Microsoft Corporation [MSFT] filed its annual report on August 1, 2019, and, in addition to the wealth of information provided in the 10-K, we came across one of the first disclosures of critical audit matters from a large accelerated filer.1
The implementation of PCAOB Auditing Standard 3101 (AS 3101): The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, adopted on June 1, 2017, makes significant changes to the auditor’s opinion. Among the new requirements is the disclosure of critical audit matters (CAMs), which took effect for audits of large accelerated filers for fiscal years ending on or after June 30, 2019, and on or after December 15, 2020, for all other required companies.2
As defined by the PCOAB, a critical audit matter is any matter arising from the audit of the 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) involved especially challenging, subjective, or complex auditor judgment.
For each critical audit matter communicated in the auditor’s report the auditor must:
- Identify the critical audit matter;
- Describe the principal considerations that led the auditor to determine that the matter is a critical audit matter;
- Describe how the critical audit matter was addressed in the audit; and
- Refer to the relevant financial statement accounts or disclosures that relate to the critical audit matter.
Now let’s look at Microsoft’s CAMs disclosure.
Deloitte identified two critical audit matters in Microsoft’s audit opinion: Revenue Recognition and Income Taxes- Uncertain Tax Positions. The Big Four audit firm provided a thorough description for the considerations that led them to determine that both were critical audit matters, as well as how these matters were addressed during the audit. And, rounding off all four must-haves, referenced the relevant financial statements.
Critical audit matters should not be confused with a company’s critical accounting policies. Critical accounting policies, as required under SEC Financial Release No. 72, are policies related to items that have a material impact on the financial statements and require significant estimates, judgments or assumptions. Unlike CAMs, critical accounting policies are determined by management, and must be disclosed in the Management’s Discussion and Analysis section of a quarterly or annual report.
The purpose of disclosing critical accounting policies is to provide a better understanding of all applied components to accounting policies by management. When areas of a company’s financial performance are based on subjective determinations, it may be wise to apply more scrutiny to those areas.
In Microsoft’s FY 2019 annual report, management identified seven critical accounting policies compared to Deloitte’s two identified CAMs:
While both CAMs and critical accounting policies identify the policies with high subjectivity, CAMs address how estimates made by management affect the audit process.
Using Microsoft’s income tax critical accounting policy as an example, we can see how judgments for the same policy are considered differently by the two entities.
Microsoft discloses information in its critical accounting policy regarding when tax benefits from uncertain tax positions are recognized. In regards to the qualification of income taxes as a critical accounting policy that requires significant estimates by management, Microsoft disclosed:
Deloitte’s CAM description for Microsoft’s income taxes adds that the uncertainty of tax positions requires considerable judgement due to Microsoft being under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. In order to evaluate management’s estimates related to income taxes, the audit firm was required to exert extensive audit effort and a high degree of auditor judgement.
The incremental disclosure from the CAM serves the user of the financial statements by identifying specific areas of challenging, subjective, or complex auditor judgment. The ongoing IRS audit seems to be an important factor for Deloitte when deciding income taxes rise to the level of a CAM, whereas management appears to disclose income taxes as a critical accounting policy regardless of whether the company is under an IRS audit.
Additionally, the new disclosure gives users valuable insight into how the auditor responded to the CAM. Deloitte not only evaluated the controls, procedures, and policies for establishing estimates, but also considered the appropriateness and consistency with which information was applied in establishing estimates.
Disclosing CAMs that involved challenging, subjective, or complex auditor judgments is an important aspect of financial statements and the adoption of the standard is intended to increase the usefulness, relevance, and context of information included in the reports.
The United States joins many other countries that have recently adopted requirements for an expanded audit report, highlighting the universal need and importance of clear and understandable elements in financial statements.
For more information on critical audit matters, please contact us by emailing info@auditanalytics.com or call 508-476-7007.
1. Open Text Corp [OTEX] also filed its annual report yesterday with the disclosure of critical audit matters.↩
2. Communication of critical audit matters is not required for audits of (1) brokers and dealers reporting under Exchange Act Rule 17a-5; (2) investment companies registered under the Investment Company Act of 1940 (“Investment Company Act”), other than companies that have elected to be regulated as business development companies;12 (3) employee stock purchase, savings, and similar plans; and (4) emerging growth companies.↩