Materiality in Critical Audit Matters Divides PCAOB Group

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By Laura Tieger Salisbury

May 27 — Some Public Company Accounting Standards Board Standing Advisory Group members deliberated over whether materiality is a necessity of the critical audit matter section of an audit report.

Materiality is often defined as what a reasonable investor would consider important in making a decision.

`Material' Component of CAM

The question becomes, should auditors be required by the PCAOB to discuss in the audit report what they specifically found to be “material” in the “tripartite test” of a critical audit matter (CAM)?

SAG members and PCAOB May 18 dissected the meaning and impact of “materiality” at a May 11 reproposal of the 2013 auditor's reporting model (09 APPR 695, 8/16/13), (10 APPR 301, 3/28/14).

SAG members praised the PCAOB for the reproposal, which they said was moving in the right direction, into alignment with other regulators including the International Auditing and Assurances Standards Board, the Financial Reporting Council in the U.K., and the E.U.

PCAOB's Most Important Project

Sir David Tweedie, former IASB chairman, described the reporting model as the most important project that the PCAOB had ever done.

He described it as “shocking” that the previous reporting model hadn't been changed for 75 years.

The PCAOB's proposal was “terrific for auditors'” and would restore people's trust in auditors after financial crises such as Enron, Tweedie said. Moreover, it is good for auditors' reputations anytime the audit report goes “towards what investors want to see” rather than what the company wants investors to see, he said.

Jennifer Rand, Deputy Chief Auditor introduced the session by saying that the PCAOB—since it began the revamp of the 75 year old standard in 2010 (07 APPR 212, 3/18/11)—had benefitted from the feedback and study of reports from other regulators. The U.S. is lagging behind the “reality around the world” of a much more informative auditors reporting model, she said.

In particular, Rand said, the PCAOB had been paying attention to the positive feedback from the U.K. which has been using a modernized auditor's reporting model for at least three years (10 APPR 351, 4/11/14). She cautioned, however, that the regulatory experience was different in the U.S., thus affecting what U.S. auditors and U.S. investors wanted from an audit report.

Investors Want to Know What's Material

SAG member Liz Murrall, director, Stewardship and Reporting, Investment Management, London, drew on positive investor responses to materiality disclosures experiences in the U.K.

She argued strongly that the PCAOB needed to “go one step further” and have auditors disclose what they found material. This disclosure gives investors a chance to evaluate how deep auditors had dived into the audit, she said.

Other SAG members Elizabeth Mooney, Vice-President, The Capital Group Companies, and Sandy Peters, Head of Financial Reporting Policy, CFA Institute, also advocated the need for materiality disclosures in the audit report. Just a CAM by itself, without materiality disclosures, requires the auditor to surmise the investor's thinking process—what goes into an investment evaluation of “materiality.”

Mooney said the auditor's report was the “communication piece with investors.” Regardless how subjective an auditor's judgment was—if it is only communicated to the audit committee—leaves investors out of the information loop, and at a distinct disadvantage.

Peters echoed Murrall's comments. The CFA Institute, has asked investors whether they want materiality disclosed and they have “resoundingly answered ‘yes,' ” Peters told the group.

Key Audit Matters Similar

Arnold Schilder, International Auditing and Assurance Standards Board chairman, said he was pleased that the PCAOB and the IAASB were agreeing on how to address global audit issues (12 APPR 10, 5/20/16).

Schilder noted a May 23 IAASB press release stating: “Comparable approaches to auditor reporting around the world will clearly benefit investors and is in the public interest. We commend the PCAOB for taking steps to enhance transparency for investors and to further global consistency.”

The IAASB views are consistent with PCAOB's Chief Auditor Martin Baumann and board member Jay Hanson statements that the IAASB's reporting model's “key audit matters” (10 APPR 117, 1/31/14) and the PCAOB's “critical audit matters” were “very close in terms of the concept.”

Other Changes to Auditor's Reporting Model

According to the reproposal, the model would remain a “pass-fail' determination, requiring the auditor's opinion on whether the financial statements are fairly presented—pass—or not—fail..

The PCAOB reproposal refined the 2013 concept of CAMs and added other auditor assurances (12 APPR 10, 5/20/16).

The revised auditor's reporting model proposal thus has features such as:

  •  statement of auditor's independent judgment;
  •  length of auditor tenure;
  •  brief overview of procedures performed on a “critical audit matter”;
  •  statement that no critical audit matters had been found, if the auditor found none; and
  •  statement that the financial statements are free of material misstatements “whether due to error or fraud.”


