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The PCAOB's proposed changes to the auditor reporting model: an in-depth overview for the classroom and beyond.

Executive Summary

After almost a decade of research, deliberation, and public input, the Public Company Accounting Oversight Board (PCAOB) appears poised to reach a conclusion on its proposal for changes to the auditor's reporting model. These changes, undoubtedly the most far- reaching in 70 years, would significantly impact what has largely been described as a pass/fail model of auditor reporting. Under current auditing standards, auditors of public companies typically follow illustrative examples of auditor reports originally adopted under SAS 58 by the Auditing Standards Board in 1988 (AICPA, 1988), and typically issue unqualified audit opinions with minor word variations from firm-to-firm.

The new model includes the reporting of critical matters encountered during the audit, as well as other provisions aimed to provide financial statement users with more relevant information about the auditor and the audit process. This paper presents the evolution of the auditor reporting model, discusses the proposed changes to the standards, provides a timeline detailing the process of developing the proposed standard, summarizes the changes to the standard auditor's report, and presents unresolved issues regarding the proposed standard.

This paper is a valuable resource for students to acquaint themselves with the proposed model, the history of the auditor's report, and an overview of the audit standard setting process. Accounting academics can use this paper in the classroom as supplemental material or assign it to students as a case project. Accordingly, we include two appendices with this paper. Appendix A provides learning objectives and implementation guidance, and Appendix B offers teaching notes with suggested questions and solutions.

Additionally, the paper provides a basis for investors, creditors, academic researchers, and practitioners to understand the history and current developments affecting the auditor reporting model. Auditors play a significant role in the quality of information available in the capital markets. In as much as our society depends on high-quality financial reporting for capital allocation decisions, understanding the nature and limitations of the auditor's report will be helpful to investors and creditors. Finally, the summary of the requirements and changes affecting the standard auditor's report presented in this paper will be useful to time-constrained practitioners, investors, and creditors when evaluating the changes to the auditor's reporting model.

Introduction

According to the PCAOB, "The standard auditor's report identifies the financial statements that were audited, describes the nature of the audit, and presents the auditor's opinion as to whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in conformity with the applicable financial reporting framework. The standard auditor's report is commonly described as a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail)." (PCAOBUS.org)

The current model of the auditor's report has been criticized for years as being uninformative to the users, yet little has been done to address this concern. (1) In an effort to remediate the issue, The PCAOB has proposed a new auditor reporting standard that will significantly change the existing auditor reporting model (ARM or "the model") and consequently the auditor's report. The objective of this paper is to provide a historical context of the auditor reporting model, discuss the proposed changes, and provide a status update on the new standard as it relates to public companies. (2)

This paper is motivated by the significant changes proposed by the new standard and its implications for auditors, as well as preparers and users of the financial statements. The paper is beneficial to many, if not all, stakeholders in the capital markets. The descriptive and visual presentation of the history of ARM offers a quick reference which should be useful to all readers. The discussion, summary and status update of the proposed changes should be valuable to practitioners and financial statement preparers and users who want to obtain knowledge about the standards but do not have the time or inclination to read the original source documents for the details.

In addition, academics will be interested in this paper as the proposed changes to the audit reporting model provide a ripe area for research, and our paper provides a contextual format to frame that research. The paper can also be used in the classroom, as it provides students with a context for evaluating the audit standard setting process. Appendix A offers learning objectives and implementation guidance, and Appendix B provides teaching notes for accounting instructors wishing to use this paper in a class project or as a teaching tool. The proposed standard has gone through a number of iterations, public comments, and roundtable discussions, which provides an excellent opportunity for students to study the nature of the audit standard setting process.

Finally, we believe various regulators and standard setters will also be interested in our paper as we summarize the issues identified by PCAOB board members in public statements as well as from a sample of comment letters from the public on the proposed standard. (3)

The remainder of the paper is presented as follows. We begin with a history of auditor reporting, followed by a discussion on the proposed auditor reporting standard, highlighting the significant elements of the new model. Next, we present readers' response to the proposed standards, and we conclude with a brief discussion on the next steps.

