The disclosure of Critical Audit Matters (CAMs), as required by AS 3101, became effective for large accelerated SEC filers with fiscal years ending on or after June 30, 2019. The European counterpart – Key Audit Matters (KAMs) – have been required under ISA 701 beginning with fiscal years ending on or after December 15, 2016.
We expect that trends with CAMs in the United States will be similar to KAMs in Europe. According to a previous analysis of KAMs, the average per annual report was 2.7 KAMs in 2018, with larger companies and companies audited by the Big Four + Grant Thornton and BDO being more likely to have a slightly higher number of KAMs.
As shown in the table below, we have collected more than 140 CAMs disclosed in the audit opinions of over 70 different companies.
We would also expect that similar topics will be identified as key or critical audit matters. In an analysis of 2017 KAMs, 20% of KAM disclosures related to asset impairment and recoverability, with a particular focus on impairment of goodwill and other intangible assets, while 16% referenced revenue, and 11% of disclosures referenced valuation of investments. Other frequent topics included income taxes, litigation, inventory, and post-retirement benefits.
Though it is too soon to identify any predictive trends among SEC registrants, there are certain items that we expect to see frequently disclosed as a Critical Audit Matter and a Key Audit Matter. These items include metrics that always involve a fair degree of complexity and estimation:
Goodwill and Intangible Assets
In order to assess goodwill and intangible assets, management must compare the fair value to its carrying value, a process that requires significant estimates for items such as cash flow forecasts, revenue growth rates, and discount rates. These significant estimates made by management in turn lead to a high degree of auditor judgment when evaluating goodwill and intangible assets.
As of the date of this post, 22% of CAMs address asset impairment and recoverability, with goodwill-only impairments appearing in 18 CAMs; that number increases to 28 when considering goodwill + intangible asset impairments.
Determining the amount of revenue to be recognized is a complex process, especially when considering companies can have multiple sources of revenue. To evaluate revenue, it is necessary to determine a variety of factors including performance obligations, selling prices, and when to actually recognize the revenue. If company management must exercise significant judgement or rely heavily on estimates when determining revenue, the related audit effort may be extensive and require a high degree of auditor judgement.
Since CAMs have been required, roughly 21% of CAMs relate to revenue recognition, with the identification of performance obligations appearing in 12 CAMs.
Acquisitions & Business Combinations
Assigning value during an acquisition is not an exact science – it requires significant assumptions, including fair value estimates, forecasted revenue growth & operating expenses, and the valuation of intangibles such as customer relationships. Therefore, auditing a company’s valuation of acquired assets may be considered a CAM, as it may present a difficult task for the auditor to assess the significant judgments that are required by management in these types of transactions. On occasion, the valuation of assets may even require the audit firm to consult with subject-matter experts.
As of the date of this post, 17% of CAMs address business combinations.
Litigation is another area that is notoriously difficult to assign a value, as the results of litigation are not under company management control. The length of a court case, amount of legal fees, and costs associated with adverse judgments are affected by myriad factors that no one can predict with absolute certainty. If a company has a litany of litigation, it may be material to their financial statements and management must heavily rely on estimates and predictions. Assessing how management assigned estimated valued or projected impact could prove challenging for the auditor.
Since CAMs have been required, 6% disclosed relate to contingent liabilities, including litigation.
Recognizing and measuring uncertain tax positions involves significant estimates and management judgment, in addition to complex considerations of the Internal Revenue Code, regulations, and tax laws.
As of the date of this post, 13% of CAMs address taxes; uncertain tax positions have been referenced in 11 CAMs to date.
It is important to note that while these topics always necessitate estimation by management, they may not always be material to a company’s financial statements, in which case the auditor would not identify the topic as rising to the level of a KAM or a CAM.
Additionally, auditors have been advised that CAMs are specific to the circumstances for each audit. Although certain topics may always require estimation, the CAM disclosure should address events specific to the audit for an individual company; if the same CAM language can be used for the same topic across multiple companies, it could indicate that the CAM disclosure isn’t specific to the circumstances. In theory, this requirement will increase insight into the audit process for each audit, since it will decrease the likelihood of the wide use of boilerplate language.
As more and more reports are filed, it will be interesting to see the number of CAMs, topics, length of disclosures, and chosen language of CAMs across industries and whether these trends resemble KAM disclosure trends.
For more information on Critical Audit Matters or Key Audit Matters please contact us.