responsibilities of the auditor, management, and the audit committee.
In doing so, some of these commenters suggested that the PCAOB consider
additional language adopted by the IAASB, in order to promote
consistency in reporting and to help users understand more fully the
separate responsibilities of each of the parties with respect to the
audited financial statements. In contrast, another commenter cautioned
that a thorough description of everyone's roles and responsibilities
would further add to repetitive boilerplate language. This commenter
suggested instead that the auditor's report provide a cross reference
to a more complete description of the roles and responsibilities of the
auditor, management, and the audit committee. This commenter did not
indicate where such cross-referenced material would appear. Given
little interest from investors in such additional language during the
Board's initial outreach and the risk that it would be boilerplate, the
final standard does not include these additional elements.
    Two accounting firms suggested describing the meaning of reasonable
assurance. The final standard requires a statement in the ``Basis for
Opinion'' section of the auditor's report that the auditor ``plan and
perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement.'' The auditing
standards describe reasonable assurance as a high level of assurance,
although not absolute assurance.\67\ During the Board's initial
outreach such additional language was considered, but there was no
investor demand for it. As a result, the final standard does not expand
the description of reasonable assurance in the auditor's report.
---------------------------------------------------------------------------

    \67\ Paragraph .10 of AS 1015, Due Professional Care in the
Performance of Work.
---------------------------------------------------------------------------

    Some commenters also suggested that the auditor's report should
include disclosure of the materiality measures used by auditors in
planning the audit. These commenters asserted that it could help inform
investors' proxy voting process for auditor ratification, as such
disclosure could be a valuable supplement to an audit fee analysis and
used to compare materiality over time to trends in restatements and
adjustments. These commenters also observed that materiality
disclosures are provided in the auditor's reports in the U.K. Other
commenters from the Board's initial outreach stated that disclosing
materiality levels in the auditor's report could have negative
implications on audit quality by reducing the element of surprise
necessary in an audit.\68\ One commenter opposed a disclosure of
materiality on the basis that it may encourage disclosure of
quantitative materiality levels and ignore qualitative aspects of
materiality, which cannot be described in a meaningful way in the
auditor's report. The Board has decided not to include this additional
element in the auditor's report at this time because disclosure may
reduce the element of surprise in the audit and overstate the
importance of quantitative rather than qualitative factors in the
auditor's overall consideration of materiality. However, the Board will
monitor the implementation of the final standard, as

well as the developments of expanded auditor reporting in other
jurisdictions, to determine if future enhancements to the auditor's
report may be warranted in this area.
---------------------------------------------------------------------------

    \68\ See PCAOB Release No. 2011-003, Appendix C, for a detailed
discussion of the staff's outreach regarding reporting materiality
levels.
---------------------------------------------------------------------------

    Additionally, some commenters suggested that the auditor's report
should define the auditor's responsibility for other information in
documents containing audited financial statements so that financial
statement users have a clear understanding. The Board's proposal
included another new auditing standard, The Auditor's Responsibilities
Regarding Other Information in Certain Documents Containing Audited
Financial Statements and the Related Auditor's Report, regarding the
auditor's responsibilities for other information outside the financial
statements. The Board has not taken any further action since the
proposal.
    A few commenters suggested including other elements, such as the
date when the auditor completed fieldwork, a statement that the auditor
looked for material fraud, disclosure when alternative dispute
resolution clauses are included in engagement letters, and disclosure
of reasons for change in the engagement partner prior to mandatory
rotation. The final standard does not include these elements because
the Board believes they would not add meaningfully to the information
already provided in the final standard or the elements go beyond what
was considered in this standard-setting project and, thus, the Board is
not including these elements at this time.
Explanatory Language and Emphasis of a Matter
Explanatory Language Required by Other PCAOB Standards
    The reproposed standard, similar to the existing standard,\69\
provided a list of circumstances in which the auditor is required to
add explanatory language to the auditor's report and included
references to other PCAOB standards in which these circumstances and
related reporting requirements are described. These circumstances
included when there is substantial doubt about the company's ability to
continue as a going concern and a restatement of previously issued
financial statements, among others.
---------------------------------------------------------------------------

    \69\ See existing AS 3101.11.
---------------------------------------------------------------------------

    The list of circumstances from the Board's reproposal did not
attract much comment, although one commenter affirmed support for
including the list. Commenters on the Board's proposal supported
providing a list in the standard of the circumstances that require
explanatory language in the auditor's report on the basis that keeping
this information in a single place would facilitate consistency in
execution. The final standard includes the list of explanatory
paragraphs and related references as reproposed.
    The reproposed standard included a requirement for the auditor to
add explanatory language in cases where the company is required to
report on ICFR but has determined that it is not required to obtain,
and did not request the auditor to perform, an audit of ICFR.\70\ The
reproposed standard included a reference to a new proposed requirement
in AS 3105, Departures from Unqualified Opinions and Other Reporting
Circumstances, for the auditor to add such explanatory language. Some
commenters were supportive of the reproposed requirement, while one
commenter did not believe such a requirement was necessary but did not
object to its inclusion.
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    \70\ This may be the case for companies that are subject to
Section 404(a) of Sarbanes-Oxley, which mandates management ICFR
reporting, but not Section 404(b), which mandates auditor ICFR
reporting. Section 404(a) generally applies to companies that are
subject to the reporting requirements of the Exchange Act, other
than registered investment companies. Certain categories of
companies that are subject to Section 404(a), such as nonaccelerated
filers and emerging growth companies, are not subject to Section
404(b).
---------------------------------------------------------------------------

    The Board also sought comment on whether the requirement to include
an explanatory paragraph in the auditor's report when the auditor did
not perform an audit of ICFR should apply not only if company's
management is required to report on ICFR, but also if management is not
required to report, such as for investment companies. Several
commenters supported expanding the requirement to all instances in
which the auditor is not engaged to opine on ICFR, and not limit it to
only when management is required to report on ICFR.
    In the Board's view, it is appropriate to add explanatory language
to the auditor's report when management has a reporting responsibility
on ICFR but the auditor is not engaged to opine on ICFR, in order to
clarify the auditor's responsibilities in this situation. For companies
for which management is not required to report on ICFR, the Board does
not believe that the auditor should have a separate reporting
responsibility. Accordingly, the final standard retains the requirement
as reproposed.\71\ The auditor may, however, choose to include such a
paragraph in the auditor's report voluntarily.
---------------------------------------------------------------------------

    \71\ See amendments to AS 3105.59-.60.
---------------------------------------------------------------------------

    Interaction between critical audit matters and explanatory
paragraphs. The reproposed standard clarified that critical audit
matters are not a substitute for required explanatory paragraphs.
However, there could be situations in which a matter meets the
definition of a critical audit matter and also requires an explanatory
paragraph, such as going concern. For these situations, the reproposal
contemplated that both the explanatory paragraph and the required
communication regarding the critical audit matter would be provided.
The auditor could include the communication required for a critical
audit matter in the explanatory paragraph, with a cross-reference in
the critical audit matter section to the explanatory paragraph.
Alternatively, the auditor could choose to provide both an explanatory
paragraph and the critical audit matter communication separately in the
auditor's report, with a cross-reference between the two sections.\72\
While the information reported in a critical audit matter may overlap
with some of the information already provided in the explanatory
paragraph, the critical audit matter would provide incremental
information, such as how the matter was addressed in the audit.
---------------------------------------------------------------------------

    \72\ When both an explanatory paragraph and a critical audit
matter communication are provided, the critical audit matter
description should not include conditional language that would not
be permissible in the explanatory paragraph. See footnote 5 of AS
2415.
---------------------------------------------------------------------------

    Commenters were generally supportive of the interaction between the
communication of critical audit matters and required explanatory
paragraphs as described in the reproposed standard. Some alternative
views, however, were expressed. One commenter thought that if a
required explanatory paragraph is also a critical audit matter,
disclosure in the auditor's report should be limited to one place in
the auditor' report. The commenter suggested that the communication
requirements for both a critical audit matter and an explanatory
paragraph be reported in the critical audit matter section of the
auditor's report with a cross reference in the explanatory paragraph
section. Another commenter suggested that the PCAOB harmonize its
approach with that of the IAASB, which requires a reference in the key
audit matter section but waives the requirements to describe the key
audit matter and how it was addressed during the audit. Finally,
another commenter thought that critical audit matter communications
should not be

permitted to be integrated with explanatory paragraphs, on the basis
that explanatory paragraphs are about matters in the financial
statements to which the auditor wants to draw the reader's attention
and are not necessarily critical audit matters.
    The final standard retains the interaction between critical audit
matters and explanatory paragraphs as reproposed. The approach provides
flexibility on auditor disclosure, yet also ensures that the
communication requirements are met.
Emphasis of a Matter
    The reproposed standard, similar to the existing standard, provided
the ability for the auditor to add a paragraph to the auditor's report
to emphasize a matter regarding the financial statements (``emphasis
paragraph'').\73\ Emphasis paragraphs are not required, but may be used
by auditors to draw the reader's attention to matters such as
significant transactions with related parties and unusually important
subsequent events.
---------------------------------------------------------------------------

    \73\ See existing AS 3101.19.
---------------------------------------------------------------------------

    The reproposed standard provided a list of potential matters that
the auditor may emphasize in the auditor's report, although the auditor
may also decide to emphasize other matters.
    Commenters were supportive of emphasis paragraphs as described in
the reproposed standard and did not suggest any additional matters to
be included in the list of potential emphasis paragraphs. The final
standard includes emphasis paragraphs as reproposed.
    Interaction between critical audit matters and emphasis paragraphs.
The reproposed standard stated that emphasis paragraphs are not a
substitute for required critical audit matters. If a matter that the
auditor considers emphasizing meets the definition of a critical audit
matter, the auditor would provide the information required for critical
audit matters, and would not be expected to include an emphasis
paragraph in the auditor's report. Although this did not generate much
comment, one commenter affirmed support for the interaction between
critical audit matters and emphasis paragraphs. The final standard
retains the interaction between critical audit matters and emphasis
paragraphs as reproposed.
Requirements of Other Regulators and Standard Setters
    Under the requirements of other regulators and standard setters,
there are no analogous explanatory paragraphs, except for reporting on
going concern. The Board's reproposed approach is similar to the
IAASB's approach to the interaction between a paragraph regarding the
company's ability to continue as a going concern and key audit matters,
although the underlying requirements for auditor reporting on going
concern vary.\74\ Under the IAASB's approach, an emphasis of matter
paragraph is not required for a matter that was determined to be a key
audit matter.\75\ The EU and the FRC have separate requirements related
to going concern reporting that do not specifically address the
interaction with their expanded auditor reporting.\76\ The IAASB, FRC,
and EU do not have requirements for reporting on ICFR.
---------------------------------------------------------------------------

    \74\ See paragraph A1 of ISA 570, Going Concern, and paragraph
15 of ISA 701.
    \75\ See paragraph 8 of ISA 706, Emphasis of Matter Paragraphs
and Other Matter Paragraphs in the Independent Auditor's Report.
    \76\ See ISA (UK and Ireland) 570, Going Concern, and see
Article 28, Audit Reporting, of Directive 2014/56/EU of the European
Parliament and of the Council (Apr. 16, 2014).
---------------------------------------------------------------------------