History of Auditor Reporting

Prior to the stock market crash in 1929, audit reports were generally non-standardized, with relatively short statements attesting to the trueness, fairness, or correctness of companies' financial statements. Investors were left largely to their own devices to determine the level of assurance being communicated by the auditor. The reporting model underwent its first major standardization in 1934 when the New York Stock Exchange (NYSE) adopted regulations which required registrants to have audit reports that included both a scope and an opinion paragraph. These new regulations were the result of a joint project between the NYSE and the American Institute of Accountants (AIA) aimed at educating investors and on improving financial-reporting practices. The wording of the paragraphs required under NYSE listing regulations was put forth by the AIA (Church, Davis, and McCracken, 2008). The purpose of standardizing the auditor's report was to assist users in identifying non-standard reports.

Over the next 60 years, audit standard setters focused primarily on changes to the wording of the standard audit report, as well as how auditors should report on non-standard issues (Church, Davis, and McCracken, 2008 p. 73). In 1988, the ASB issued Statement on Auditing Standard (SAS) No. 58, Reports on Audited Financial Statements, which introduced today's unqualified and modified opinion reports (AICPA 1988).

The most recent changes to the auditor's reporting model for public companies occurred when the PCAOB was created in 2003 and the subsequent adoption of Auditing Standard No. 1 (PCAOB 2004a) and Auditing Standard No. 2 (PCAOB 2004b). (4) Auditing Standards No.

1 (AS No. 1) changed the title of the report to indicate that the audit firm is registered with the PCAOB and also changed the reference to generally accepted auditing standards (GAAS) to those standards adopted by the PCAOB. Auditing Standard No. 2 (later superseded by Auditing Standard No. 5) developed the framework for auditors to audit internal control over financial reporting (ICFR) and created the reporting requirements under that framework. (5)

Prior to this, auditing standards did not exist for the audit of internal controls and the auditor's subsequent reporting on the results of an internal control audit, other than those prescribed by SAS 70 for data service organizations. The model adopted by the PCAOB required audit firms to conduct a combined audit of the financial statements (FS) and an audit of the design and operating effectiveness of internal control over financial reporting (ICFR), but provide the firms with the option to present the audit opinion on the financial statements and the opinion on ICFR in one report or on two separate reports. (6) On an FS audit, auditors may issue either an unqualified, qualified, adverse, or disclaimers of opinion. On an ICFR audit, the auditor may issue an unqualified or adverse opinion. (7) In rare cases, a qualified opinion might be issued where the scope of the audit of internal control is impaired.

It is also important to recognize that U.S. GAAS for non-public entities continues to be promulgated by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Since the creation of the PCAOB, the ASB has continued its standard setting activities for non-public entities, some of which have been focused on the auditor's reporting model. The changes to the audit report for non-public entities are mainly non-substantive and consist primarily of format changes of existing content. The most notable change in the audit report narrative is an increase in the discussion of management's responsibilities for the financial statements and the company's internal controls. Further discussion of the reporting model for non- public entities is outside the scope of this paper.

Standard Setting Time Line

Exhibit 1 illustrates the standard setting timeline of the proposed auditor reporting standard. Concern over the communicative value of the auditor's report is not a new phenomenon; it has been on the minds of regulators, academics, and practitioners for quite some time. For example, in 1978 the Commission on Auditor's Responsibilities (CAR) (8) reported that "Evidence abounds that communication between the auditor and users of his work--especially through the auditor's standard report--is unsatisfactory. The existing report has remained essentially unchanged since 1948 and its shortcomings have often been discussed." (CAR 1978 page xxiv). The Commission later discusses the expectations gap between the auditor's responsibility under GAAS and the public's expectations, and concludes that one of the main reasons for a lack of change to the auditor reporting model are concerns over increasing auditors' legal liability.

During the 1970s and 1980s several other commissions, most notably the National Commission on Fraudulent Financial Reporting (known as the "Treadway Commission") also made recommendations to change the auditor reporting model in 1987. At the time, the commissions had little effect on the standard setting process, so most recommendations were not implemented.

The 1990s were a dramatic time for the accounting profession. In the backdrop of the economic boom, many accounting firms expanded their professional practices beyond traditional audit and tax services at the encouragement of the AICPA. By the late 1990s and early 2000s, many accounting practices were obtaining a large portion of their revenues from non-audit services and the perceived bond between the auditor and their clients grew strong. Ultimately, a rash of high-profile accounting scandals led to the collapse of one of the then Big-5 accounting firms (Arthur Andersen) and the end of self-regulation of the accounting profession. Congress viewed the integrity of the financial reporting process in the capital markets as key to a successful and vibrant economy and thus created the PCAOB to restore investors' confidence in the financial reporting process and to regulate the audits and auditors of public companies.

