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PCAOB Hears Concerns About Dilution of Internal Control Standard

The PCAOB's Standing Advisory Group yesterday convened to discuss the proposed changes to Auditing Standard No. 2 ("AS2") regarding the audit of internal controls and the separate topic of the performance of forensic audits. Ed Trott, an observer with the FASB, noted that the problem with AS2 was with its implementation rather than its content. He asked whether the PCAOB was getting the right message out with a proposal to replace the standard rather than to amend it. Some see Auditing Standard No. 5, which would supersede AS2 if adopted, as a relaxation of the original standard, he said.

Joseph Carcello, with the University of Tennessee, raised concerns about the overemphasis on efficiency in both the PCAOB's proposed standard and the SEC's proposed guidance for management in preparing reports on internal control over financial reporting. He warned that focusing on efficiency by a regulator can result in a decline of audit quality. Carcello noted that an increased reliance on management's judgment does not work if management is part of the fraud. Regulators should prescribe a level of performance, in his view.

Robert Kueppers, with Callan Associates, Inc., said he does not believe the industry is getting the wrong message with respect to efficiency, but agreed that it is not a good idea to embed efficiency in a standard. John Kellas, an observer with the IAASB, agreed that efficiency is important, but quality must come first. If the original standard bred inefficiency, he said it is sometimes better to start again. AS5 does not reflect a relaxation of the original standard, but a different approach, in his view.

Lynn Turner, with Glass Lewis & Co., noted that the standard is written by and for auditors. Auditors need to use resources such as analyst reports and market prices in connection with their audits, he said. Turner cited statistics which found that companies that had restated their financial statements had underperformed market indexes by 18% to 20%. That's a humongous amount, he said. Auditors are not looking at the right things, in his view, which is a gaping hole in the standard. He said the standard is perceived as allowing auditors to do less testing and warned that the PCAOB will be held accountable for that.

Ted White, a consultant to the Council of Institutional Investors, agreed that efficiency should not be preeminent in the standard. Investors have not complained about the costs associated with AS2, he added. Quality is of the greatest importance, according to White. He is alarmed by any perceptions that the PCAOB is weakening its standard.

Thomas Ray, the PCAOB's chief auditor, said the proposed standard is not different from the original in substance, but places greater emphasis on risk and judgment. Auditors must exercise appropriate judgment, he said.

Craig Omtvedt, with Fortune Brands, reported that, in the field, no one views AS5 as a reduction of the existing standard. It will allow for much more qualitative audits, in his view. The standard will help ensure that good people do it right, he said, but does not address the problem of bad people, management override and outright fraud. He believes the management process is highly ineffective. Until that is gotten right, the certifications will only reflect good people getting it right, he said. Omtvedt said that about 70% of the assurance should be that there is no fraud, but we are woefully inadequate at catching fraud.

Cynthia Richson, with IRRC Institute, also asserted that there is a perception that the PCAOB is relaxing its internal control standard. She believes the PCAOB should have stood firm on the original standard by citing the two years of inspection work it has under its belt. It looks like companies complained loud enough and often enough so that something had to be done. She agreed that investors have not complained about the cost and that the focus should be on the quality of the audit. If the implementation of the standard was a problem, then address that, she said. She urged the PCAOB to keep the perception issue in mind as it proceeds.

PCAOB member Kayla Gillan said she was perplexed by such statements. She acknowledged the importance of perception and said that any perception that the PCAOB is watering down or relaxing the standard concerns her. Gillan noted that if people would read the statements by Board members at the meeting during which the revised standard was proposed, they would see that the focus was on doing the highest quality audit as efficiently as possible.

Christianna Wood, with the California Public Employees' Retirement System, said the test will be how the Board responds to audits in the next few years. The PCAOB must try to find the right balance and must send the right message to the marketplace, she said. The focus should be on effectiveness over efficiency, she said.

Arnold Hanish, with Eli Lilly, said it is regrettable that people are tearing away at what the PCAOB staff has done. He said the view is different "in the trenches." Hanish believes the revised standard allows the appropriate dialogue between preparers of financial statements and the auditors. Hanish said that companies are willing to pay the price. It's the level of detail and the lack of focus that were of concern.

Jacquelyn Lumb