Information About Certain Audit Participants
    On May 9, 2016, the SEC approved new rules and related amendments
to the Board's auditing standards, including amendments to AS 3101,
that will provide investors and other financial statement users with
information about engagement partners and other accounting firms that
participate in audits of issuers.\77\ Firms will be required to file
Form AP with the PCAOB for each issuer audit, disclosing this
information. In addition to filing Form AP, firms will also have the
choice to include this information in the auditor's report.\78\ The
final standard incorporates the adopted amendments to AS 3101 for
situations in which the auditor decides to include information about
certain audit participants in the auditor's report. The final standard
requires the auditor to use an appropriate section title when providing
this information in the auditor's report, but does not require a
specific location in the auditor's report.
---------------------------------------------------------------------------

    \77\ See PCAOB Release No. 2015-008.
    \78\ When the auditor divides responsibility for the audit under
AS 1205, Part of the Audit Performed by Other Independent Auditors,
the auditor's report must acknowledge the involvement of the other
auditor.
---------------------------------------------------------------------------

Requirements of Other Regulators and Standard Setters
    The IAASB requires the auditor to include the name of the
engagement partner in the auditor's report for audits of listed
entities.\79\ Under EU law, the engagement partner is required to sign
the audit report in all EU countries, including the United Kingdom.\80\
Unlike disclosure of the engagement partner's name, disclosure of other
accounting firms that participated in the audit is not required by the
IAASB, FRC, or the EU.
---------------------------------------------------------------------------

    \79\ See paragraph 45 of ISA 700.
    \80\ Directive 2006/43/EC of the European Parliament and of the
Council, Article 28, Audit Reporting (May 17, 2006).
---------------------------------------------------------------------------

Form of the Auditor's Report
    The reproposed standard required the ``Opinion on the Financial
Statements'' section to be the first section of the auditor's report,
immediately followed by the ``Basis for Opinion'' section. The
reproposed standard did not specify an order for the remaining sections
of the auditor's report, which would include explanatory paragraphs and
critical audit matters. This approach allowed for consistency in the
location of the opinion and basis for opinion sections, with
flexibility for the other elements of the auditor's report. The
reproposed standard also required titles for all sections of the
auditor's report to provide consistency and assist users in identifying
the individual sections of the auditor's report.
    Commenters were generally supportive of the proposed changes to the
form of the auditor's report, because the changes will:
     Enhance the clarity and comparability of disclosures;
     Make it easier for investors to find the opinion since it
will be listed first;
     Help facilitate a comparison between auditor's reports;
and
     Allow for an appropriate level of flexibility and ease of
use without being overly prescriptive.
    Some commenters suggested the PCAOB should be consistent with other
standard setters in the ordering of section titles in the auditor's
report. One commenter expressed concern that the ordering of the
components of the opinion and the heading of the critical audit matter
section of the report may be misunderstood to imply that critical audit
matter communications are separate and distinct from the auditor's
opinion, which could be misinterpreted as a piecemeal opinion. In light
of the commenter support described above, the Board is adopting the
form of the auditor's report as reproposed. As previously discussed,
the final standard includes revised introductory language in the
auditor's report to avoid the potential misperception that the
communication of critical audit matters provides piecemeal opinions.

Requirements of Other Regulators and Standard Setters
    The reproposed approach with respect to the order of the sections
of the auditor's report is generally consistent with that of the
IAASB.\81\ The EU and FRC do not specify an order to the auditor's
report.
---------------------------------------------------------------------------

    \81\ See paragraphs 23-28 of ISA 700.
---------------------------------------------------------------------------

Application to Other Audits Performed Under PCAOB Standards
    There are situations in which an auditor may be required by law or
regulation, or voluntarily agrees, to perform an audit engagement in
accordance with PCAOB standards for a company whose audit is not
subject to PCAOB oversight.\82\ For example, SEC rules permit audits
under PCAOB standards in connection with offerings under Regulation A
and Regulation Crowdfunding.\83\ In these situations, certain elements
of the auditor's report required under the final standard, such as the
use of ``registered public accounting firm'' in the title or the
statement regarding independence requirements, may not apply.
Additional guidance for these situations will be provided.
---------------------------------------------------------------------------

    \82\ Under the Sarbanes-Oxley Act, as amended by the Dodd-Frank
Wall Street Reform and Consumer Protection Act, the PCAOB oversees
the audits of ``issuers'' and brokers and dealers reporting under
Exchange Act Rule 17a-5. See Sarbanes-Oxley Act Section 101. An
``issuer'' under the Sarbanes-Oxley Act is an entity whose
securities are registered under Section 12 of the Exchange Act, or
that is required to file reports under Section 15(d) of the Exchange
Act, or that files or has filed a Securities Act registration
statement that has not yet become effective and that it has not
withdrawn. See Sarbanes-Oxley Section 2(a).
    \83\ See Securities Act Form 1-A, Part F/S (b)(2) and
(c)(1)(iii); Regulation Crowdfunding Rule 201(t) instruction 9, 17
CFR 227.201(t).
---------------------------------------------------------------------------

Amendments to Other PCAOB Standards
    The Board has adopted amendments to several of its existing
auditing standards solely to conform to the final standard. The Board
is not adopting any further changes to these existing auditing
standards at this time, although the Board recognizes that some of the
existing auditing standards, such as the redesignated standard AS 3105,
may need further updating. The Board may consider proposing further
changes to these standards under separate standard-setting projects.
AS 3105, Departures From Unqualified Opinions and Other Reporting
Circumstances
    Existing AS 3101.10 and .20-.76 address departures from the
auditor's unqualified opinion, such as a qualified opinion, an adverse
opinion, or a disclaimer of opinion, and other reporting circumstances,
such as reporting on comparative financial statements. These paragraphs
are redesignated as AS 3105.\84\ Commenters who addressed this topic
generally supported the reproposed amendments to AS 3105, including
amending the example auditor's reports to conform with the example
auditor's report in the final standard. The Board also received some
comments suggesting further changes to AS 3105, such as updating
descriptions of and references to accounting requirements that are no
longer current \85\ and updating certain terminology (e.g., changing
references from ``entity'' to ``company''). The Board may consider such
updates as part of a separate standard-setting project.
---------------------------------------------------------------------------

    \84\ AS 3101.01-.09 and .11-.19 are amended and restated as AS
3101, The Auditor's Report on an Audit of Financial Statements When
the Auditor Expresses an Unqualified Opinion.
    \85\ The Board has issued guidance regarding the status of
outdated descriptions of and references to U.S. GAAP in PCAOB
standards. See PCAOB, Staff Questions and Answers, References to
Authoritative Accounting Guidance in PCAOB Standards (Sept. 2,
2009). Among other things, this guidance provides that auditors
should disregard descriptions of and references to accounting
requirements in PCAOB standards that are inconsistent with the FASB
Accounting Standards Codification (``ASC'').
---------------------------------------------------------------------------

    The Board has adopted final amendments to AS 3105 that are
substantially similar to the reproposal. The amendments to AS 3105 are
not intended to change the circumstances in which the auditor would
depart from an unqualified opinion. The changes from the current
standard will primarily: (1) Require the communication of critical
audit matters in certain circumstances; (2) revise certain terminology
to align with the final standard; and (3) amend the illustrative
reports for the basic elements of the final standard and the required
order of certain sections of the auditor's report.
    AS 3105 includes:
Communication of Critical Audit Matters in Reports Containing Other
Than Unqualified Opinions
    a. Qualified opinion--Amendments to AS 3105 will require that when
the auditor expresses a qualified opinion, the auditor's report also
include communication of critical audit matters, if critical audit
matter requirements apply.
    b. Adverse opinion--The existing requirements related to an adverse
opinion are not amended to require the auditor to communicate critical
audit matters. In the Board's view, the most important matter to
investors and other financial statement users in such circumstances
would be the reason for the adverse opinion.
    c. Disclaimer of opinion--The existing requirements related to a
disclaimer of an opinion are not amended to require the auditor to
communicate critical audit matters. In the Board's view, the most
important matter to investors and other financial statement users in
such circumstances would be the reason for the disclaimer of opinion.
Requirements of Other Regulators and Standard Setters
    Under the IAASB's approach, a matter giving rise to a qualified,
adverse, or disclaimer of opinion is by nature a key audit matter.\86\
However, in such circumstances: (1) The matter should not be described
in the key audit matter section of the auditor's report, (2) the
auditor should report on the matter in accordance with applicable
standards, and (3) the auditor should include a reference in the key
audit matter section to the basis for modified opinion section where
the matter is reported.\87\ The requirements to determine and
communicate key audit matters, other than the matters giving rise to
the modified opinion, would still apply when the auditor expresses a
qualified or adverse opinion, but not when the auditor disclaims an
opinion on the financial statements.\88\ The FRC and the EU do not
include specific requirements for expanded auditor reporting when the
auditor's report contains other than an unqualified opinion.
---------------------------------------------------------------------------

    \86\ See paragraph 15 of ISA 701.
    \87\ Id.
    \88\ See paragraph A7 of ISA 701 and paragraph 29 of ISA 705,
Modifications to the Opinion in the Independent Auditor's Report.
---------------------------------------------------------------------------

Other Amendments to PCAOB Standards
    The amendments to other PCAOB standards are substantially as
reproposed. These include:
     AS 1220, Engagement Quality Review--amending to require
the engagement quality reviewer to evaluate the engagement team's
determination, communication, and documentation of critical audit
matters;
     AS 1301, Communications with Audit Committees--amending to
require the auditor to provide to and discuss with the audit committee
a draft of the auditor's report;
     AS 2201, An Audit of Internal Control Over Financial
Reporting That Is Integrated with An Audit of Financial Statements--
amending the example auditor's report to conform with the example
auditor's report on the financial statements in the final standard;
     AS 2820, Evaluating Consistency of Financial Statements--
amending to

include the existing reporting requirements and illustrative
explanatory language related to a change in accounting principle or a
restatement that is currently in AS 3105; and
     AS 4105, Reviews of Interim Financial Information--
amending to include the basic elements of the final standard, where
applicable.
    Conforming amendments were also made to every PCAOB standard that
refers to the auditor's report. Commenters generally supported the
amendments as reproposed.
    A commenter suggested revising AS 3305, Special Reports, to conform
to the example auditor's report in the final standard. Since reports
pursuant to AS 3305 are rarely filed with the SEC, as noted by this
commenter, the Board does not believe these reports should be updated
at this time. As described above, the Board may consider updating this
standard as part of a separate standard-setting project.