The earliest signs that the PCAOB had become interested in reviewing the auditor's reporting model appear in 2005 when the Standing Advisory Group (SAG) (9) of the PCAOB discussed the auditor reporting model at two separate meetings under two distinct themes. (10) The first theme focused on the determinants of how auditors make their reporting decisions, and the second theme focused on the outputs, principally the content of the auditor's report and the information conveyed (Church et al. 2008). No action was taken regarding the model subsequent to these meetings.

The next push for revisions to the auditor reporting model came in 2008 when the U.S. Department of the Treasury's Advisory Committee on the Auditing Profession (ACAP) recommended that the PCAOB undertake a standard-setting initiative to consider improvements to the standard auditor report.

On June 21, 2011 the PCAOB issued a concept release titled "Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Auditing Financial Statements" (PCAOB 2011). In this release, the PCAOB proposed the following changes to the audit report, (1) an auditor discussion and analysis, (2) required and expanded use of emphasis of matter paragraphs, (3) auditor assurance on items outside the financial statements, and (4) clarification of language in the standard auditor's report (PCAOB 2011).

In consideration of these changes, the PCAOB conducted a number of outreach activities including a roundtable discussion in September 2011, SAG meetings in November 2011, 2012, and 2013, and a number of public meetings throughout the process. These meetings sought to engage and solicit the thoughts and opinions of a broad constituency including auditors, academics, investors, preparers, regulators, and others involved in the capital markets. The PCAOB issued the proposed auditing rule in August 2013 and solicited public comment on the proposal on or before May 2, 2014. (11)

Exhibit 2

The Proposed Auditor Reporting Standards:

A Summary of Significant Changes to the Auditor's Report

Critical Audit Matters

* Identify critical audit matters

* Communicate, in the audit report, critical audit matters or that
none were identified

* Describe in the audit report the considerations that led the
auditor to determine that the matter was a critical audit matter

* Refer to the accounts and disclosures that relate to the critical
audit matter, when applicable

* Document process of determining critical matters with sufficient
detail to support the conclusions reached

Additional disclosures

* Provide additional wording stating that the auditor is
independent in accordance with federal securities laws and PCAOB
standards

* Disclose the auditor's length of tenure with the audit client in
the audit report

* Adjust wording in audit report to reflect that the auditor is
responsible for detecting material deficiencies in the financial
statements, whether due to error or fraud

* Clarify in the audit report that the footnotes are an integral
part of the financial statements

Responsibility for 'other information

* Evaluate (rather than merely read and consider) "other
information" reported in filings containing the audited financial
statements

* Add a new paragraph to the standard auditor report describing the
level of auditor's responsibility for other information

* Report any material misstatements or inconsistencies between
audited financial statements and other information


Proposed Audit Reporting Standards

Based on feedback received from comments letters and other outreach activities, the Board decided not to directly propose any of the alternatives presented in the Concept Release in the proposed rule. (12) Instead, the proposed standard incorporates some of the fundamental concepts presented in the concept release into three main provisions geared to enhance the transparency of the financial statements and the informativeness of the auditor's report. The provisions include communication of critical audit matters; the addition of new elements to the standard auditor's report on auditor independence; clarification of the auditor's responsibility for fraud and notes to the financial statements; and disclosure of the length of auditor tenure.

We discuss these provisions in more depth in the following sections.

Critical Audit Matters

One of the more significant requirements of the proposed changes to the auditor reporting model calls for the identification and reporting of critical audit matters. The PCAOB defines critical audit matters as those that involve the most difficult, subjective, and complex auditor judgments; pose the most difficulty to the auditor in obtaining sufficient, appropriate evidence; or pose the most difficulty to the auditor in forming an opinion on the financial statements (PCAOB, 2013 p. A1-6). If applicable, the auditor would modify the audit report to contain a description of the critical audit matter identified; the considerations that led the auditor to classify the matter as a critical audit matter; and refer to the accounts and disclosures related to the critical audit matter (PCAOB, 2013 p. A1-8).

Critical matters will be discussed in the auditor's report under a section titled "Critical Audit Matters." In this section, auditors would individually disclose matters identified as critical audit matters, discuss the nature of the critical audit matters, and state that the identification of these matters does not alter the auditor's opinion on the financial statements and accompanying footnotes, taken as a whole. (See Exhibit 3 for an illustrative example of the new auditor's report, with two paragraphs showing Critical Audit matters.)

