As defined by the PCAOB, a critical audit matter (CAM) is any matter that the auditor communicated or was required to communicate to the company’s audit committee, and is related to items that are material to the company’s financial statements, as well as items that involved challenging, subjective, or complex judgment.
The disclosure of CAMs, as required by AS 3101, became effective for large accelerated filers with fiscal years ending on or after June 30, 2019, and on or after December 15, 2020, for all other required companies.
That being said, we’ve been coming across more and more CAM disclosures. After analyzing these disclosures, it’s clear that this section of the auditor’s report will be an extremely useful tool for investors, shareholders, and analysts when reading through financial statements.
The standardized form of the audit report was developed in the 1940s to provide uniform language that would make audit reports more comparable. Historically, these audit reports follow a pass/fail model, because, as the PCAOB has described, “the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).”
However, the work that goes into an audit is notoriously complex – more complex than a simple pass/fail model. The complexities of an audit may not be adequately represented using a standardized model for an audit report, as the finished product of an audit consists of an opinion that is typically only a few paragraphs in length. And those few paragraphs are often tucked away in lengthy annual financial statements, sometimes hundreds of pages in length.
Furthermore, audit opinions often consist of dense language with boilerplate disclosures, and the average investor or reader of financial statements without a CPA background or a familiarity with audits may not be able to easily derive meaning or understand the complexities of the audit.
Since CAMs are related to accounts or disclosures that are material to the financial statements, as well as areas of the audit that were particularly challenging for the auditor, those reading the financial statements will be provided clues – through the CAM disclosures – of what areas may need more scrutiny prior to making important decisions.
However, it is important to note that CAMs are only identified if the matter relates to accounts or disclosures that are material to the financial statements. There may be important matters that would not constitute CAMs because they are not related to material accounts or disclosures. As the PCAOB has advised:
CAMs are required to relate to accounts or disclosures that are material to the financial statements. Materiality is not solely based on quantitative factors; it also reflects qualitative factors.
This element of the CAM definition is grounded in the financial statement presentation and disclosures of the applicable financial reporting framework. Matters that meet the other elements of the CAM definition may or may not be CAMs, depending on whether they relate to accounts or disclosures that are material to the financial statements.
As an example of the usefulness of CAM disclosures, consider the example of Procter & Gamble [PG]. P&G recently filed their annual report containing CAMs, one of which was “Goodwill and Intangible Assets – Shave Care Goodwill and Gillette Indefinite Lived Intangible Asset“. After reading the CAM in the annual report, an investor would be signaled to give additional attention to the company’s goodwill and intangible assets – particularly as it relates to P&G’s shave care.
This CAM is particularly notable, as a week prior to filing its annual report, P&G disclosed a large impairment charge of $8.0 billion ($8.3 billion before tax) to adjust carrying values of goodwill and trade name intangible assets in its Gillette Shave Care business.
Although the impairment was disclosed prior to the annual report in this case, CAMs will provide invaluable information; sharing important aspects of a company’s financial statements, making it easier for investors to understand the whole picture.
For more information on Critical Audit Matters please contact us.