D. Economic Considerations and Application to Audits of Emerging Growth
Companies

    The Board is committed to analyzing the economic impacts of its
standard setting. The following discussion addresses the potential
economic impacts, including potential benefits and costs, considered by
the Board. The Board has sought information relevant to economic
consequences several times over the course of the rulemaking.
Commenters provided views on a wide range of issues pertinent to
economic considerations, including potential benefits and costs, but
did not provide empirical data or quantified estimates of the costs or
other potential impacts of the standard. The potential benefits and
costs considered by the Board are inherently difficult to quantify,
therefore the Board's economic discussion is primarily qualitative in
nature.
    Commenters who discussed the economic analysis in the Board's
reproposal provided a wide range of views. Some commenters pointed to
academic research for the Board to consider in support of their views.
One commenter asserted that the Board's release did not provide a true
economic analysis of the pros and cons of mandating the reporting of
critical audit matters, but only referenced academic studies on the
purported benefits of such reporting. Another argued that the changes
described in the reproposal would lead to a significant increase in
costs, and that no compelling case had been made that the benefits
would exceed the costs. The SEC's Investor Advocate said that the
Board's economic analysis made a compelling case as to why the required
reporting of critical audit matters would reduce informational
asymmetries and add to the total mix of information available to
investors.\89\ The Board has considered all comments received and has
sought to develop an economic analysis that evaluates the potential
benefits and costs of the final standard, as well as facilitates
comparisons to alternative Board actions.
---------------------------------------------------------------------------

    \89\ See letter from Rick A. Fleming, Investor Advocate, SEC
(Aug. 15, 2016) at 3, available on the Board's Web site in Docket
034.
---------------------------------------------------------------------------

Need for the Rulemaking
Critical Audit Matters
    Generally, investors and other financial statement users know less
about a company's financial performance than do others closer to the
financial reporting process, particularly management. This information
asymmetry \90\ can result in situations where capital is allocated
suboptimally. The system of financial reporting in the United States,
which requires periodic reporting of information, including annual
financial statements, helps address the information asymmetry between
investors and management. Board of directors and audit committee
oversight of the financial reporting process can further reduce this
information asymmetry by enhancing the quality of the information
disclosed to the public. As part of this system, the audit of the
financial statements also helps reduce the information asymmetry
investors face by providing an independent opinion about whether the
financial statements are presented fairly in all material respects.
---------------------------------------------------------------------------

    \90\ Economists often describe ``information asymmetry'' as an
imbalance, where one party has more or better information than
another party.
---------------------------------------------------------------------------

    Companies' operations continue to become more complex and global.
In addition, over the last decade, there have been changes in the
financial reporting frameworks relating to accounting estimates and an
increasing use of fair value as a measurement attribute, together with
new related disclosure requirements.\91\ These estimates and fair value
measurements, which are important to a financial statement user's
understanding of the company's financial position and results of
operations, can be highly subjective, require significant judgment, and
can result in increased measurement uncertainty in financial
statements.\92\ The increased complexity of financial reporting,
including the growing use of complex accounting estimates and fair
value measurements, may contribute to the information asymmetry between
investors and management, despite the fact that management is required
to provide significant disclosures to investors and other financial
statement users. Some commenters on the reproposal have stated that
investors would find information provided by the auditor, an
independent third party, particularly relevant in this setting.
---------------------------------------------------------------------------

    \91\ See PCAOB Staff Consultation Paper, Auditing Accounting
Estimates and Fair Value Measurements (Aug. 19, 2014).
    \92\ See IAASB Project Proposal, Revision of ISA 540, Auditing
Accounting Estimates, Including Fair Value Accounting Estimates, and
Related Disclosures (Mar. 2016).
---------------------------------------------------------------------------

    As part of the audit, auditors often perform procedures involving
challenging, subjective, or complex judgments, such as evaluating
calculations or models, the impact of unusual transactions, and areas
of significant risk. Although the auditor is required to communicate
with the audit committee regarding such matters, the auditor's report
has not been expanded to provide this information to investors and
generally provides only a standardized pass/fail opinion. Because the
auditor's report generally does not contain audit-specific information,
it provides very little of the information the auditor knows about the
company, its financial reporting, and the challenges of the audit.
Given the increased complexity of financial reporting, which requires
the auditor to evaluate complex calculations or models and make
challenging or subjective judgments, the current form of the auditor's
report does little to address the information asymmetry between
investors and auditors.
    The Board believes that expanding the auditor's report to provide
information about especially challenging, subjective, or complex
auditor judgments will help investors and other financial statement
users ``consume'' the information presented in management's financial
statements more effectively. Stated in economic terms, in the Board's
view, an expanded auditor's report will reduce the information
asymmetry between investors and auditors, which should in turn reduce
the information asymmetry between investors and management about the
company's financial performance. Reducing information asymmetry about
the company's financial reporting should lead to a more efficient
allocation of capital.
    Some commenters supported the reporting of critical audit matters
as a means of reducing the information asymmetry between investors and
auditors. Other commenters disagreed with the Board's approach and

questioned whether the Board could or should attempt to reduce
information asymmetry by requiring expanded auditor reporting. The
Board believes that requiring expanded auditor reporting as a means of
reducing the information asymmetry between investors and auditors is
consistent with its statutory mandate to ``protect the interests of
investors and further the public interest in the preparation of
informative, accurate and independent audit reports.'' \93\ Investors
are the intended beneficiaries of the audit, but investors do not
receive information about specific work performed during the audit. The
final standard seeks to enhance the form and content of the auditor's
report to make it more relevant and informative to investors and other
financial statement users.
---------------------------------------------------------------------------

    \93\ Section 101(a) of Sarbanes-Oxley.
---------------------------------------------------------------------------

Increasing the Informativeness of the Auditor's Report To Address
Information Asymmetry
    The communication of critical audit matters will reduce the
information asymmetry between investors and auditors by informing
investors and other financial statement users about areas of the audit
that required especially challenging, subjective, or complex auditor
judgment, including the principal considerations for determining the
matters and how the matters were addressed in the audit. The Board
believes that auditor reporting of critical audit matters will provide
investors with audit-specific information that should facilitate their
analysis of the financial statements and other related disclosures. The
communication of critical audit matters in the auditor's report should
also help investors and analysts who are interested in doing so to
engage management and the audit committee with targeted questions about
these issues.\94\ Ultimately, while not every critical audit matter
will be useful for every investor, broadly, the Board believes that
having the auditor provide investors and other financial statements
users with additional information about especially challenging,
subjective, or complex auditor judgments should help reduce the
information asymmetry that exists between investors and management by
providing additional insights on the financial statements.
---------------------------------------------------------------------------

    \94\ The FRC observes that, in some instances, investors have
begun to use the information provided in the expanded auditor's
reports in the U.K. to engage with audit committees. See FRC,
Extended Auditor's Reports, A Further Review of Experience (Jan.
2016) (``FRC 2016 Report'').
---------------------------------------------------------------------------

    The communication of critical audit matters should also assist
investors in assessing the credibility of the financial statements and,
in at least some instances, audit quality.\95\ For example, the
description of how the auditor addressed the critical audit matter will
help investors understand the types of issues that the auditor grappled
with in addressing these challenging, subjective, or complex areas of
the audit, which should allow a deeper and more nuanced understanding
of the related financial statement accounts and disclosures.
Furthermore, investors have consistently stated that having the auditor
rather than the company, provide this type of information would be of
added value to investment decision making.\96\ Commenting on the
reproposal, the SEC's Investor Advocate noted that investors want to
hear directly from the auditor and that this point is confirmed by
surveys of professional investors, as well as by certain academic
research.\97\ This commenter agreed with the premise in the reproposal
that, because the auditor is required to be independent, information
provided by the auditor may be viewed by investors as having greater
credibility than information provided by management alone.
---------------------------------------------------------------------------

    \95\ It is often not possible to observe the difference between
financial reporting quality and audit quality. An academic study
conceptually models the path through which the financial reporting
and audit processes result in audited financial reporting outcomes.
The authors postulate that although audit quality and pre-audit
financial reporting quality are distinct constructs, the two
processes are often inseparable in terms of observable financial
reporting outcomes in archival research. See Lisa Milici Gaynor,
Andrea Seaton Kelton, Molly Mercer, and Teri Lombardi Yohn,
Understanding the Relation between Financial Reporting Quality and
Audit Quality, 35 Auditing: A Journal of Practice & Theory 1, 1-22
(2016).
    \96\ See IAG 2011 survey and CFA survey and poll results.
    \97\ See letter from Rick A. Fleming, Investor Advocate, SEC
(Aug. 15, 2016) at 3, available on the Board's Web site in Docket
034 (citing Brant E. Christensen, Steven M. Glover, and Christopher
J. Wolfe, Do Critical Audit Matter Paragraphs in the Audit Report
Change Nonprofessional Investors' Decision to Invest? 33 Auditing: A
Journal of Practice & Theory 71, 71-93 (2014)).
---------------------------------------------------------------------------

    Reporting of critical audit matters should provide insights that
will add to the mix of information that could be used in investors'
capital allocation decisions, for example, by:
     Highlighting the aspects of the financial statement audit
that the auditor found to be especially challenging, subjective, or
complex;
     Enabling comparison of these aspects of the audit across
companies, for example audits of companies within the same industry;
and
     Enabling comparison of these aspects of the audit for the
same company over time.
    Many companies commenting on the reproposal argued that the
reporting of critical audit matters would not increase the
informativeness of the auditor's report. For example, several of these
commenters claimed that the reporting of critical audit matters would
simply duplicate management disclosure without adding additional
information, or that critical audit matters would not provide value-
relevant information. Other commenters asserted that the reporting of
critical audit matters would result in the auditor's report becoming a
lengthy list of boilerplate disclosures, which would contribute to
disclosure overload or run contrary to the SEC's disclosure
effectiveness initiative. Several commenters said that critical audit
matters could confuse investors if the information in the auditor's
report was duplicative of management's disclosures but was presented in
a different manner, or if the critical audit matter presented
information without appropriate context.
    By contrast, investor commenters overwhelmingly agreed that the
communication of critical audit matters would make the auditor's report
more informative. One commenter said that, although critical audit
matters in themselves would not provide investors with all the
information needed in the face of growing financial complexity,
critical audit matters would add to the total mix of information
available to investors, and would contribute to their ability to
analyze companies, form a multifaceted understanding of them, and make
informed investment decisions. Another commenter noted that, in
jurisdictions where the expanded auditor's report is available, it is
one of the earliest elements of the company's annual report that they
read because it typically highlights the more judgmental elements of
the company's accounting, which often provides insights that form a
basis for discussions with management.
Mandated Rather Than Voluntary Reporting
    Auditors have not developed a practice of providing information in
the auditor's report beyond what is required, even though investors
have consistently requested that the auditor's report become more
informative. Current standards provide a framework for auditors to
provide limited additional information through emphasis paragraphs,\98\
but in general these only point to a disclosure in the company's
financial statements without providing any additional description of

the matter and, as noted below, emphasis paragraphs are infrequent in
practice. Auditor reporting about matters significant to the audit is
not prohibited in an emphasis paragraph, but current standards do not
encourage auditors to include such information in their report and do
not provide a framework for doing so.
---------------------------------------------------------------------------

    \98\ See existing AS 3101.19.
---------------------------------------------------------------------------

    There are many other potential reasons why auditors are not
providing information voluntarily in the auditor's report, whether
about the financial statements or the audit. For example, the
historical model of management disclosing information and the auditor
attesting to the information may lead companies to resist voluntary
additional reporting by the auditor, either through emphasis paragraphs
or with respect to information about the audit, which the auditor would
be better positioned to communicate than management. Further, auditors
may believe that providing additional information could potentially
expose them to liability or that doing so could be interpreted as a
disclaimer of opinion or a partial opinion as to the identified
matters. Finally, in general, there may be disincentives to voluntary
reporting if the disclosing party is not able to fully capture the
benefits of the disclosures,\99\ and parties may also exhibit a bias
toward the status quo.\100\ All of these factors disincentivize
auditors from voluntarily providing further information about the
audit, even if investors and other financial statement users would
respond favorably to receiving additional information.
---------------------------------------------------------------------------

    \99\ Academic research finds that there are certain situations
in which disclosure may be socially optimal but not privately
optimal. Auditors and companies may resist voluntary expanded
auditor reporting because of concerns that certain types of
spillover effects (or externalities) may create a competitive
disadvantage. For a summary of this line of research, see Luigi
Zingales, The Future of Securities Regulation, 47 Journal of
Accounting Research 391, 394-395 (2009). Professor Zingales is the
founding director of the PCAOB's Center for Economic Analysis, now
known as the Office of Economic and Risk Analysis. The research
cited above was published before he joined the PCAOB.
    \100\ Research in behavioral economics suggests that when facing
a set of decisions, individuals are more likely to stick to the
known outcome (status quo) than would be expected based on the
theory of rational decision making under uncertainty. There are a
variety of reasons why individuals may choose the status quo outcome
in lieu of an unknown outcome, including aversion to the uncertainty
inherent in moving from the status quo to another option. See
William Samuelson and Richard Zeckhauser, Status Quo Bias in
Decision Making, 1 Journal of Risk and Uncertainty 7, 7-59 (1988).
---------------------------------------------------------------------------