In addition to the reporting requirements, auditors would also be responsible for properly documenting critical audit matters.

In accordance with Auditing Standard No. 3, "audit documentation should be prepared in sufficient detail to provide a clear understanding of its purpose, source, and the conclusions reached" (PCAOB, 2004c p. A1-3). According to the current proposal, auditors' documentation should be clear enough such that an experienced auditor with no previous connection with the engagement would understand the reasons for including and/ or excluding certain matters as critical audit matters (PCAOB, 2013 p. A1-10).

New Basic Elements

The proposed ARM requires a number of new elements and clarifying language to the standard audit report under a section titled "Basis of Opinion," to provide investors and other financial statement users with information about the audit and the auditor (PCAOB, 2013). Under the proposed requirements, auditors would be required to explicitly state in this section that they are required to be independent in accordance with United States federal securities laws and applicable rules and regulations of the SEC and PCAOB, and to provide information about the length of tenure with the audit client by stating the year the auditor first began serving as the company's auditor.

Exhibit 3

Illustrative Sample of the New Auditor's Report (14)

Report of Independent Registered Public Accounting Firm (Proposed
changes are shown in Italics.)

To the shareholders and board of directors of X Company

Introduction

We have audited the accompanying balance sheets of X Company (the
"Company") as of December 31, 20X2 and 20X1, the related statements
of operations, stockholders' equity, and cash flows, for each of
the three years in the period ended December 31, 20X2, and the
related notes (collectively referred to as the "financial
statements"). These financial statements are the responsibility of
the Company's management.

We are a public accounting firm registered with the Public Company
Accounting Oversight Board ("PCAOB") (United States) and are
required to be independent with respect to the Company in
accordance with the United States federal securities laws and the
applicable rules and regulations of the Securities and Exchange
Commission ("SEC") and the PCAOB. We or our predecessor firms have
served as the Company's auditor consecutively since [year].

Basis of Opinion

Our responsibility is to express an opinion on the Company's
financial statements based on our audits. We conducted our audits
in accordance with the standards of the PCAOB. Those standards
require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of
material misstatement, whether due to error or fraud.

Our audits included performing procedures to assess the risks of
material misstatement of the financial statements, whether due to
error or fraud, and performing procedures that respond to those
risks. Such procedures include examining, on a test basis,
appropriate evidence regarding the amounts and disclosures in the
financial statements. Our audits also included evaluating the
accounting principles used and significant estimates made by
management, as well as evaluating the overall presentation of the
financial statements. We believe that our audits provide a
reasonable basis for our opinion.

Opinion on the Financial Statements

In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of the
Company as of [at] December 31, 20X2 and 20X1, and the results of
its operations and its cash flows for each of the three years in
the period ended December 31, 20X2, in conformity with [the
applicable financial reporting framework].

Critical Audit Matters

The standards of the PCAOB require that we communicate in our
report critical audit matters relating to the audit of the current
period's financial statements, or state that we determined that
there are no critical audit matters. Critical audit matters are
those matters addressed during the audit that (1) involved our most
difficult, subjective, or complex judgments; (2) posed the most
difficulty to us in obtaining sufficient appropriate evidence; or
(3) posed the most difficulty to us in forming our opinion on the
financial statements. The critical audit matters communicated below
do not alter in any way our opinion on the financial statements,
taken as a whole.

[Include critical audit matters]

The Auditor's Responsibilities Regarding Other Information

In addition to auditing the Company's financial statements in
accordance with the standards of the PCAOB, we evaluated whether
the other information, included in the annual report on [SEC
Exchange Act form type] filed with the SEC that contains both the
December 31, 20X2 financial statements and our audit report on
those financial statements, contains a material inconsistency with
the financial statements, a material misstatement of fact, or both.
Our evaluation was based on relevant audit evidence obtained and
conclusions reached during the audit. We did not audit the other
information and do not express an opinion on the other information.
Based on our evaluation, we have not identified a material
inconsistency or a material misstatement of fact in the other
information.

[Signature]

[City and State or Country]

[Date]


Also, in this section the auditor is required to provide clarification regarding the auditors' responsibilities towards the notes to the financial statements and to the detection of misstatements. More specifically, the proposed standards require auditors to explicitly clarify that the financial statements under audit include the footnotes; that the audit includes procedures to assess the risk of material misstatement whether due to error or fraud; and that the auditor has responded to identified risks. These statements do not expand the auditors' responsibilities, they merely clarify the auditors' responsibilities in an effort to reduce the expectation gap between the perception of financial statement users and the reality of what auditors do, created by ambiguity of the existing auditor report. This section is positioned immediately after the Introduction paragraph of the auditor's report. (See Exhibit 3 for the wording of this new paragraph).

