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PCAOB Proposes New Standard for Auditing Internal Controls

The Public Company Accounting Oversight Board approved for comment a proposed standard for the audit of internal control over financial reporting. When it is adopted, it will supersede Auditing Standard No. 2. PCAOB Chairman Mark Olson said the standard and related proposals will eliminate unnecessary requirements while preserving the key principles. The PCAOB also proposed a new standard for auditors to use the work of others that would supersede AU Section 322 and the current Auditing Standard No. 2 directions, and proposed a new independence standard relating to the pre-approval of internal control services.

Deputy Chief Auditor Laura Phillips described the revised standard as a shorter, reorganized standard that outlines the audit process from the planning stage through the integration of the internal control audit with the audit of financial statements. The standard provides guidance on tailoring the audit to the attributes of smaller, less complex companies and provides a foundation for guidance the PCAOB plans to issue next year.

The new standard revises the Auditing Standard No. 2 definitions of material weakness and significant deficiency to encompass a "reasonable possibility" that a significant misstatement will not be prevented or detected. The audit report will express only one opinion on internal control that works in tandem with the proposal the SEC issued last week in its proposed guidance for management. The new standard refocuses the auditors' multi-location testing requirements on risk rather than coverage.

The new standard on using the work of others would apply to the audit of internal control over financial reporting and the financial statement audit. It provides a single framework for relying on the work of others and eliminates the "principle evidence" requirement in Auditing Standard No. 2. The principle evidence provision in Auditing Standard No. 2 requires an auditor to obtain the principle evidence relating to his or her opinion. Ms. Phillips said it appeared that the provision may have unnecessarily hampered auditors from using the work of others to the extent the board thought was appropriate. The proposed standard also changes the date of the auditor's report from the date of the completion of the field work to the date on which the auditor has obtained sufficient competent evidence to support his or her opinion.

Board member Daniel Goelzer, who was an observer at the meetings of the SEC's Advisory Committee on Smaller Public Companies, said that proposed Auditing Standard No. 2 will go a long way to addressing the problem of scalability that concerned smaller companies. The standard contains a separate section on scalability with specific guidance for smaller company audits. Mr. Goelzer said it is essential that the PCAOB get this aspect of the standard right, given the importance of smaller companies to the economy.

Mr. Goelzer added that there are limits to what the PCAOB can accomplish. In the years since Auditing Standard No. 2 was adopted, the board discovered how the implementation of a standard matters as much as the words it contains. Assistant Chief Auditor Sharon Virag advised that the new standard addresses almost every area of concern raised in the advisory committee's final report.

With respect to the proposed standard on using the work of others, board member Charles Niemeier said he was skeptical about the cost savings that could be achieved. The auditing standards have long permitted auditors to rely on the testing and the other work of the internal auditors to support their opinions, he noted. While he is not convinced the standard needs to be changes, Mr. Niemeier said he is encouraged by the attempt to focus auditors on the risk of management bias, such as through the use of compensation incentives.

Board member Bill Gradison referred to the rarity of a regulator acknowledging so quickly that its rules need to be rewritten. However, he noted that Section 404 is virtually identical to Section 112 of the Federal Deposit Insurance Corporation Improvement Act relating to internal controls for banks. Given that Congress also legislated internal controls in the Foreign Corrupt Practices Act in 1977, Mr. Gradison said that it is hard to conclude that Congress acted hastily on internal controls in the Sarbanes-Oxley Act.

Mr. Gradison said the success of the new standard will not be apparent until the spring of 2008 for accelerated filers and at least the spring of 2009 for non-accelerated filers. He emphasized the need for patience, which he said has been in short supply.

After the meeting, Mr. Olson was asked from where he thought the most pressure would come in the comments on the new standard. He said likely from either end of the spectrum--those who would have liked to see large groups of companies relieved entirely from Section 404 responsibility or those who were satisfied with Auditing Standard No. 2 and will think the board has gone too far.

The comment period on the proposed standards will be open for 70 days. Once adopted, the SEC has to approve the standards before they become effective. The PCAOB desires an effective date as early in 2007 as possible.

The PCAOB also adopted a rule to allow an adjustment to its minimum requirement for audit firm inspections. The amendment will permit the PCAOB to rearrange its schedule for the inspection of firms that registered in the first two years of the board's operations to smooth out the workload. Although the board voted to adopt the rule, it will seek comment for 60 days. The rule will expire June 30, 2007 unless the board acts to extend it.