    The Board believes that the required reporting of critical audit
matters will promote more complete and consistent disclosure of audit-
specific information to financial statement users who may be interested
in it.\101\ Mandatory disclosure can also improve the allocative
efficiency of capital markets by decreasing the costs associated with
gathering information, or by providing market participants with
information that otherwise would have been difficult or impossible for
them to gather.\102\
---------------------------------------------------------------------------

    \101\ Academic research on disclosure explores these types of
positive externalities, as well as certain negative externalities.
See, e.g., Ronald A. Dye, Mandatory versus Voluntary Disclosures:
The Cases of Financial and Real Externalities, 65 The Accounting
Review 1, 1-24 (1990); or Anat R. Admati and Paul Pfleiderer,
Forcing Firms to Talk: Financial Disclosure Regulation and
Externalities, 13 The Review of Financial Studies 479, 479-519
(2000).
    \102\ See, e.g., John C. Coffee, Jr., Market Failure and the
Economic Case for a Mandatory Disclosure System, 70 Virginia Law
Review 717, 717-753 (1984).
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The final standard requires auditors to disclose in the auditor's
report the number of years they have served consecutively as the
auditor for the company. Although some commenters dispute the value of
this information, investor commenters have indicated that the length of
the relationship between the auditor and the company would be a useful
data point. The growing trend toward voluntary disclosure of this
information by companies suggests that increasing numbers of companies
believe that the market finds the disclosure useful.\103\ Further,
there is a line of academic research suggesting that there is an
association between auditor tenure and increases or decreases in audit
quality.\104\
---------------------------------------------------------------------------

    \103\ See Center for Audit Quality and Audit Analytics, 2016
Audit Committee Transparency Barometer (Nov. 2016). See also Ernst &
Young, Audit Committee Reporting to Shareholders 2016 (Sept. 2016).
    \104\ See below for a discussion of academic research regarding
auditor tenure.
---------------------------------------------------------------------------

    Although investors may be able to determine auditor tenure by, for
example, reviewing past auditor's reports, for many companies the
information is not readily available even through a manual search
process. Furthermore, while some companies voluntarily provide
information about auditor tenure in the proxy statement, many do not.
Many companies are also not subject to the proxy rules (for example,
most investment companies, foreign private issuers, and many companies
whose securities are not listed on a national securities exchange). In
cases where the information is provided voluntarily, it is not provided
in a consistent location. The Board believes that these issues create
unnecessary search costs for investors who wish to evaluate information
about auditor tenure. Mandatory disclosure of auditor tenure in the
auditor's report will provide a consistent location for this
information and will reduce search costs relative to the current
baseline for investors who are interested in auditor tenure, especially
in the case of companies that do not voluntarily provide such
information or for which the information is not available through the
EDGAR system. Mandatory disclosure of auditor tenure in the auditor's
report may also be more likely to encourage further discussion of
auditor tenure by management and the audit committee and potential
disclosure in company filings.
    The existing auditor's report also does not describe important
aspects of the auditor's responsibilities under existing auditing
standards, such as the auditor's responsibility to detect material
misstatements, whether due to error or fraud; the auditor's
responsibility for the notes to the financial statements; and the
auditor independence requirement. This may contribute to misperceptions
by investors and other financial statement users about the auditor's
role and responsibilities, including with respect to these matters.
Academic research suggests that there are a number of ways in which
investor perceptions of the role and responsibilities of the auditor
may diverge from what current professional standards require.\105\ In
addition, the existing standards do not require a uniform approach to
basic content, such as the addressee of the report and the form of the
auditor's report, which may increase the time and costs of processing
the information in the auditor's report. The final standard contains
provisions requiring the basic elements in the auditor's report to be
presented more uniformly.
---------------------------------------------------------------------------

    \105\ See, e.g., Bryan K. Church, Shawn M. Davis, and Susan A.
McCracken, The Auditor's Reporting Model: A Literature Overview and
Research Synthesis, 22 Accounting Horizons 69, 69-90 (2008); Glen L.
Gray, Jerry L. Turner, Paul J. Coram, and Theodore J. Mock,
Perceptions and Misperceptions Regarding the Unqualified Auditor's
Report by Financial Statement Preparers, Users, and Auditors, 25
Accounting Horizons 659, 675-676 (2011); or Theodore J. Mock, Jean
B[eacute]dard, Paul J. Coram, Shawn M. Davis, Reza Espahbodi, and
Rick C. Warne, The Audit Reporting Model: Current Research Synthesis
and Implications, 32 Auditing: A Journal of Practice & Theory 323,
323-351 (2013).
---------------------------------------------------------------------------

    Commenters generally supported the reproposed changes to these
basic elements of the auditor's report. Some commenters noted that the
enhanced descriptions of the auditor's responsibility to detect
material misstatements would clarify the auditor's responsibilities for
financial

statement users, other commenters offered suggestions for refinement,
such as aligning the requirements to the IAASB model or amending the
description to more clearly define the auditor's role within the
context of the financial reporting regulatory framework.
    Commenters also generally supported including a statement on the
auditor's independence requirement. For example, some commenters stated
that adding a statement by the auditor on their independence would
reinforce investors' understanding of the auditor's requirement to
remain independent and objective in expressing the audit opinion. Other
commenters said that the enhanced description of the independence
requirement could provide a meaningful reminder of the importance of
auditor independence. However, other commenters said that the enhanced
description of auditor independence was either unnecessary, or would
not have a significant impact on auditor behavior. Based on broad
commenter support, the Board is adopting these additional improvements
to the auditor's report as reproposed.
Baseline
Critical Audit Matters
    The auditor's report in the United States today generally consists
of three paragraphs that include limited audit-specific information.
The existing auditor's report identifies the company's financial
statements that were audited, provides a standardized description about
the nature of an audit, and provides an opinion on whether the
company's financial statements are fairly presented, in all material
respects, in conformity with the applicable financial reporting
framework. The auditor's report is often described as a pass/fail model
because the report only conveys the auditor's opinion on whether the
financial statements are fairly presented (pass) or not (fail) and
typically provides limited information about the nature of the work on
which the opinion is based.
    The Board's current standards also require that the auditor add
explanatory paragraphs to the auditor's report under specific
circumstances, such as when there is substantial doubt about the
company's ability to continue as a going concern or a restatement of
previously issued financial statements. When included, these paragraphs
generally consist of standardized language that provides limited audit-
specific information.
    The auditor may also, at his or her discretion, include emphasis
paragraphs in the auditor's report to emphasize a matter regarding the
financial statements. Generally, an emphasis paragraph only points to a
disclosure in the company's financial statements without providing any
additional description. Under current practice, emphasis paragraphs are
infrequent.\106\ Auditors may also, at their discretion, include
language in the auditor's report indicating that they were not engaged
to examine management's assertion about the effectiveness of internal
control over financial reporting.\107\
---------------------------------------------------------------------------

    \106\ In the audit reports of approximately 6,350 issuers with
fiscal year 2014 filings, PCAOB staff identified audit reports
containing explanatory paragraphs to emphasize matters in the
financial statements in approximately 2 percent of the filings.
    \107\ See paragraph .10 of AI 20, Other Information in Documents
Containing Audited Financial Statements: Auditing Interpretations of
AS 2710.
---------------------------------------------------------------------------

    Academic research confirms the view of the Board and many
commenters that the current form of the auditor's report conveys little
of the audit-specific information obtained and evaluated by the
auditor.\108\ Academic research also finds that investors 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 much additional informational value about a particular
audit.\109\ These findings align with the consistent call from
investors, over the course of the Board's rulemaking process, for a
more informative auditor's report.\110\
---------------------------------------------------------------------------

    \108\ See Church et al., The Auditor's Reporting Model: A
Literature Overview and Research Synthesis 69-90.
    \109\ See Gray et al., Perceptions and Misperceptions Regarding
the Unqualified Auditor's Report by Financial Statement Preparers,
Users, and Auditors 659-684; Mock et al., The Audit Reporting Model:
Current Research Synthesis and Implications 323-351.
    \110\ Academic research has found that, in some instances, the
inclusion of explanatory language in the auditor's report may
provide investors with additional value-relevant information. A
recent academic study suggests that auditor's reports containing
certain types of explanatory paragraphs required under existing
standards may provide information about the likelihood that
financial statements will be subsequently restated. The authors
argue that the inclusion of such an explanatory paragraph in the
auditor's report can provide a signal to investors about the risk of
misstatement of the company's financial statements. See Keith
Czerney, Jaime J. Schmidt, and Anne M. Thompson, Does Auditor
Explanatory Language in Unqualified Audit Reports Indicate Increased
Financial Misstatement Risk? 89 The Accounting Review 2115, 2115-
2149 (2014).
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The existing auditor's report is not required to have a specified
addressee but it may be addressed to the company whose financial
statements are being audited, its board of directors, or
stockholders.\111\ Under current practice, the auditor's report is
generally addressed to one or more of the following: (1) The board of
directors and stockholders/shareholders, or their equivalent for
issuers that are not organized as corporations; (2) the plan
administrator or plan participants for benefit plans; and (3) the
directors or equity owners for brokers or dealers.\112\
---------------------------------------------------------------------------

    \111\ See existing AS 3101.09.
    \112\ This information is based on a review by PCAOB staff of a
random sample of 2014 fiscal year-end auditor's reports for issuers,
benefit plans, and brokers and dealers.
---------------------------------------------------------------------------

