Financial analysts have another disclosure to consider when you’re trying to evaluate the strength of a company: critical audit matters (CAMs), published by a company’s external audit firm.
CAMs started arriving in corporate annual reports earlier this summer, and you’ll see many more filers start including CAMs in annual reports next year. They are important issues in a firm’s financial reporting processes (hence the “critical” part) as identified by the firm’s external auditor.
CAMs do not necessarily mean anything is amiss with the filer’s financial data, although that can be the case sometimes. Rather, CAMs refer to items in the firm’s financial statements that both (a) are material to the financial statements; and (b) involve “especially challenging, subjective, or complex auditor judgment.”
So CAMs are really a glimpse into which issues an audit firm identifies as potentially important, either because an issue is hard to quantify (say, the precise value of thinly traded derivatives) or because a company’s internal controls for that item aren’t as bulletproof as the audit firm would like those controls to be.
This is a big deal because until now, most audit reports have been pretty boring. In most cases, those reports simply confirmed that the firm’s financial data seems reliable and in accordance with U.S. Generally Accepted Accounting Principles — nothing more. Nice to know, but not terribly informative for financial analysts.
Most firms will have at least one CAM in the auditor’s report; some might have numerous CAMs. Those CAMs might also change over time, as a company updates its internal controls or changes its financial operations.
Large filers had to start including CAMs in their audit reports for fiscal years ending on or after June 30, 2019 — so we’ve seen some CAMs already from filers with June 30 fiscal year-ends, and we’ll see lots more by spring 2020. Smaller firms will start including CAMs for annual reports filed in 2021.
Start at our Interactive Disclosures page. From the “choose footnote/disclosure type” menu on the left, select “Report of Independent Registered Public Accounting Firm.” Then in the text search field on the right, enter “critical audit matters” to see what comes up. See Figure 1, below.
Right now you won’t see too many results, since not too many large filers work on a June 30 fiscal year-end. But we did find some, and have examples below.
Brady Corp. ($BRC) reported a valuation allowance related to taxes as a CAM. The audit firm (Deloitte & Touche) had this to say:
The Company recognizes deferred income tax assets and liabilities for the estimated future tax effects attributable to temporary differences and carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized in the future…
The Company’s determination of the valuation allowance involves estimates. Management’s primary estimate in determining whether a valuation allowance should be established is the projection of future sources of taxable income. Auditing management’s estimate of future sources of taxable income, which affects the recorded valuation allowances, required a high degree of auditor judgment and an increased extent of effort, including the need to involve our income tax specialists.
Cisco Systems ($CSCO) reported this CAM related to revenue recognition, as described by audit firm PwC:
As described in Note 2 to the consolidated financial statements, management assesses relevant contractual terms in its customer arrangements to determine the transaction price and recognizes revenue upon transfer of control of the promised goods or services in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. Management applies judgment in determining the transaction price, which is dependent on the contractual terms. In order to determine the transaction price, management may be required to estimate variable consideration when determining the amount and timing of revenue recognition.
The principal considerations for our determination that performing procedures relating to the identification of contractual terms in customer arrangements to determine the transaction price is a critical audit matter are there was significant judgment by management in identifying contractual terms due to the volume and customized nature of the Company’s customer arrangements.
In each case, the audit firm then explained the procedures it used to try to understand the CAM as much as possible. That’s part of what audit firms must now report for CAMs as dictated by accounting industry regulators.
So that’s the critical information about critical audit matters. They can help a financial analyst understand what’s important to watch in corporate financial statements, and how audit firms are approaching those issues.
How you approach those issues is up to you. Calcbench is here to give you a clear path to finding them.