A critical audit matter (CAM) is a new element of the auditor’s report required by a 2017 Public Company Accounting Oversight Board (PCAOB) auditing standard (AS 3101). It is any matter arising from the audit of a company’s financial statements that was communicated or required to be communicated to the audit committee and that 1) relates to accounts or disclosures that are material to the financial statements and 2) involves especially challenging, subjective, or complex auditor judgment. CAM regulations were born from the communications among auditors, the audit committee, and company management about complex matters that were happening as part of the audit. CAMs are a way of bringing third-party investors into that communication and sharing those important items, making communication among all parties more transparent and effective at putting everyone on the same page about what is critical to the company.
How can financial executives use CAMs to improve existing communications processes?
Mike Yates: The first step for financial executives should be to understand why something is a CAM. A CAM might come from a breakdown in internal controls. Or a CAM might arise simply because a matter is especially challenging to the auditor, even though there might be no internal process that management needs to change. Once financial executives understand why something is a CAM, they can look at their existing processes for potential improvements that might alleviate a CAM.
As far as communications go, financial executives should have an open dialogue with auditors regarding CAMs and potential CAMs throughout the year. Also, financial executives should examine their communication to third parties and how they are sharing information about these difficult audit matters or critical estimates in the cases of quarterly earnings calls, releases, and 10-K filings, for example.
After consideration of CAMs, financial executives might determine that they need to enhance their communications with outside parties regarding the different critical matters of the company. As a result, CAMs can improve internal processes, internal controls, and the overall quality of communications.
Being that it's the first year for CAMs, how many CAMs do you think companies should expect to have?
Yates: That is a difficult question to answer, as the facts and circumstances surrounding each audit are going to be very different. The standard allows for zero CAMs to be reported, and it is unlimited on the topside. So, there could be situations where a public filing has zero CAMs, or a public filing might have six or more CAMs. We’ll probably find out a lot within the first 12 months of CAMs being reported. While zero is possible, I have a feeling that auditors are going to be looking for and identifying one or two critical audit matters. If a company has a breakdown of controls causing a material weakness to be reported, more CAMs likely will be identified. This is purely a guess based on thinking back over the history of audits that I have experienced.
Are we likely to see a spike in the number of CAMs in year one with a decrease in the following years?
Yates: CAMs probably will be adjusted going in both directions. Because the number of CAMs depends on facts and circumstances, many factors play into a CAM. Examples include:
- New accounting regulations
- Industry changes
- Economic changes
As noted, outside factors not controllable by the company could affect CAMS. Both companies and researchers are going to be looking for the norms. After year one, some companies and audit firms will be asking whether they are above the norm, below the norm, or aligned with the norm and whether they are telling the right story to the financial statement users.
If all of a company’s CAMs this year are nonrecurring items, will that company have CAMs next year?
Yates: The question brings up the term “nonrecurring items.” I don’t believe that’s within the audit standard from the PCAOB, but there’s a belief in the marketplace that some CAMs are controllable, and other CAMs are not. Certain nonrecurring items would be those items that the company has the ability to control, and once the company introduces a new process or new controls, the CAM could be alleviated.
Material weaknesses are good examples of triggering points for many CAMs. Typically, material weaknesses cause the auditors to create different, more challenging procedures that would not be performed in the normal environment. Thus, a company might have a CAM related to a material weakness. The next year, management remediates the material weakness, and the matter might not be a CAM moving forward.
A company also could have a nonrecurring item such as undertaking a business combination in a year. Business combinations usually involve very significant fair value estimates, which can represent a CAM. Based on the facts and circumstances surrounding the acquisition in subsequent years, the year one CAM, a nonrecurring item, might fall off.
You mentioned that some CAMs are controllable. Can you go into a little more detail on controllable versus noncontrollable items?
Yates: The terms “controllable” and “noncontrollable” are not in the standards, but I've used them in training sessions to talk about CAMs. Controllable items typically relate to a company’s material weaknesses. The company is responsible for designing internal controls to mitigate the risk that is present at the company. Management does its own risk assessment process to identify controls to minimize that risk. Auditors then perform an evaluation of management’s risk assessment. If the auditors identify a material weakness, that could mean a few things:
- The controls as designed are insufficient to minimize risk or they do not operate effectively.
- The risk is material to the company.
- The auditor is required to design tests unique to the risk.
A controllable CAM, as I define it, is one where management could have controlled the situation. For example, management had the opportunity to develop and execute internal controls over fair value to reduce risk, and either the design of the control failed or the control did not operate effectively. This situation, depending on the risk involved, may lead to a CAM.
How can CAMs relate to a company’s critical accounting estimates?
Yates: Critical accounting estimates are going to be prime targets of CAMs. In saying that, I refer to the standard and the requirements for the auditor’s assessment.
A CAM must be something that has been communicated to the audit committee or was required to be communicated, and the communication must relate to a material account or disclosure within the financial statements. Once a matter meets those two criteria, it doesn’t necessarily create a CAM. The auditor then considers specific factors in the standard as well as anything else that might make the matter involve especially challenging, subjective, or complex auditor judgment. Many of these factors can relate directly to estimates.
One of the factors relates to the assessment of significant risk. As the name implies, critical accounting estimates are vital to the company, and they are risky. In many cases, critical estimates and significant risk go hand in hand.
Then the auditor looks at the effort that management has put into the estimate and its level of subjectivity. By the time the auditor gets through the critical estimates evaluation, many of the items that the PCAOB identified within the standard might apply.
Within the CAM disclosure, the auditors are responsible for identifying the matter and explaining the reasons it is a CAM. That’s really what the investors and management want to know – why something is a CAM. Critical estimates year over year have a good chance of being CAMs, because there’s not a lot management can do with some of these critical estimates – they’re just especially challenging. This is especially true when the firm needs to look outside its audit team for specialized skills to assess and evaluate the critical accounting estimate, which might be a CAM in year one, year five, and year 10. And it’s not because management is doing anything wrong. In today’s age of accounting where we have a lot of fair value estimates, some matters are just very likely going to be CAMs.
Critical accounting estimates are key in the auditor’s assessment. Although not every critical estimate is a CAM, critical estimates are among the key triggering points for CAMs.
What is something about CAMs that financial executives should know but might be afraid to ask their auditors?
Yates: What were the close calls for CAMs? If I were sitting on the other side of the table, I would want to know about any other items that might have caused the auditors to pause in their assessment. I would seek to understand the “why” behind a matter almost being a CAM. That information might tell me more about my company and improvements that can be made to avoid having certain matters turn into CAMs in the future.
Mike Yates, Partner, Assurance Professional Practice
Mike Yates has been a part of the Crowe assurance professional practice since 1997. In his current role, Yates is responsible for providing guidance to the firm on auditing matters and working with the audit methodology group to verify compliance with audit standards. Yates has a leadership role in providing written comment letters from Crowe on proposed auditing standards and is responsible for performing pre-issuance review of engagements, analyzing engagement risks, and consulting with engagement teams on audit-related matters. He serves on several Center for Audit Quality task forces that address audit quality, provide guidance on new developments, and consult on technical matters.