Expanded responsibilities for "other information:" As it relates to other information, auditors continue to have certain responsibilities for information--other than the financial statements--that is included in a company's 10-K or 20-F filed with the SEC, and information incorporated by reference in the annual report. Under existing auditing standards (AU Section 550), auditors have a responsibility to "read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements." Moreover, the auditor is not required to perform procedures or corroborate other information in documents in which the audited financial statements appear unless he concludes that a material discrepancy exists between the audited financial statements and the other information.

The new standards, as proposed, effectively codify and expand auditors' responsibilities with regards to other information. The proposed auditor's report includes a section after "critical audit matters," titled, "The Auditor's Responsibilities Regarding Other Information." This section adds new language to the auditor's report that describes the auditor's responsibilities for other information, and states whether the other information contains a material inconsistency, a material misstatement of fact, or both (PCAOB, 2103) (See Exhibit 3 for an example of the wording to be included in this section.)

In addition to the new reporting requirement, auditors will also be required to evaluate the other information, effectively expanding their responsibilities in this area. The evaluation of other information focuses on four general areas (PCAOB, 2013 p. A2-3):

* Consistency of quantitative data contained within the other information and the audited financial statements and relevant audit evidence,

* Consistency of qualitative statements contained within the other information and the audited financial statements and relevant audit evidence,

* Other information not related to the financial statements, but contained within the other information and it's consistency with relevant audit evidence and audit conclusions, and

* Mathematical accuracy of the information contained within other information

Consistent with current auditing standards, the auditor has responsibilities when a material misstatement, material misstatement of fact, or both are identified. Generally, when a departure is identified, the auditor first requests management to correct the inconsistency in the other information. If management does not appropriately revise the other information, the auditing standard provides auditors with many responses depending on when the inconsistency is discovered. These responses may include reporting the matter to those charged with governance, withholding the auditor's report, modifying the standard auditor report, and withdrawing from the engagement (PCAOB, 2013 p. A2-5).

Responses on the Proposed Standard

As of May 2, 2014, the PCAOB received 246 public comments regarding the proposed standards. (13) The responses represent a very broad constituency of commenters from industry, academia, investors, trade-organizations, state CPA societies, governmental entities, advocacy groups, CPA firms, individual practitioners, as well as students. Compared to comments received from other PCAOB's proposals, the comments on the auditor reporting model have received more than the typical number of responses, symbolizing the gravity of the debate. In comparison, the PCAOB's proposal on auditor communications with audit committees and the proposal on related parties received 44 and 37 comments, respectively.

The responses vary in length from one page commentaries to more than 25 pages of criticism on the proposal. The side taken on the debate also differs considerably, ranging from investors' support for the proposal at one end of the spectrum to auditors' criticism on the other end. We review a random sample of 20 comment letters to identify common themes addressed by constituencies. Consistent with the findings of Joseph V. Carcello, EY and Business Alumni Professor and the Executive Director of the Corporate Governance Center at the University of Tennessee, we find that most of the responses received by the PCAOB regarding the proposed auditing standard oppose the inclusion of critical audit matters in the audit report (Carcello, 2013 p.4).

Respondents also appear to be concerned about the cost versus benefits of the proposed standard, possible delays in delivery of the audit report due to additional audit procedures and document requirements under the new standard, the disclosure of information under critical audit matters that might not otherwise be required to be disclosed (e.g. going-concern deliberations, pending legal liability determinations, etc.), and the expansion of auditors' responsibilities regarding other information, claiming a possible shift in the traditional role of the auditor into areas that are not appropriate. Surprisingly, respondents generally did not object to reporting auditor tenure, although several suggested that this information would be better suited in a proxy statement.

Conclusion

Changes to the auditor reporting model proposed by the PCAOB are far reaching and significant, concurring with a general movement by regulators around the world for auditor reform. Recently, The Financial Reporting Council, the UK's independent financial regulator, and the EU Parliament adopted changes or made preliminary agreements on audit reform, including rules that would require auditors to produce more detailed and informative audit reports.