    The current auditor's report also includes the report title, the
date, and the name and location of the accounting firm's office issuing
the report. The auditor is not currently required to disclose in the
auditor's report the number of years it has served as auditor for the
company. However, as noted earlier, many larger companies have begun
voluntarily disclosing auditor tenure in the proxy statement.
    Currently, the title of the auditor's report, ``Report of
Independent Registered Public Accounting Firm,'' provides the only
indication of the auditor's independence.
Benefits
Critical Audit Matters
    Economic theory commonly attributes two benefits to mandatory
disclosure. First, the disclosure of previously unknown, value-relevant
information directly benefits the market because it allows market
participants to make better-informed decisions. Second, the disclosure
of such information may indirectly benefit the market because some
parties may change their behavior in positive ways after information is
disclosed.
Direct Benefit: More Informative and Useful Auditor's Report
    The Board believes that auditor communication of critical audit
matters will reduce the information asymmetry between investors and
auditors, which should in turn reduce the information asymmetry between
investors and management about the company's financial performance.
Some commenters on the reproposal agreed that the information provided
in critical audit matters would be used by various types of investors
in a number of different ways that are consistent with the framework
outlined in the reproposal:
     Informing--Identification of the matters arising from the
audit that the auditor considered especially challenging, subjective,
or complex,

together with a description of how the auditor addressed those matters,
which should provide valuable information. For example, some commenters
said that:
     Critical audit matters would add to the total mix of
information available to investors, and would contribute to their
ability to analyze companies and make investment decisions;
     Investors would use critical audit matters in the same way
that they use any other financial disclosure; critical audit matters
would add an additional perspective to management's disclosures;
     Insights on critical audit matters may be relevant in
analyzing and pricing risks in capital valuation and allocation;
     Critical audit matters would inform investor models of
company financial performance;
     Critical audit matters would augment and add more
dimension to the information provided by the financial statements and
the critical accounting policies and estimates; and
     The communication of critical audit matters would lower
the cost of acquiring information for financial statement users.
     Framing--Critical audit matters should provide investors
with a new perspective on the financial statements and focus their
attention on the related financial statement accounts and disclosures,
which should facilitate their analysis of the financial statements, and
help them assess financial performance, for example by highlighting
potentially relevant information or by reducing the costs to process or
search for the information. For example, some commenters said that:
     Critical audit matters would focus investors' attention on
key financial reporting issues and identify areas that deserve more
attention;
     In jurisdictions where expanded auditor reporting is
available, it focuses users' attention on issues that would be
pertinent to understanding a company as a long-term investor; and
     Information in critical audit matters would contribute to
investor understanding and consumption of information in the financial
statements.
     Monitoring--The ability to identify and evaluate the
matters identified as critical audit matters should also help investors
and analysts engage management with targeted questions about these
issues and support investor decisions on ratification of the auditor.
For example, some commenters said that:
     Critical audit matters would facilitate the ability of
investors to monitor management's and the board of director's
stewardship of the company by highlighting accounting and auditing
issues and other matters that investors may wish to emphasize in their
engagement with management; and
     Critical audit matters would provide important information
on how the auditor has addressed an issue, which investors can use in
evaluating the rigor of the audit and making proxy voting decisions,
including ratification of the audit committee's choice of external
auditor.
    Critical audit matters may be used by different types of investors
in different ways. For example, retail investors (or others who may act
on their behalf, such as analysts, credit rating agencies, or the
financial press) may use the additional information to help them
identify and analyze important aspects of the financial statements.
Larger investors, on the other hand, may also use critical audit
matters as a basis for engagement with management.
    The communication of critical audit matters aims to provide
investors and financial statement users with specific information about
the audit of a company's financial statements. Some commenters were
concerned, however, that the communication of critical audit matters
could lead to a reduction in comparability of auditor's reports.
Although differences in critical audit matters from period to period
and across companies may make auditor's reports less uniform, to the
extent the information provided is useful in evaluating the financial
performance, highlighting these differences should contribute to the
overall mix of information. Further, some commenters on the proposal
said that investors are interested in information that is specific to
the audit of a company's financial statements, and therefore, would
expect differences in auditor's reports across companies and reporting
periods. Investors also have indicated that they are accustomed to
analyzing company-specific information, such as information in
financial statements or MD&A that is specific to a company or a
reporting period.
    A body of academic research regarding the possible effects of
expanded auditor reporting is emerging.\113\ The Board has been
monitoring this research with a view towards assessing its potential
relevance to this rulemaking. The Board is mindful of several issues
that limit the extent to which this research can inform its decision
making. Much of this research is unpublished and at a relatively early
stage. The current conclusions may be subject to multiple
interpretations and it is possible that results from this research may
be revised during the peer review process. Moreover, it may be
difficult to generalize results outside the context of specific
studies. For example, in considering the implications of academic
studies based on data from other jurisdictions, differences between the
Board's final standard and the requirements in other jurisdictions must
be taken into account. In addition, specific characteristics of the
U.S.-issuer audit market may make it difficult to generalize
observations made in other markets because of differences in baseline
conditions (for example, market efficiency, affected parties, policy
choices, legal environment, and regulatory oversight). As to
experimental research in particular, it should be noted that the
experimental setting may not provide study participants with
information that is representative of the information environment in
which market participants actually operate; for instance, if new
information appeared more salient to study participants than it would
to a market participant, the impact of expanded auditor reporting would
be overstated in an experimental setting. In addition, some of these
studies were conducted based on earlier versions of rule text that
differs from the final standard, which may affect the extent to which
the results can inform the Board in evaluating potential effects of the
final standard.
---------------------------------------------------------------------------

    \113\ For a review of relevant academic research, see Jean
B[eacute]dard, Paul Coram, Reza Espahbodi, and Theodore J. Mock,
Does Recent Academic Research Support Changes to Audit Reporting
Standards? 30 Accounting Horizons 255, 255-275 (2016).
---------------------------------------------------------------------------

    As discussed in more detail in the economic analysis contained in
the reproposal, the results from early research analyzing the
informational value of expanded auditor reporting are
inconclusive.\114\ Some studies found that expanded auditor reporting
could provide investors with new and useful information, while other
studies found that the benefits attributable to expanded auditor
reporting were not statistically significant, but that it could produce
unintended consequences. These limited findings may be due to the fact
that the results of the studies represent averages for large samples of
companies. On average, investors may already have access to a variety
of information sources (such as annual reports, news media, and analyst

research reports) which may contain similar information about a
company. However, expanded auditor reporting may be relatively more
informative for companies where alternative sources of information are
less available (e.g., those companies with less analyst coverage).
---------------------------------------------------------------------------

    \114\ See PCAOB Release No. 2016-003, Section VI.C.1.a.
---------------------------------------------------------------------------

    In response to the reproposal, two commenters submitted studies
suggesting that expanded auditor reporting has increased the
informative value of the auditor's report. One experimental study
tested the communicative value of expanded auditor reporting by
analyzing how key audit matters affected investment professionals'
assessment of a company's business economics, as well as their
confidence in making that assessment.\115\ The authors found that
specific informational content of the key audit matter affected the
study participants' perceived level of trust associated with the
auditor's report, which then affected the perceived level of trust
associated with the financial statements and their assessment of the
company's business economics. Another study analyzed whether the
communicative value of auditor's reports changed following the
implementation of expanded auditor reporting in the United
Kingdom.\116\ The author found that the readability of auditor's
reports increased in the post-implementation period, and that the use
of negative and uncertain words in expanded auditor's reports captured
more client-specific audit risk.\117\ In addition, the author found
limited evidence that the dispersion of analysts' EPS forecasts
decreased following the implementation of expanded auditor reporting,
suggesting an improved information environment. The author argued that
expanded auditor reporting was successful at increasing the
communicative value of the auditor's report, and that analyst behavior
changed accordingly. In contrast, another recent experimental study
found that including critical audit matters reduced the readability of
the auditor's report but did not incrementally inform nonprofessional
investors' valuation judgments. However, the study suggested that the
reporting of a critical audit matter lowers nonprofessional investors'
perceptions of management's credibility when earnings just meet
analysts' expectations. The study was designed and implemented using
the definition of critical audit matters and related reporting
requirements from the Board's proposal, which differ from the final
standard.\118\
---------------------------------------------------------------------------

    \115\ See Annette Koehler, Nicole Ratzinger-Sakel, and Jochen
Theis, Does the Reporting of Key Audit Matters Affect the Auditor's
Report's Communicative Value? Experimental Evidence from Investment
Professionals (working paper submitted as comment letter No. 18,
available on the Board's Web site in Docket 034).
    \116\ See Kecia Williams Smith, Tell Me More: A Content Analysis
of Expanded Auditor Reporting in the United Kingdom (working paper
submitted as comment letter No. 71, available on the Board's Web
site in Docket 034).
    \117\ The author uses several measures designed to assess the
readability of texts which, the study notes, have been used in
several other published academic studies addressing the readability
of financial disclosure. See id. at 5.
    \118\ See Brian Carver and Brad Trinkle, Nonprofessional
Investors' Reactions to the PCAOB's Proposed Changes to the Standard
Audit Report (March 2017) (working paper, available in Social
Science Research Network).
---------------------------------------------------------------------------

    In addition, in reviewing the experience of expanded auditor
reporting in the United Kingdom, the FRC observed that investors
greatly value the information provided in expanded auditor
reporting.\119\ This view is confirmed by UK investors that commented
on the reproposal. The FRC noted that, in the two years following the
implementation of the new requirements, an association of investment
managers has recognized in an annual awards ceremony those specific
auditor's reports found to be most clear and most innovative in
providing insight into the audit of the company's financial
statements.\120\ In addition, the FRC notes that users of the new
auditor's reports identified certain descriptions of risks that they
found to be more useful--such as descriptions that are specific to the
entity being audited. Further, the FRC report noted that, in the second
year of implementation, a much greater proportion of risks were set out
in a more meaningful and transparent way.\121\ As noted above, the
FRC's requirements for expanded auditor reporting are different from
the final standard, and the baseline legal and regulatory environment
is not the same as in the United States. Nevertheless, the Board
believes that there are sufficient similarities for the UK experience
to be generally informative in its decision-making.
---------------------------------------------------------------------------

    \119\ See FRC 2016 Report.
    \120\ See FRC, March 2015--Extended Auditor's Reports, A Review
of Experience in the First Year; and FRC 2016 Report.
    \121\ Id.
---------------------------------------------------------------------------

    While it is too early for the body of academic research on expanded
auditor reporting to provide a conclusive answer, investors commenting
during the Board's standard-setting process have consistently affirmed
the usefulness of expanded auditor reporting and the FRC's observations
on the early experience of investors in the United Kingdom are
consistent with this view. Accordingly, the Board believes that auditor
communication of critical audit matters will add to the mix of
information that investors can use.
Indirect Benefit: Improved Audit and Financial Reporting Quality
    In general, information asymmetry can lead to situations in which
an agent (such as an auditor) takes actions that do not coincide with
the best interests of the principal (such as an investor), if the
agent's incentives are misaligned.\122\ This type of problem is the
result of the inability of the principal to observe or monitor the
agent's behavior, which also inhibits the principal's ability to
identify and reward optimal behavior, or punish sub-optimal behavior.
Economic theory posits that the disclosure of information can have
indirect effects that lead to changes in behavior.\123\ In the context
of expanded auditor reporting, the additional information provided in
the auditor's report could be beneficial to investors by providing more
information about the audit, which could affect their voting decisions.
To the extent that this could influence the terms of the auditor's
engagement, academic research suggests ``any additional information
about the agent's action, however imperfect, can be used to improve the
welfare of both the principal and the agent.'' \124\
---------------------------------------------------------------------------

    \122\ Economists use principal-agent theory to analyze
situations where one party (the principal) hires another party (the
agent) to perform certain tasks and decision-making ability is
delegated to the agent. For a general discussion of principal-agent
theory, see, e.g., Michael C. Jensen and William H. Meckling, Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure, 3 Journal of Financial Economics 305, 305-360 (1976), or
Bengt Holmstrom, Moral Hazard and Observability, 10 The Bell Journal
of Economics 74, 74-91 (1979).
    \123\ See, e.g., George Loewenstein, Cass R. Sunstein, and
Russell Golman, Disclosure: Psychology Changes Everything, 6 Annual
Review of Economics 391, 391-419 (2014).
    \124\ See Holmstrom, Moral Hazard and Observability at 75.
---------------------------------------------------------------------------

    This suggests that making aspects of the audit more visible to
investors through the communication of critical audit matters should
provide some auditors, management, and audit committees with additional
incentives to change their behavior in ways that may enhance audit
quality and ultimately financial reporting quality. For instance, the
communication of critical audit matters could lead:
     Auditors to focus more closely on the matters identified
as critical audit matters;
     Audit committees to focus more closely on the matters
identified as critical audit matters and to engage the

auditor and management about the adequacy of the related disclosures;
and
     Management to improve the quality of their disclosures
because they know that investors and the auditor will be scrutinizing
more closely the matters identified as critical audit matters.
    The communication of critical audit matters could lead auditors to
increase their focus on the matters identified in the auditor's report
as critical audit matters. As suggested by commenters, the
communication of critical audit matters could further incentivize
auditors to demonstrate the level of professional skepticism necessary
for high quality audits in the areas of the critical audit matters.
Other commenters stated that the reporting of critical audit matters
could result in increased audit quality. For example, auditors could
feel that the potentially heightened scrutiny of the matters identified
as critical audit matters may warrant additional effort to satisfy
themselves that they have obtained an appropriate amount of audit
evidence to support their opinion.
    The communication of critical audit matters could also heighten
management's attention to the relevant areas of financial statements
and related disclosures. Several commenters stated that the reporting
of critical audit matters would lead management to improve the quality
of their disclosures or adopt more widely accepted financial reporting
approaches in these areas.\125\
---------------------------------------------------------------------------

