public companies expressed less support than investors for moving toward IFRS in the US. While most appeared to understand the theoretical merits of such a move, many said the costs outweighed the benefits for smaller companies.

The SEC made no decisions at the roundtable and is expected to decide later this year if, when and how to incorporate IFRS into the US financial reporting system.

What audit committees can do now

While the discussions in the US and Europe on audit matters are preliminary, audit committees should stay informed to understand the proposals and their potential effect on the audit committee’s role in the financial reporting process.

1 James R. Doty, speech to the SEC and Financial Reporting Institute 30th Annual Conference, Pasadena, CA, 2 June 2011.

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