Although the comment period on the proposed rule was initially closed in December, 2013 and more than 200 comment letters were received, the debate regarding the proposed revisions to the auditors reporting model is not resolved. The PCAOB held a public meeting in April 2014 to discuss the comments received and subsequently reopened the comment period.

It is speculated that a re-proposal may be necessary to close the gap between investors' expectations and the proposed changes. If all goes as the PCAOB plans, the effective date of the proposed standards and related amendments would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2015, subject to SEC's approval. If such approval was granted, auditors, investors, and other capital market participants would see the first significant changes to the auditor reporting model in over 70 years.

APPENDIX A CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE

Overview of Learning Objectives

The primary objective of this learning-oriented case is designed to illustrate the auditor's responsibilities related to financial reporting, particularly as it relates to the presentation of the auditor's opinion report. Information in this paper also lends itself to a discussion of the potential impact on the investors, creditors and other stakeholders as a result of the additional information revealed by auditors pertaining to the detection of internal control deficiencies identified during performance of the audit, and the risk implications with the audited issuer. (15)

These issues can all be explored through a likely classroom discussion surrounding the real-world current event of this historic potential standard-setting rule. By incorporating changes to auditor reporting models recently implemented in other countries, students can explore issues and questions concerning the impact of culture and regulation; as well as the requirements of foreign issuers registered with the Public Company Accounting Oversight Board (PCAOB).

Implementation Guidance

This paper may be used to enhance the student's understanding of the PCAOB's standard setting process, and of auditor reporting for use in either an undergraduate or graduate auditing course. In addition, given similar recent changes in other countries and an overall direction towards international accounting and auditing standards, this paper could also be used in an international accounting course, or a governmental accounting course.

We recommend that this case be assigned individually in order to enhance the overall learning experience, as well as limit the likelihood that teams may divide responsibilities, and dilute learning in an effort to reduce time on-task.

Potential Enhancements

In order to facilitate an even deeper understanding of the proposed ARM as well as the PCAOB's standard setting process, case questions could be added that require students to research the authoritative standards and demonstrate their knowledge by discussing the specific issues. Students could also be directed to review public comment letters, exposure documents, and roundtable transcriptions, and prepare summaries and/or analyze those materials. The cases may be assigned as independent projects or in teams.

Suggestions for project-oriented assignments

Students' responses to these questions would depend on the extent and quality of their research. These projects are suitable as graduate level team or individual projects.

1. Go to the PCAOB website (www.pcaobus. org) and download the PCAOB latest Concept Release related to the auditor reporting model. Read the Release and formulate a response to the PCAOB on the Concept Release that was due May 2, 2014; assume one of the following roles:

a. An Investor

b. An Auditor

c. A Regulator

d. A Student

e. An Academic Professor

2. Accounting regulators in other countries (e.g. United Kingdom) recently changed their Auditor's Reporting Model as well. Research and locate the new auditor's reporting model in one of these countries and compare and contrast the changes made in that country's report to the changes being proposed by the PCAOB in the United States.

APPENDIX B

Teaching Notes

The following questions are suitable for undergraduate and graduate courses in accounting and auditing.

These suggested solutions should be viewed as relatively comprehensive answers to the proposed Auditor Reporting Model (ARM) questions. Instructors may elect to award full credit to the extent that students address the primary core of each question, and partial credit if, in the instructor's judgment, the student has failed to address the primary question or has failed to provide sufficient citations where appropriate. The overview of the proposed ARM is designed to be scalable, and the suggested solutions presented below cover the comprehensive overview.

3. Using a timeline format, document the history of auditor reporting. Please include the responsible organization within each phase.

Suggested Solution:

* Prior to 1929--Non-standardized reporting with short statements on trueness, fairness, or correctness of companies' financial statements

* 1934--Standardized report required by NYSE & AIA: must have scope and opinion paragraphs

* 1988--ASB's SAS No. 58, Reports on Audited Financial Statements, introduced the current version of the unqualified and modified opinion reports

* 2003--Creation of the PCAOB fuels changes to the reports for public companies pursuant to AS 1 and AS 2 (later superseded by AS 5). The title of the report changed to include the word "registered" to indicate that a firm is a registrant of the PCAOB, and GAAS reference changed to "those standards adopted by the PCAOB." AS 5 also requires firms to conduct an audit of internal controls over financial reporting (ICFR), integrated with the audit of the financial statements (FS). Firms must provide an ICFR audit opinion report together with the FS report (as one report) or separately (as 2 reports). ASB instituted increased disclosure of management's responsibility for the FS and the company's internal control, plus other minor format changes to the report of non-public companies.

