Early Returns on Critical Audit Matters

Earlier this fall large corporations started to file annual reports that, for the first time ever, included “critical audit matters” identified by their audit firms. CAMs have been a controversial idea for quite some time, but they’re here — and now we have some early research on which subjects audit firms are flagging for CAM disclosure.

Kral Ussery, a public accounting firm based in Dallas, just published a research note that examined the CAMs disclosed by 50 large companies that filed annual reports in August and September. These are the first companies subject to CAMs disclosure, with scads more set to follow in coming months. 

So what did Kral Ussery find? The  single biggest category of CAMs disclosure related to goodwill impairment, followed by revenue recognition and accounting for acquisitions as the next most common subjects. 

All 50 companies had at least one CAM included in their report, and two topped out with four CAM disclosures. The average was 1.8 CAM disclosures per company — although with such a small sample size, you have to wonder whether that number might change by next spring, when we have CAMs data on hundreds of companies. 

It’s also important to remember that while CAMs are included in a company’s annual report, the company itself doesn’t identify or disclose CAMs. The company’s external audit firm does that, and technically CAMs are part of the audit firm’s report (which is then included with the company’s 10-K filing). 

So which audit firms reported how many CAMs? Kral Ussery compiled this nifty table, below. 

That’s quite a range, when you think about it. EY clients, for example, on average had more than twice as many CAMs (2.7) as PwC clients (1.2). Again, we might see those numbers change as we get more data from more companies, but right now — wow. 

More Detail on CAMs

The research note identified 89 CAMs among all 50 companies. The major categories of issues, and the number of CAMs related to those issues, were:

• Goodwill and indefinite-lived intangible asset impairment (24)
• Revenue recognition (19)
• Accounting for acquisitions, including the valuation of intangible assets (11)
• Tax contingencies (11)
• Fair value of liabilities or equity (6)
• Inventory valuation and reserves (4)
• Allowance for loan and lease losses (3)
• Contingent liability judgments, including loss contingencies (3)

Plus a few other oddball categories that garnered only one or two CAMs each.

In truth, none of this is surprising. CAMs were created as part of a new auditor report format the Public Company Accounting Oversight Board approved in 2017. For more than two years, the PCAOB and other voices in the audit community have been saying that all companies should expect to have at least one CAM in their annual report; and most companies should be prepared for several CAMs. That’s pretty much what Kral Ussery found. 

Moreover, also remember that every critical audit matter is supposed to meet two criteria: it relates to accounts that are material to the company’s financial statements; and involves “especially challenging, subjective, or complex auditor judgment.”

In that case, of course items like goodwill impairment, revenue recognition, and the intangible assets involved in an acquisition are prime candidates for CAMs. All three items are material to just about every large company under the sun, and they can involve some very challenging, subjective judgment. 

Like, how does a company decide when goodwill is suddenly impaired? How do you decide what the intangibles in an M&A deal are worth? How much of those valuations are based on hard, proven data, and how much on smoke some CFO or consultant is blowing up the board’s backside? 

What to Do With CAMs

Internal auditors and corporate accounting teams will want to watch how the first year of CAMs compliance unfolds, because it could have implications for changes to your financial reporting processes that the audit firm and your board might want to impose later. 

For example, a CAM relating to allowances for loan losses or to management estimates could be a sore point with the audit committee. Management abuse of estimates and manipulation of allowances for doubtful accounts are both time-honored ways to commit fraud — so if your audit firm discloses a CAM related to loan losses or estimates, it’s not far-fetched that your audit committee will want to revamp internal controls to eliminate that challenging, subjective judgment. 

Then again, I also wonder whether CAMs will become just another pro forma disclosure that audit firms and companies make, without conveying any useful information to investors. I’ve already met some audit consultants who believe that’s what will happen, where audit firms tell all their clients: “You’re going to have two CAMs this year, and they’ll be on these issues because the PCAOB is on our backs to come up with something, so live with it.” 

That would be a shame, because CAMs could be a useful disclosure to make. But it wouldn’t be the first time the disclosure-industrial complex took a good idea and watered it down to pointlessness. Anyway, we’re not there yet. 

Right now CAMs may provide a useful roadmap for internal control professionals to understand weaknesses in financial reporting, and how to handle those weaknesses. Maybe you’ll need to fix them; maybe you’ll just fight with your auditor for a while and be confident that your subjective judgment is right. 

Either way, more to come soon.