Recognizing and documenting critical audit matters (CAMs)can be challenging, but they are a necessary part of the process to ensure transparency and good judgment. To help you with this, we’re defining what a CAM is, common examples, and how to document them.
What is a critical audit matter?
Critical audit matters are essential to audit reports for public companies under the Public Company Accounting Oversight Board (PCAOB) standards. CAMs provide transparency into areas subject to audit that involve complex, subjective, or challenging issues to investors and other stakeholders.
PCAOB defines critical audit matters as matters that arose during the audit and were communicated or required to be communicated to the audit committee, relating to accounts or disclosures that involve especially challenging, subjective, or complex auditor judgments.
Determining critical audit matters
Independent auditors are responsible for exercising professional judgment when determining whether a matter qualifies as a CAM based on specific factors, including:
- Risk of Material Misstatement: Areas with a heightened risk of material misstatement due to error or fraud, such as complex accounting principles, unusual transactions, subjective estimates with high degrees of uncertainty, or other areas with significant judgment increase this risk.
- Extent of Audit Effort: Areas requiring significant effort, such as specialized audit techniques, extensive testing, or involving multiple audit team members or specialists.
- Nature of Evidence Obtained: The difficulty or complexity of obtaining sufficient, appropriate audit evidence, including reliance on third parties.
- Potential Impact on Financial Statements: Matters with a significant effect on the financial statements or disclosures are prioritized.
Examples of critical audit matters
Not all matters communicated to the audit committee will qualify as CAMs. For instance, routine matters that do not involve significant complexity or judgment may not meet the threshold. Common examples of critical audit matters include the following:
Revenue Recognition
Revenue recognition can be complex due to varying contract terms, multiple performance obligations, or significant management estimates about variable consideration. For example, recognizing revenue for long-term construction contracts based on percentage-of-completion often requires detailed judgment.
Income Tax Uncertainties
Accounting for uncertain tax positions involves complex tax laws, interpretations, and significant judgment. Auditors may encounter challenges in assessing the likelihood of outcomes or measuring the number of benefits to recognize.
How to communicate critical audit matters
Communicating a critical audit matter in a PCAOB audit report involves a structured approach designed to provide clarity and relevance to stakeholders. The PCAOB’s AS 3101 outlines the requirements for including CAMs in an audit report. The objective is to ensure that investors and other users of the financial statements understand the significant issues encountered during the audit and how they were addressed.
Drafting a critical audit matter
Identify the CAM: Begin by clearly stating the critical audit matter. Use precise and descriptive language to explain the issue that arose during the audit. This should include the specific account(s) or disclosure(s) related to the CAM.
Example: "The valuation of goodwill for the Company’s Agriculture segment was identified as a critical audit matter due to the significant judgment and assumptions required in the impairment analysis."
Describe why you consider the matter to be a CAM: Explain why the matter requires especially challenging, subjective, or complex auditor judgment. This description should reference the characteristics of the CAM that led to its identification.
Example: "Goodwill impairment testing involves complex estimates and assumptions, including projected revenue growth rates, profit margins, and the discount rate applied. These inputs are highly sensitive to future market conditions and management’s strategic plans, making the evaluation subjective and challenging."
Describe how you addressed the matter in the audit: Detail the audit procedures performed to address the critical audit matter, providing readers with insight into the nature and extent of the auditor’s response. Avoid overly technical language while ensuring the explanation reflects the audit work done.
Example: "Our audit procedures included evaluating the reasonableness of management’s assumptions by comparing them to historical performance and industry trends. We involved valuation specialists to assess the appropriateness of the discount rate and other key inputs. Additionally, we tested the mathematical accuracy of the underlying models and performed sensitivity analyses to evaluate the impact of changes in key assumptions."
Reference the relevant financial statement accounts or disclosures: Include references to the specific financial statement accounts or disclosures where the CAM is addressed. This helps users locate additional context and details.
Example: "The disclosures related to goodwill impairment testing are included in Note 8 to the consolidated financial statements."
Disclosing when there are no critical audit matters
It’s important to note that if you determine that there are no critical audit matters, you need to communicate this in your report, specifically using the following language from The PCAOB: “Critical audit matters are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: 1) relate to accounts or disclosures that are material to the financial statements and 2) involved our especially challenging, subjective, or complex judgments. We determined that there are no critical audit matters.
By following these best practices, you can provide greater transparency and reduce information asymmetry between investors, auditors, and management.
Learn more with CPE courses from Becker
Whether you want to learn more about critical audit matters, learn about the latest PCAOB updates, or build your knowledge in other audit topics, Becker can help. Check out these CPE courses to take the next step in your learning:
- Evaluating Internal Controls
- PCAOB Audit Standards, Part 1
- Professional Judgment in Audit
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