4. Briefly describe the general stages of the PCAOB's typical standard setting process. You may use the Standard Setting Timeline illustrated in Exhibit 1 as a reference.

Suggested Solution

* A problem is recognized and brought to the PCAOB's attention (source is varied)

* SAG discuss item of interest and advises the PCAOB on its merit

* PCAOB issues a concept release to gather public opinion and comments on severity of the issue and overall impact, including cost/ benefit analysis of new standard or rule.

* PCAOB holds multiple public meetings/ roundtable discussion (sometimes also before issuing the concept release) to review and discuss comment letters after the comment period has closed.

* PCAOB analyzes comment letters and proposes a new standard/rule or modification to an existing one.

* PCAOB opens comment period on proposed rule and analyzes comments

* PCAOB obtains SEC's approval of new or modified rule and if approved, issues the new standard/rule.

Students could also explore the PCAOB's website for detailed information on the standard setting process.

5. Do you think the current pass/fail model of the auditor's opinion report needs to be changed? Please explain your answer.

Suggested Solution

Answers will vary.

6. Discuss the pros and cons of the proposed ARM? Do you think it should become a rule? Please explain your answer.

Suggested Solution

This answer will vary but most students may

include the following as pros and cons:

PROS:

* Increase transparency

* Investors learn more from the auditor about critical matters and other information

* Improve audit quality as auditors will pay closer attention to findings

* Increase auditor responsibilities

CONS:

* Cost to implement

* Little or no added value as financial statement disclosures contain the same information

* Unsophisticated users may misinterpret the information presented

* Possible increase in auditor litigation

* Longer time to issue the audit report

* Increase auditor responsibilities

7. Exhibit 3 provides a sample of the Proposed Auditor's Report. What other (or additional) changes to the current auditor's opinion report, not proposed in the concept release, would you suggest?

Suggested Solution

Answers will vary.

8. The proposed ARM suggests three main categories of change: Critical Audit Matters, New Basic Elements, and Expanded Responsibilities for "other information." Discuss the basic elements of each category.

Suggested Solution

Critical Audit Matters

* Identify critical audit matters

* Communicate, in the audit report, critical audit matters or that none were identified

* Describe in the audit report the considerations that led the auditor to determine that the matter was a critical audit matter

* Refer to the accounts and disclosures that relate to the critical audit matter, when applicable

* Document process of determining critical matters with sufficient detail to support the conclusions reached

Additional disclosures

* Provide additional wording that the auditor is independent in accordance with federal securities laws and PCAOB standards

* Disclose the auditor's length of tenure with the audit client in the audit report

* Adjust wording in audit report to reflect that the auditor is responsible for detecting material fraud whether due to error or fraud

* Clarify in the audit report that the footnotes are an integral part of the financial statements

Responsibility for 'other information'

* Evaluate (rather than merely read and consider) "other information" reported in filings containing the audited financial statements

* Add a new paragraph to the standard auditor report describing the level of auditor's responsibility for other information

* Report any material misstatement or inconsistencies between audited financial statements and other information

References

AICPA 1988. Reports on Audited Financial Statements. Statement on Auditing Standards No. 58. New York, NY: Auditing Standards Board

Carcello, Joseph V. 2013. Comment letter to the PCAOB. http://pcaobus.org/Rules/ Rulemaking/Docket034/205b_Carcello.pdf

Church, Brian K., Shawn M. Davis, and Susan A. McCracken. 2008. The Auditor's Reporting Model: A Literature Overview and Research Synthesis. Accounting Horizons, 22: 69-90.

Commission on Auditor's Responsibilities (CAR). 1978. Report, Conclusions, and Recommendations. New York, NY

Kranacher, Mary-Jo. 2011. The Auditor Reporting Process: An Opportunity for Fundamental Change. The CPA Journal, 22: 69-90.