    \125\ To substantiate this point, one commenter cited a memo
prepared for the clients of an international law firm that noted
management should consider revising or supplementing their own
disclosures relating to issues raised in expanded auditor's reports
to ensure that the totality of disclosures around the issue are
complete and accurate. See Sullivan & Cromwell LLP, Audit Reports,
PCAOB Releases Reproposal of Amendments to Its Audit Report Standard
(May 25, 2016).
---------------------------------------------------------------------------

    An experimental study analyzed the joint effect of expanded auditor
reporting and audit committee oversight on management disclosure
choices.\126\ The author found that the study participants, who were
currently serving as public company financial executives, chose to
provide the greatest level of disclosure when they knew that the
auditor's report would provide a more detailed description of the
accounting estimate, and the audit committee exhibited strong
oversight. The author argued that, similar to what other academic
research has found regarding the resolution of audit adjustments,
information presented in critical audit matters would be the outcome of
a negotiation process between the auditor and management.
---------------------------------------------------------------------------

    \126\ See Stephen H. Fuller, The Effect of Auditor Reporting
Choice and Audit Committee Oversight Strength on Management
Financial Disclosure Decisions (working paper submitted as comment
letter No. 49, available on the Board's Web site in Docket 034).
---------------------------------------------------------------------------

    Increased management attention to the related aspects of the
financial statement accounts and disclosures described in the critical
audit matters should, at least in some cases, lead to an incremental
increase in the quality of the information presented. Academic research
has shown that increased quality of information could result in a
reduction in the average cost of capital.\127\
---------------------------------------------------------------------------

    \127\ See, e.g., Richard A. Lambert, Christian Leuz, and Robert
E. Verrecchia, Information Asymmetry, Information Precision, and the
Cost of Capital, 16 Review of Finance 1, 1-29 (2012). Professor Leuz
is an economic advisor at the PCAOB. The research cited above was
published before he joined the PCAOB.
---------------------------------------------------------------------------

    In addition, the communication of critical audit matters may
enhance the audit committee's oversight efforts by providing an
additional incentive for the audit committee to engage with the auditor
and management about the matters identified as critical audit matters
and the adequacy of the company's related disclosures. Although some
commenters stated that the required communication of critical audit
matters would ``chill'' communications between the auditor and the
audit committee, others said that it would enhance communications
between these parties. Further, it should be noted that the final
standard does not change the Board's existing requirements on audit
committee communications, other than requiring the auditor to provide
the audit committee with a draft of the auditor's report.
    To the extent changes in the behavior of auditors, audit
committees, and management occur, they could lead to an incremental
increase in audit quality and financial reporting quality, which should
increase investors' confidence in the reliability of the financial
statements. Some commenters stated that a more transparent and
informative auditor's report could heighten user confidence in the
audit and the audited financial statements. Academic research suggests
that an increase in investor confidence should decrease the average
cost of capital.\128\ As discussed in the economic analysis of the
reproposal, some empirical studies conducted in other jurisdictions
provide evidence that expanded auditor reporting increased audit
quality, while other studies found that it did not have a measurable
effect on audit quality.\129\ The Board is not aware of any empirical
studies indicating that expanded auditor reporting had a negative
effect on audit quality.
---------------------------------------------------------------------------

    \128\ See Luigi Guiso, Paola Sapienza, and Luigi Zingales,
Trusting the Stock Market, 63 The Journal of Finance 2557, 2557-2600
(2008). Professor Zingales is the Founding Director of the PCAOB's
Center for Economic Analysis, now known as the Office of Economic
and Risk Analysis. The research cited here was published before he
joined the PCAOB.
    \129\ See PCAOB Release No. 2016-003, Section VI.C.1.b,
footnotes 154-156 and accompanying text.
---------------------------------------------------------------------------

Indirect Benefit: Differentiation Among Auditor's Reports
    If investors and other financial statement users perceive and
respond to differences in the quality and usefulness of the information
communicated by auditors regarding critical audit matters, expanded
auditor reporting should serve as a potential means of greater
differentiation among accounting firms and engagement partners.\130\
One commenter stated that the reporting of critical audit matters would
allow auditors to differentiate themselves, and that this
differentiation would provide useful information to investors and other
financial statement users. If expanded auditor reporting allows
investors to differentiate among accounting firms and engagement
partners, it should provide a more nuanced signal of audit quality and
financial reporting reliability.
---------------------------------------------------------------------------

    \130\ On May 9, 2016, the SEC approved new rules and related
amendments to the Board's auditing standards, including amendments
to AS 3101, that will provide investors and other financial
statement users with information about engagement partners and other
accounting firms that participate in audits of issuers. See PCAOB
Release No. 2015-008.
---------------------------------------------------------------------------

    The FRC report also noted that there are clear differences among
accounting firms in the approaches taken to implement the
requirements.\131\ For example, one firm went beyond the FRC's
requirements by including audit findings for the risks of material
misstatement in the majority of its auditor's reports in the second
year of implementation, which other firms did far less frequently. The
FRC's observations may suggest that accounting firms took different
approaches to expanded auditor reporting as a means of distinguishing
themselves based on the quality and usefulness of the information
provided in their auditor's reports. Furthermore, as discussed in the
economic analysis of the reproposal, an academic study argued that
investors found the auditor's reports issued by some accounting firms
to be more useful than others.\132\ One commenter specifically noted
that mandatory auditor rotation was introduced in the UK at the same
time

as expanded auditor reporting, and that this may have provided
accounting firms with motivation to differentiate themselves.
---------------------------------------------------------------------------

    \131\ See FRC 2016 report.
    \132\ See PCAOB Release No. 2016-003, Section VI.C.1.b, footnote
161 and accompanying text.
---------------------------------------------------------------------------

    In addition to relying on the audit committee (which, at least for
exchange-listed companies, is charged with overseeing the external
auditor), in the absence of differentiation based on the auditor's
report, users of financial statements may rely on proxies such as the
reputation of the accounting firm issuing the auditor's report,
aggregated measures of auditor expertise (for example, dollar value of
issuer market capitalization audited or audit fees charged), or
information about the geographic location of the office where the
auditor's report was signed as signals for audit quality. Academic
research finds, however, that these are imperfect signals of audit
quality.\133\
---------------------------------------------------------------------------

    \133\ See, e.g., Jere R. Francis, A Framework for Understanding
and Researching Audit Quality, 30 Auditing: A Journal of Practice &
Theory 125, 125-152 (2011) and Mark DeFond and Jieying Zhang, A
Review of Archival Auditing Research, 58 Journal of Accounting and
Economics 275, 275-326 (2014).
---------------------------------------------------------------------------

    The identification and description of critical audit matters should
permit differentiation among auditor's reports based on investor
perceptions of their informativeness and usefulness. In some instances
it may also provide a signal of audit quality. Because the
determination and communication of critical audit matters may reflect a
variety of considerations, however, critical audit matters may not bear
directly on audit quality. For example, the choice of which critical
audit matters to communicate or how to describe them may reflect
considerations such as the company's business environment and financial
reporting choices, accounting firm methodology, engagement partner
characteristics, and legal advice. Thus, a more detailed description of
critical audit matters may not necessarily reflect a higher quality
audit than a less informative description of such matters.
    Nevertheless, informative descriptions of how the audit addressed
critical audit matters should provide insight into the extent and
appropriateness of the auditor's work. Moreover, it is possible that
thoughtful, audit-specific, and useful critical audit matters (or,
conversely, generic and uninformative critical audit matters) could
affect investor perceptions of the auditor's work and willingness to
provide useful information. As a result, the communication of critical
audit matters, potentially in conjunction with disclosures regarding
the identity of the engagement partner and other accounting firms that
participated in the audit,\134\ and other relevant information should
enable differentiation among engagement partners and accounting firms
on that basis.
---------------------------------------------------------------------------

    \134\ See PCAOB Release No. 2015-008.
---------------------------------------------------------------------------

Additional Improvements to the Auditor's Report
    The final standard will introduce new requirements regarding
auditor tenure, the addressee of the auditor's report, and statements
in the auditor's report related to auditor independence and the
auditor's responsibility for reporting on ICFR.\135\ In addition, the
final standard contains other changes to the form of the auditor's
report, which are intended to improve and clarify the language for
certain elements, such as statements related to the auditor's
responsibilities regarding the notes to the financial statements, and
to promote a consistent presentation of this information across
auditor's reports.
---------------------------------------------------------------------------

    \135\ In circumstances where management is required to report on
ICFR but the auditor is not and has not performed an audit of ICFR,
the final standard requires a statement to that effect in the
auditor's report.
---------------------------------------------------------------------------

    Investor commenters have consistently supported disclosing tenure
in the auditor's report. In the Board's view, which is consistent with
the views of some commenters,\136\ disclosing information about auditor
tenure in the auditor's report will provide a consistent location for
this information and decrease the search costs, relative to the current
environment of voluntary reporting, for some investors and other
financial statement users who are interested in this information.
---------------------------------------------------------------------------

    \136\ See below for a discussion of academic research regarding
auditor tenure.
---------------------------------------------------------------------------

    The statement regarding the auditor's existing obligation to be
independent of the company is intended to enhance investors' and other
financial statement users' understanding about the auditor's
obligations related to independence and to serve as a reminder to
auditors of these obligations. By requiring the auditor's report to be
addressed to certain parties, the Board will be promoting uniformity in
the addressees of the auditor's report.
    Commenters were generally supportive of the reproposed changes to
the form of the auditor's report. For example, some commenters stated
these enhancements would make the auditor's report easier to read and
would facilitate comparisons between auditor's reports for different
companies by providing a consistent format.
Costs and Potential Unintended Consequences
Costs
    Commenters on the reproposal raised concerns that the rule would
impose various types of costs, but generally did not quantify those
costs. Even those that, at an earlier stage of the rulemaking,
conducted limited implementation testing of the proposal were unable to
provide a quantified cost estimate. Given lack of data, the Board is
unable to quantify costs, but provides a qualitative cost analysis.
    As an additional means of assessing potential cost implications of
the final standard, PCAOB staff has reviewed data from the first year
of implementation of expanded auditor reporting in the United
Kingdom.\137\ As discussed below, staff analyzed a variety of data
points that may be associated with potential costs, including audit
fees, days required to issue the auditor's report, and the content of
the expanded auditor's report. It should be noted that it may be
difficult to generalize observations from the UK experience. For
example, the reporting and documentation requirements relating to
expanded auditor's reports in the United Kingdom differ from those in
the final standard, the baseline legal environments are different, and
the UK requirements apply only to companies with a premium listing on
the London Stock Exchange and not, for example, to smaller companies
that list on London's AIM market.
---------------------------------------------------------------------------

    \137\ See PCAOB, White Paper on the Auditor's Reports of Certain
UK Companies that Comply with International Auditing Standard (UK
and Ireland) 700 (``PCAOB White Paper'') (May 2016), available on
the Board's Web site in Docket 034.
---------------------------------------------------------------------------

