ACC 546 Week 3 Audit Reporting and Required Communications Example

Writing the Critical Audit Matter on a Bank's Credit Loss Allowance: The Auditor's Report, Its Required Elements and the Communications With the Audit Committee at a Composite Regional Bank Holding Company

[Student Name]

University of Phoenix

ACC/546: Auditing

Week 3 Assignment

[Instructor Name]

[Date]

The bank, its figures and the audit team are composites written for a model paper; standards and research findings come from the sources listed.

A composite bank holding company operates 84 branches in three states and holds $6.2 billion in assets, including $4.6 billion of loans. Its allowance for credit losses is $58 million, estimated under the expected credit loss approach adopted in 2023. The audit team has completed its fieldwork and is drafting the auditor's report on the financial statements and on internal control over financial reporting. The modern auditor's report still says whether the statements are fairly presented, but it now also tells investors where the auditor found the judgments hardest. This paper drafts the report and plans the communications that precede it.

The Elements of the Report

Under the PCAOB's reporting standard, the report begins with the opinion, stating the auditor's conclusion that the statements fairly present the bank's financial position, results of operations and cash flows under generally accepted accounting principles, in all material respects (Public Company Accounting Oversight Board, 2017). A basis for opinion section follows, stating that the statements are management's responsibility, that the auditor is a PCAOB-registered firm required to be independent and that the audit was conducted under PCAOB standards to obtain reasonable assurance. The report then includes critical audit matters, a statement of how long the firm has audited the bank, the firm's signature, city and date. Because the bank is an accelerated filer, the firm also opines on internal control, in a combined report or a separate one referred to in the financial statement report.

Determining Critical Audit Matters

A critical audit matter is any matter arising from the audit that was communicated or required to be communicated to the audit committee, relates to accounts or disclosures material to the financial statements and involved especially challenging, subjective or complex auditor judgment. The team considered several candidates. The allowance for credit losses met all three criteria. The valuation of goodwill from a branch acquisition was communicated to the committee but involved a comfortable excess of fair value over carrying amount, so it was not especially challenging this year. The accounting for a new interest rate swap program was complex in principle but straightforward in execution. The team concluded there was one critical audit matter.

Drafting the Critical Audit Matter

The report must identify the matter, describe the principal considerations that led the auditor to determine it is critical, describe how it was addressed and refer to the relevant notes. The draft reads, in substance:

As described in Note 5, the allowance for credit losses on loans was $58 million at December 31. Management estimates expected losses using models that apply historical loss rates to pools of loans with similar risk characteristics, adjusted for a reasonable and supportable forecast of economic conditions, and then applies qualitative adjustments for factors not captured by the models, including concentrations in commercial real estate office loans. We identified the qualitative adjustments as a critical audit matter because they require significant management judgment and auditing them involved especially subjective auditor judgment and the use of professionals with credit expertise.

Our procedures included testing controls over management's review of the qualitative adjustments; evaluating the relevance and reliability of the data management used, including office occupancy and appraisal data; testing the reasonableness of the adjustments by comparing them with loan-level trends and peer information; and evaluating whether the adjustments were consistent with other evidence obtained during the audit.

The description refers to the bank's own disclosures rather than providing new information about the company, which the standard directs.

Audit Evidence Behind the Matter

The procedures described in the critical audit matter summarize a substantial body of work. The team's credit specialists reviewed 140 commercial loans individually, compared the bank's forecast scenarios with published economic forecasts and recomputed the allowance for each pool. They also looked back at last year's qualitative adjustments against actual charge-offs to judge whether management's estimates had been biased.

When the Report Would Change

If the allowance were materially misstated and management refused to correct it, the firm would issue a qualified or adverse opinion. If the firm could not obtain sufficient evidence, it would qualify or disclaim. Explanatory paragraphs, which do not modify the opinion, are required in other situations, such as substantial doubt about going concern, a change in accounting principle with a material effect or a restatement to correct a misstatement. An emphasis paragraph may be added for a matter the auditor wishes to highlight, such as a significant subsequent event.

Communications With the Audit Committee

The PCAOB's communications standard requires the auditor to communicate with the audit committee throughout the audit (Public Company Accounting Oversight Board, 2012). Before the report, the team will have communicated the audit strategy and significant risks, critical accounting policies and estimates, including the allowance, significant unusual transactions, difficult or contentious matters for which the team consulted outside the engagement, the uncorrected misstatements and their effect, any disagreements with management, which there were none, and the critical audit matters it intends to report, with a draft of the language. It will also report the one significant deficiency found in internal control, over the timeliness of loan risk rating updates, which did not rise to a material weakness.

Private Company Reports Compared

If the bank were private, its auditor would follow the AICPA's reporting standard. The report would also begin with the opinion and include a basis for opinion, but key audit matters would be optional, reported only if the auditor were engaged to do so, and there would be no tenure statement. Going concern, emphasis and other matter paragraphs work similarly. The comparison shows that the public company report's added elements respond to investors who, unlike a private company's lender, cannot ask the auditor directly.

Wording and Review

Because the critical audit matter will be read by investors, analysts and possibly regulators, its wording was reviewed by the engagement quality reviewer and the firm's national office. The reviewers checked that it described the auditor's work accurately, did not imply a separate opinion on the allowance and used language consistent with the bank's disclosures.

Research on Critical Audit Matters

Gimbar et al. (2016) found in an experiment that disclosing critical audit matters could affect how jurors assessed auditor liability, with effects that depended on the precision of the accounting standard involved. That research suggests the language should be specific and accurate, since it may be read not only by investors but also in disputes.

Conclusion

The auditor's report on the bank will contain an unmodified opinion, a basis for opinion, one critical audit matter on the qualitative adjustments to the allowance for credit losses, auditor tenure and the firm's signature. The critical audit matter describes why the matter was difficult and how it was addressed, referring to the bank's own notes. Required communications with the audit committee ensured that nothing in the report will surprise the committee.

References

Gimbar, C., Hansen, B., & Ozlanski, M. E. (2016). The effects of critical audit matter paragraphs and accounting standard precision on auditor liability. The Accounting Review, 91(6), 1629-1646. https://doi.org/10.2308/accr-51382

Public Company Accounting Oversight Board. (2012). Communications with audit committees (Auditing Standard No. 16).

Public Company Accounting Oversight Board. (2017). The auditor's report on an audit of financial statements when the auditor expresses an unqualified opinion (AS 3101).