Public Company Accounting Oversight Board (PCAOB). 2004a. References in the Auditor's Report to the Standards of the Public Company Oversight Board. Auditing Standard No. 1. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2004b. An audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Auditing Standard No. 2. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2004c. Audit Documentation. Auditing Standard No. 3. Washington D.C.: PCAOB

Public Company Accounting Oversight Board (PCAOB). 2011. Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards. http://pcaobus.org/Rules/Rulemaking/ Docket034/Concept_Release.pdf

Public Company Accounting Oversight Board (PCAOB). 2013. The Auditor's Report on an Audit of Financial Statement when the Auditor Expresses an Unqualified Opinion; The Auditor's Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Amendments to PCAOB Standards. http://pcaobus.org/Rules/ Rulemaking/Docket034/Release_2013-005_ ARM.pdf

Weirich, Thomas R., and Alan Reinstein. 2014. The PCAOB's Proposed New Audit Report: Exploring the New Language and Elements. The CPA Journal, April: 24-25.

Veena L. Brown, Sheldon B. Lubar School of Business, University of Wisconsin-Milwaukee

brownvml@uwm.edu

Joseph E. Trainor, The Peter J. Tobin College of Business, St. John's University, New York

trainorj@stjohns.edu

Endnotes

(1) While many groups have considered and recommended changes to the standard auditor's report in an effort to enhance the auditor's overall communication to financial statement users, the only change made over the last 70 years were (1) the addition of a paragraph explaining the scope of the audit, (2) the adoption of Auditing Standard No. 1, References in Auditors' Reports to the Standards of the Public Company Accounting Oversight Board, and (3) adoption of Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.

(2) Non-public entities follow auditing reporting standards issued by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AIPCA).

(3) In April 2014, the CPA Journal published an article titled, The PCAOB's Proposed New Audit Report by Weirich and Reinstein. This paper differs from that article as it provides an in-depth overview of the history of the auditor's reporting model and offers insight into the PCAOB's standard setting process. Weirich and Reinstein (2014) offer a brief general summary of the proposed new model and historical events. Our paper also includes teaching notes, learning objectives and implementation guidance for instructors wishing to use this paper in the classroom.

(4) Congress enacted the Sarbanes Oxley Act of 2002 (SOX) which created the Public Company Accounting Oversight Board (PCAOB) to oversee public company auditors and ultimately restore public confidence in the U.S. capital markets.

(5) AS No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements supersedes Auditing Standard No. 2 effective for fiscal years ending on or after November 15, 2007

(6) However, if separate reports are used, the standards require audit firms to reference the nature of audit opinion issued on the other audit in an additional paragraph on the audit opinion report (for example, in a 4th paragraph of the FS standard audit report, the auditor will note the opinion issued on the ICFR audit and vice versa).

(7) An adverse opinion is issued if the auditor reports one or more material weaknesses in internal controls.

(8) The Commission on Auditor's Responsibilities (CAR) was an independent commission formed by the American Institute of Certified Public Accountants (AICPA). Its members represented a broad constituency including practitioners, regulators, former regulators, attorneys, and investors.

(9) The Standing Advisory Group (SAG) was convened by the Public Company Oversight Board (PCAOB) to advise the PCAOB on the development of auditing and related professional practice standards. The SAG includes auditors, investors, public company executives, academics, and others. The SAG meets two or three times a year and is chaired by the Board's Chief Auditor and Director of Professional Standards.

(10) The meetings were held on February 16, 2005 and October 5-6, 2005.

(11) PCAOB Release No. 2013-005, PCAOB Rulemaking Docket Matter No. 034: The auditor's report on an audit of financial statements when the auditor expresses an unqualified opinion; the auditor's responsibilities regarding other information in certain documents containing audited financial statements and the related auditor's report; and related amendments to PCAOB standards. The comment period was initially closed on December 11, 2013 but later reopened with the new closing date of May 2, 2014.

(12) Interested readers may refer to PCAOB Release No. 2013-005 for more information on the reasons for this decision.

(13) Twenty-four (24) of the comment letters were received between the close of the first (December 11, 2013) and the second (May 2, 2014) comment periods. All letters are published on the PCAOB website. Six letters were received subsequent to the reopening of comment period. These additional comments were not yet analyzed by the PCAOB staff at the time this paper was written.

(14) Adapted from the PCAOB's Proposed Auditing Standards (Release No. 2013-005) with changes in bold

(15) The term 'issuer' as used by the PCAOB denotes an entity trading on U.S. stock exchanges; and thus is required to be audited by a registered firm subject to PCAOB oversight, inspection, and enforcement actions.
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Title Annotation:Public Company Accounting Oversight Board
Author:Brown, Veena L.; Trainor, Joseph E.
Publication:Review of Business
Geographic Code:1USA
Date:Jun 22, 2014
Words:6940
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