Critical Audit Matters
    The Board anticipates that the final requirements regarding
critical audit matters will have potential cost implications for
auditors and companies, including their audit committees. Such costs
will likely relate to additional time to prepare and review auditor's
reports, including discussions with management and audit committees, as
well as legal costs for review of the information provided in the
critical audit matters. In addition, auditors may choose to perform
more audit procedures related to areas reported as critical audit
matters (even though performance requirements have not changed in those
areas), with cost implications for both auditors and companies.
    For auditors, costs might represent both one-time costs and
recurring costs. One-time costs could be incurred as a

result of: (1) Updating accounting firm audit and quality control
methodologies to reflect the new reporting requirements; and (2)
developing and conducting training of accounting firm personnel on the
new reporting requirements. When updating methodologies, some
accounting firms will likely also develop new quality control processes
related to additional review or consultation on the determination,
communication, and documentation of critical audit matters. One
commenter suggested that the initial implementation costs could place a
significant and possibly disproportionate burden on smaller accounting
firms.
    Recurring costs will primarily reflect additional effort expended
in individual audits. The final standard does not impose new
performance requirements other than the determination, communication,
and documentation of critical audit matters, which will be based on
work the auditor has already performed. However, there will be some
additional recurring costs associated with drafting descriptions of
critical audit matters and related documentation. It is likely that
senior members of the engagement teams, such as partners and senior
managers, will be involved in determining the critical audit matters
and developing the language to be included in the auditor's report. In
addition, reviews by others, such as the engagement quality reviewer
and national office, will also result in recurring costs. Additional
time might also be incurred by the auditor as a result of discussions
with management or the audit committee regarding critical audit
matters.
    Companies, including audit committees, will likely also incur both
one-time and recurring costs as a result of the final standard. One-
time costs could be incurred, for example, in educating audit committee
members about the requirements of the new standard and in developing
management and audit committee processes for the review of draft
descriptions of critical audit matters and the related interaction with
auditors. Recurring costs will include the costs associated with
carrying out those processes, as well as any increase in audit fees
associated with the new reporting requirements or legal fees stemming
from a review of critical audit matter communications.
    If the drafting and review of critical audit matter reporting takes
place towards the end of the audit, there will also be an opportunity
cost associated with the time constraints on the parties involved
(including, for example, management, the engagement partner, the audit
committee, and the auditor's and company's respective legal counsel).
The end of the audit is a busy period in which multiple issues may need
to be resolved before the auditor's report can be issued. At the same
time, companies and management may also be in the process of finalizing
the annual report. Time spent drafting and reviewing the communication
of critical audit matters could occur at the same time as other
important work in the financial reporting and audit process, and would
likely involve senior management that command relatively high annual
salaries or experienced auditors and lawyers with relatively high
hourly billing rates. In addition, the communication of critical audit
matters could lead to changes in management's disclosures, which may
result in more effort and cost in the financial reporting process.
    Several commenters on the reproposal claimed that the required
reporting of critical audit matters would lead to increased audit fees,
but none provided data or estimates regarding the magnitude of the
increases they expected. Commenters on the proposal had differing views
about the likely magnitude of direct costs associated with auditor
reporting of critical audit matters. Some commenters said that there
would not be material additional costs for communication of critical
audit matters, as these matters would already have been communicated to
the audit committee. This may suggest that a substantial amount of the
work required to communicate critical audit matters would already have
been completed earlier in the audit.
    One commenter argued that the changes described in the reproposal
would lead to a significant increase in costs, and that no compelling
case had been made that the benefits would exceed the costs. Some
commenters noted that investors would be expected to ultimately bear
the cost of the audit, and these commenters have voiced strong support
for expanded auditor reporting since the project's inception. This
suggests that they consider the benefits of expanded auditor reporting
to justify the costs, and would support additional fees for additional
useful information.
    Audit fees do not fully reflect the cost of implementing expanded
auditor reporting to the extent that accounting firms choose to absorb
those additional costs and because audit fees do not reflect the impact
of any additional demand on management's time associated with expanded
auditor reporting. Subject to those limitations, in its review of the
implementation of expanded auditor reporting in the United Kingdom, the
PCAOB staff did not find evidence of statistically significant
increases in audit fees following the first year of expanded auditor
reporting.\138\ For 53 percent of the companies analyzed, audit fees
for the year of implementation remained the same or decreased as
compared to the prior year's audit fees. Audit fees increased for the
remaining companies. The PCAOB staff found that the average change in
audit fees was an increase of approximately 5 percent, roughly
consistent with the findings of academic research described in the
economic analysis in the reproposal. However, the staff found that the
median change in audit fees was zero. Collectively, these results seem
to suggest that outlier companies with relatively large increases in
audit fees drove the result for the average change in audit fees. It
should be noted that the PCAOB staff's review did not analyze whether
other factors, such as inflation, changes in the economic environment
and corporate risk, corporate acquisitions, or the implementation of
other regulatory changes, contributed to the documented increase in
audit fees.
---------------------------------------------------------------------------

    \138\ Id.
---------------------------------------------------------------------------

    One commenter on the reproposal noted that the caveats described
above are important because the inability to fully gauge the costs of
expanded auditor reporting could lead the Board to underestimate the
costs associated with the rule, which may bear disproportionately on
smaller companies and their auditors. Another commenter also asserted
that the costs of expanded auditor reporting are likely to be
disproportionately borne by smaller companies because the reproposed
rule had, in their estimation, limited scalability. The Board believes
that the complexity and costs associated with determining, documenting,
and communicating critical audit matters should generally depend on the
nature and complexity of the audit. This would in turn depend on the
complexity of the operations and accounting and control systems of the
company.
Additional Improvements to the Auditor's Report
    The changes adopted to the basic elements of the auditor's report
do not represent a significant departure from the reproposal. Some of
the enhanced basic elements will have cost implications for auditors,
although these costs are not expected to be significant. One-time costs
will primarily relate to updating methodology and training and

the initial determination of the first year the auditor began serving
consecutively as the company's auditor. Based on comments received, it
does not appear that the changes adopted to the basic elements will
impose significant recurring costs, because the year in which tenure
began will not change and the other amendments involve standardized
language that, once implemented, will be the same or very similar
across different auditor's reports every year.
Potential Unintended Consequences
Time Needed To Issue the Auditor's Report
    As a result of the additional effort required to determine,
communicate, and document critical audit matters, some commenters said
that it would take auditors longer to issue their reports. On this
point, the PCAOB staff study did not find evidence that compliance with
the United Kingdom's expanded auditor reporting requirements delayed
the issuance of auditor's reports in the first year of implementation.
Based on the study, for companies that had three years of financial
statements, a new form auditor's report was issued, on average, in 63
days from the company's fiscal year end date in the year of
implementation, as compared to 64 days in the prior year and 65 days
two years earlier. Further, academic research cited in the economic
analysis of the reproposal similarly did not find that the UK reporting
requirements led to delays in financial reporting.\139\
---------------------------------------------------------------------------

    \139\ See PCAOB Release No. 2016-003, section VI.D.2.a, footnote
169 and accompanying text.
---------------------------------------------------------------------------

Number and Content of Critical Audit Matters
    Some commenters indicated an expectation that the auditor's report
would include a long list of critical audit matters or that auditors
would have incentives to communicate an overly long list of critical
audit matters. For example, some commenters said that this would occur
because the auditor would be motivated to communicate as much as
possible in an effort to mitigate any future liability for unidentified
critical audit matters, or as a means to avoid potential consequences
of being second-guessed by regulators or others. Other commenters
asserted that such a development could make the auditor's report overly
long, contributing to disclosure overload and conflicting with the
SEC's disclosure effectiveness project. Other commenters indicated that
expanded auditor reporting could lead to boilerplate language that
would diminish the expected value of the critical audit matters and
obscure the clarity of the auditor's opinion. If auditors fail to
provide audit-specific information, the communication of critical audit
matters will not decrease information asymmetry about the audit, and
may obscure other important information included in the auditor's
report and the audited financial statements.
    The final requirements aim to provide investors with the auditor's
unique perspective on the areas of the audit that involved the
auditor's especially challenging, subjective, or complex judgments.
Limiting critical audit matters to these areas should mitigate the
extent to which expanded auditor reporting could become standardized.
Focusing on auditor judgment should limit the extent to which expanded
auditor reporting could become duplicative of management's reporting.
Also, while some commenters argued that liability concerns would
increase the number of critical audit matters auditors communicate,
others suggested that liability concerns would minimize the additional
statements auditors make.
    The PCAOB staff study did not find evidence that expanded auditor
reporting in the United Kingdom resulted in a very large number of risk
topics or none at all in the first year of implementation.\140\ On
average, the auditor's reports in the first year of implementation
included descriptions of four risk topics, with total risk topics
ranging from one to eight. Additionally, the descriptions of the risks
of material misstatement in the auditor's reports in the first year of
implementation were not presented in standardized language, but
included variations in content length, description, and presentation.
The most frequently described risk topics related to revenue
recognition, tax, and goodwill and intangible assets. The FRC report on
the first two years of expanded auditor reporting in the United Kingdom
finds a similar range and average number of risk topics disclosed in
both the first and second year of implementation.\141\ The FRC report
also finds disclosure of similar risk topics in the second year of
implementation of expanded auditor reporting in the United
Kingdom.\142\
---------------------------------------------------------------------------

    \140\ See PCAOB White Paper.
    \141\ See FRC 2016 Report.
    \142\ Id.
---------------------------------------------------------------------------

    Further, the FRC found that, in the second year of expanded auditor
reporting in the United Kingdom, the discussion of risks has improved
relative to the first year of implementation and that the majority of
auditor's reports provided discussion of risks that were more tailored
to the company under audit, thus avoiding generic or standardized
wording.\143\ These findings suggest that, thus far, expanded auditor
reporting has not become standardized in the United Kingdom.\144\
---------------------------------------------------------------------------

    \143\ Id.
    \144\ The Board finds the UK experience instructive, although it
is, of course, possible that differences between the UK and U.S.
litigation and regulatory environments may influence the extent to
which these findings would generalize to the U.S. market.
---------------------------------------------------------------------------

Effects of Increased Attention to Critical Audit Matters
    The communication of critical audit matters could lead auditors,
company management, and the audit committee to spend additional time
and resources on reviewing the adequacy of the work performed on the
related financial statement accounts and disclosures. While this could
lead to an incremental improvement in audit and financial reporting
quality for the identified critical audit matters, it is also possible
that there may be increased costs for auditors as a result of the
requirements. For example, even though the final standard does not
mandate the performance of additional audit procedures other than with
respect to communication of critical audit matters, it is possible that
some auditors may perform additional procedures. If that occurs, the
associated costs may be passed on--in whole, in part, or not at all--to
companies and their investors in the form of higher audit fees.
Further, increased procedures may also require additional time from the
company's management to deal with such procedures. Some commenters
suggested that the increased attention on certain matters could also
lead to a related decrease in audit and financial reporting quality if
other material aspects of the financial statements and disclosures
receive less attention.
    Some commenters argued that including critical audit matters in the
auditor's report would impair the relationship between auditors and
management or auditors and the audit committee. Other commenters
suggested that the required reporting of critical audit matters would
inhibit communication among the auditor, management, and the audit
committee because of concerns about what would be publicly communicated
in the auditor's report. One commenter also suggested that auditors may
include additional matters in audit committee communications out of
concern that an

omission could lead to regulatory sanctions or liability. Other
commenters have said that it would enhance communication among the
participants in the financial reporting process.
    An experimental study analyzed how the strength of audit committee
oversight of the financial reporting process varied with the presence
of sophisticated investors and knowledge of forthcoming expanded
auditor reporting.\145\ The author found that study participants, most
of whom were experienced audit committee members, asked fewer probing
questions if they knew that the auditor would be providing a discussion
of the significant accounting estimate in the auditor's report. The
author argued that by asking fewer probing questions audit committee
members subconsciously insulated themselves from potential challenges
mounted by investors regarding the appropriateness of the company's
financial reporting. The Board is not aware of evidence this has
occurred in the jurisdictions that have adopted expanded auditor
reporting. Moreover, it may be difficult in an experimental setting to
recreate the actual legal responsibility and potential liability that
audit committee members face, which may limit the extent to which the
experimental results would generalize to actual behavior in real-world
settings.
---------------------------------------------------------------------------