Materiality Added to CAM Determination

PCAOB Chairman James Doty explained to Bloomberg BNA May 18 that the change from the original proposal—adding materiality to the financial statements into the “critical audit matter” definition— would “result in significant items reported as critical audit matters” and that the “tripartite test” for a CAM, in the reproposal, would include:

  •  something communicated to the audit committee or required to be communicated to the audit committee;
  •  relates to accounts or disclosures that are material to the financial statements; and
  •  involved especially challenging, subjective, or complex auditor judgment.


`Omitted Facts.'

An audit report in the U.S. would also be governed by the Supreme Court's definition of materiality in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), a securities fraud case.

The Supreme Court's definition refers to omitted facts.

“An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. In other words, the court must determine whether under all the circumstances, the omitted fact would have assumed actual significance in the decision of the shareholder.”

Murrall told Bloomberg BNA that she didn't think that investors or auditors benefitted from having to rely on a definition of materiality from a judicial body.

She expressed this view in regard to recent Financial Accounting Standards Board disclosure proposals also.

According to the Conceptual Framework for Financial Reporting, “information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.”

U.S. Commenters Weren't Interested

Both Rand and Baumann responded that because there was only one comment letter on materiality after the 2013 proposal, the PCAOB didn't believe it was important to U.S. investors.

However, Baumann later in the meeting said that he hoped the reproposal would spark comment letters on the issue.

Jessica Watts, PCAOB's associate chief auditor, pointed out that the reason the reproposal had added materiality to the definition of CAM was because investors had commented that otherwise, auditors would feel obliged to report immaterial matters—those not important to the financial statement.

Materiality: Financial Statements or Scope

Baumann, after many SAG commenters had weighed in with their views, clarified what he considered had become two different discussions.

The first, he said, was what the PCAOB meant by materiality—“looking at a set of financial statements and determining are all disclosures that are materially important there, and based on both quantitative and qualitative assessments, determining whether matters in the financial statements are material and then evaluating if CAM that pertain to matters in the financial statements are material.”

Baumann distinguished this from what he believed SAG members were saying they wanted to know more about, what he referred to as the scope of the audit. He said the PCAOB's meaning was different from the U.K. requirement for the auditor to disclose “what is the materiality threshold for trying to set tolerable misstatements and determining the scope of work.”

Brian Croteau, Securities and Exchange Commission, noted that what the PCAOB was trying to establish was quite different from the ongoing Financial Accounting Standards Board determination of materiality—another concern expressed by Murrall—and he encouraged commenters to provide feedback to the PCAOB.

Quantitative, Qualitative Measures of Materiality

The difference between quantitative and qualitative measures and their overlap in financial statements is perhaps best defined in the Securities and Exchange Commission's Staff Accounting Bulletin 99: Materiality by the SEC. According to SAB 99, misstatements are not immaterial simply because they fall beneath a numerical threshold.

SAB 99 cautions registrants and auditors not to necessarily conclude that just because a misstatement or omission of an item falls under a 5 percent threshold in the financial statements, that the item is not material. It defines “material” as a substantial likelihood that a reasonable person would consider it important.

Full Analysis of All Relevant Considerations

In its Statement of Financial Accounting Concepts No. 2, FASB stated the essence of the concept of materiality as: “The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”

Doty—in an e-mail to Bloomberg BNA May 26—said that the question of whether auditors should disclose a quantitative materiality threshold raised a difficult issue because “it is important that auditors also evaluate the qualitative materiality for significant matters that may not meet that threshold.”

Doty indicated that he would be concerned if audit opinions were understood not to consider matters that “may not meet a quantitative materiality threshold but nevertheless are qualitatively material to investors.”

Hanson told Bloomberg BNA May 11 that a key question to be resolved with the input of investors was whether disclosure of CAMs would provide the investor with “useful information” in terms of making an investment decision. He gave the example that the investor may be more interested in looking at an objective measure such as revenue—found in the financial statements—rather than an auditor's description of CAMs.

FASB's Disclosure Projects Addressing Materiality

In FASB's proposed Notes to Financial Statements (ASC 235): Assessing Whether Disclosures are Material, the board summarizes that the Supreme Court's definition of materiality is the proper one.

FASB Chairman Russell Golden said May 18 that the board was attempting to align a conceptual framework to that of the auditing standard as well as securities laws, and wanted stakeholders' input on how best to do that (12 APPR 10, 5/20/16).

To contact the reporter on this story: Laura Tieger Salisbury in Washington at

To contact the editor responsible for this story: Ali Sartipzadeh at

For More Information

The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and Related Amendments is on the PCAOB website at the

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