    \145\ Yoon Ju Kang, Are Audit Committees More Challenging Given
a Sophisticated Investor Base? Does the Answer Change Given
Anticipation of Additional Mandatory Audit Report Disclosure?
(working paper submitted as comment letter No. 17, available on the
Board's Web site in Docket 034).
---------------------------------------------------------------------------

    Similarly, as described in the economic analysis of the reproposal
and asserted by at least one commenter, management may have an
incentive to withhold information from the auditor in order to prevent
an issue from being described in the auditor's report. It seems
unlikely, however, that management would or could withhold information
from the auditor on the most critical issues in the audit because it
could result in a scope limitation. On the contrary, it may be just as
likely that management would communicate more information to the
auditor as a means of demonstrating that an issue is not challenging,
subjective, or complex, and, therefore, would not need to be described
in the auditor's report.
    Under the final standard, critical audit matters are determined
from the matters communicated or required to be communicated to the
audit committee. As noted earlier, with respect to any matters already
required to be communicated to the audit committee, there should not be
a chilling effect or reduced communications to the audit committee.
Therefore, it would seem that any chilling effect would relate to
matters that are not explicitly required to be communicated to the
audit committee, although, as previously described, given the breadth
of current communication requirements, the Board believes there will
likely be few communications affected by that possibility.
Potential Impact on Management Disclosure
    Several commenters stated that the communication of critical audit
matters would give auditors leverage to encourage disclosure of
information by management. While some commenters asserted that this
would be beneficial, others claimed it would be an unintended negative
consequence of requiring the communication of critical audit matters.
Several commenters characterized this as inappropriately expanding the
role of the auditor in the financial reporting process, while
undermining the role of management and the audit committee. In their
view, this would be especially problematic if the final standard
permitted the auditor to communicate information that was not otherwise
required to be disclosed (for example, because it did not meet a
specified threshold for disclosure, such as a significant deficiency in
internal control over financial reporting). Commenters claimed that
auditor communication of this ``original information'' would cause a
number of unintended consequences, including significant costs,
disclosure of confidential or competitively sensitive information, and
potentially misleading or incomplete information.
    Investors and other commenters pointed out that, although expanded
auditor reporting would give the auditor additional leverage over
management's disclosure choices, this could result in improvements in
the usability of financial statements and increases in financial
reporting quality. One of these commenters cited academic research
noting that, in current practice, disclosure is already guided by an
iterative process between management and the auditor. This commenter
reasoned that concerns regarding ``original information'' were
misplaced because the iterative process would reduce the likelihood
that the auditor would be a source of original information since
critical audit matters would likely overlap with increased management
disclosure.
    Another commenter pointed out that auditors would not have
incentives to interpret the Board's rule to require disclosure of
original information in most situations. For example, concerns about
the limitations of their knowledge and expertise, potential liability
implications, and friction in the relationship with the company are
likely to discourage auditors from going beyond management disclosures.
Nevertheless, the final standard contemplates that the auditor will do
so only when it is necessary to describe the principal considerations
that led the auditor to determine that a matter was especially
challenging, subjective, or complex and how the matter was addressed in
the audit. The Board believes that this provision is needed in order to
ensure that the fact that management did not provide a disclosure would
not prevent the auditor from communicating a critical audit matter.
    Although the communication of critical audit matters may lead to
changes in the incentives for the auditor, company management, and the
audit committee to communicate with each other, initial anecdotal
evidence from the Board's outreach activities suggests that the
implementation of expanded auditor reporting in the United Kingdom has
not chilled such communications.
Changes in Perceived Assurance on the Auditor's Report, Including
Perceptions of Auditor Liability
    The communication of critical audit matters could have liability
implications for auditors. In addition, because the communication of
critical audit matters requires auditors to discuss aspects of the
audit that they found to be especially challenging, subjective, or
complex, it is possible that some investors and financial statement
users may misconstrue the communications to mean that auditors were
unable to obtain reasonable assurance about the matters identified as
critical audit matters. Some commenters have said that the
communication of critical audit matters could lead to changes in the
way investors and financial statements users perceive the level of
assurance provided by the auditor on matters identified as critical
audit matters, including that it could undermine the basic pass/fail
opinion. This could lead investors to erroneously conclude that there
is a problem with the audit either in the areas identified in critical
audit matters or other areas, or that auditors are providing separate
assurance about the presentation of the financial statements, which may
have implications for perceptions of auditor responsibility in the
event of an audit failure.

    As discussed in the economic analysis of the reproposal, several
academic papers analyze certain risks associated with communicating
critical audit matters, including perception of auditor
responsibility.\146\ If the communication of critical audit matters
were to lead to a reduction in perceived auditor responsibility, as is
suggested by some academic research, and this in turn reduced auditor
liability, it is possible that auditors may feel that less audit work
is needed on the matters identified as critical audit matters, which
could adversely affect audit quality (although the Board's other
auditing standards, reinforced through firm quality control and Board
inspections and enforcement activity, should provide a disincentive for
auditors to decrease the amount or quality of audit work performed). It
is difficult to draw generalizable conclusions based on the findings of
these studies. In part, this is because their results vary and are
sometimes contradictory, with some studies finding that expanded
auditor reporting increases perceived auditor responsibility and others
finding that it decreases perceived auditor responsibility. This may
suggest that the results are sensitive to the experimental design and
the context in which information is presented to study participants. In
addition, it is not clear how the findings would correlate with changes
in auditor behavior, because perceptions of auditor responsibility may
be a poor proxy for actual auditor responsibility or liability.
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    \146\ See PCAOB Release No. 2016-003, Section VI.D.2.d,
footnotes 182-186 and accompanying text.
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    To address the risk that the communication of critical audit
matters could result in the perception of separate assurance, the final
standard requires the following statement in the auditor's report:

    The communication of critical audit matters does not alter in
any way [the auditor's] opinion on the financial statements, taken
as a whole, and [the auditor is not] by communicating the critical
audit matters . . . providing separate opinions on the critical
audit matters or on the accounts or disclosures to which they
relate.

The purpose of this statement is to make clear that the communication
of critical audit matters in an auditor's report should not be
interpreted as altering the level of assurance on any aspect of the
audit report, including the identified critical audit matters. In this
regard, the Board also notes the view of some commenters that critical
audit matters are likely to be used by institutional investors that are
unlikely to misinterpret the information.
Auditor Tenure
    Many commenters stated that information regarding the auditor's
tenure included in the auditor's report could result in inappropriate
and inconsistent assumptions about correlations between auditor tenure
and/or independence and audit quality. Academic research on the
relationship of tenure to audit quality has varied conclusions. For
instance, some academic research indicates that engagements with short-
term tenure are relatively riskier or that audit quality is improved
when auditors have time to gain expertise in the company under audit
and in the related industry.\147\ Other academic research suggests
that, at least prior to 2001, both short tenure (less than five years)
and long tenure (greater than fifteen years) can have detrimental
effects on audit quality.\148\ Still other academic research indicates
that investors are more likely to vote against, or abstain from,
auditor ratification as auditor tenure increases, which may suggest
that investors view long-term auditor-company relationships as
adversely affecting audit quality.\149\
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    \147\ See, e.g., Joseph V. Carcello and Albert L. Nagy, Audit
Firm Tenure and Fraudulent Financial Reporting, 23 Auditing: A
Journal of Practice & Theory 55, 55-69 (2004) and Timothy B. Bell,
Monika Causholli, and W. Robert Knechel, Audit Firm Tenure, Non-
Audit Services, and Internal Assessments of Audit Quality, 53
Journal of Accounting Research 461, 461-509 (2015).
    \148\ See, e.g., Larry R. Davis, Billy S. Soo, and Gregory M.
Trompeter, Auditor Tenure and the Ability to Meet or Beat Earnings
Forecasts, 26 Contemporary Accounting Research 517, 517-548 (2009).
    \149\ See, e.g., Mai Dao, Suchismita Mishra, and K. Raghunandan,
Auditor Tenure and Shareholder Ratification of the Auditor, 22
Accounting Horizons 297, 297-314 (2008).
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    The disclosure of auditor tenure is intended to add to the mix of
information that investors can use. However, commenters other than
investors did not support disclosure of auditor tenure in the auditor's
report on the basis that such disclosure would not provide value to
investors or could result in false conclusions about correlations
between auditor tenure and audit quality or between auditor tenure and
auditor independence. Many of these commenters recommended that, if the
Board determined to require disclosure of auditor tenure, it should be
disclosed in Form AP rather than in the auditor's report as a means of
avoiding these inferences.
Alternatives Considered, Including Policy Choices Under the Final
Standard
    After considering the comments received, the Board is adopting a
new auditor reporting standard, AS 3101 and related amendments to its
standards. The final standard retains the pass/fail model while
expanding auditor reporting to include the communication of critical
audit matters. Investor commenters have consistently asked for
additional information in the auditor's report to make it more
informative about the audit of the company's financial statements.
    As described below, the Board has considered a number of
alternative approaches to achieve the potential benefits of enhanced
auditor reporting.
Alternatives Raised by Commenters
Only Cross-Reference to Management's Disclosures
    Some commenters suggested that, instead of communicating critical
audit matters as reproposed, auditors should only identify the critical
audit matters and provide a cross-reference to management disclosures
(i.e., not describe the principal considerations that led the auditor
to determine a matter is a critical audit matter or how it was
addressed in the audit), or refer to or list critical accounting
policies and estimates as disclosed by management. The Board believes
that communicating the principal considerations that led the auditor to
determine that a matter is a critical audit matter and how it was
addressed in the audit will provide useful information beyond simply
referencing existing management disclosure, and is more responsive to
investor requests for more information from the auditor's perspective.
Auditor Association With Other Company Disclosures
    Other commenters suggested more specific auditor assurance on
particular management disclosures, such as inclusion of a statement in
the auditor's report that the audit included evaluation of the
accounting policies and significant estimates, with a cross-reference
to management's disclosures, or a statement of auditor concurrence with
the critical accounting policies and estimates of the company. One
commenter suggested that audit committees should disclose critical
audit matters with a corresponding confirmation from the independent
auditor.
    Several commenters on the proposal also suggested that the Board
should consider auditor association with, or attestation on, portions
of MD&A, specifically management's critical accounting policies and
estimates, as an alternative to expanded auditor reporting. These
commenters have

argued that such an association could increase the quality and
reliability of the information subject to the procedures.
    Some commenters on the concept release, including investors, said
that they were not supportive of separate assurance by the auditor on
information outside of the financial statements as an alternative to
expanded auditor reporting, primarily because the related auditor
reporting would have appeared in a standardized form and would not
provide audit-specific information. Requiring such reporting might