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Officials Provide Views of PCAOB at ALI-ABA Program

Board member Daniel Goelzer, Director of Enforcement and Investigations Claudius Modesti, and Deputy Chief Auditor Laura Phillips presented the views of the PCAOB at ALI-ABA's recent course of study on accountants' liability. The officials discussed proposed Auditing Standard No. 5 on internal controls, the inspection process and enforcement. Phillips noted that the SEC's message with its proposed guidance for management is that no change is necessary if issuers are content with their internal control process. There is nothing optional in the PCAOB standard, she said. The Board is deliberately trying to change behavior. The revised proposal will result in a methodology change, she said, and some auditors have told clients the scoping requirement for multi-location environments alone could result in a 10% reduction in fees.

Goelzer noted that the idea behind the revised proposal was to bring the PCAOB's guidance into the standard. Phillips said the Board would be discouraged if nothing changes following the adoption of the new standard. On the other hand, she said it should not require a complete retooling. Many commenters have advised the Board that its proposed standard on using the work of others is not necessary. Phillips said that view presents an interesting decision for the Board to make.

The Board is expected to adopt a final standard on May 24. The standard then goes to the SEC for approval. Phillips said people should be analyzing the proposal now and going into high gear rather than sitting in neutral waiting for the SEC to act. As long as the PCAOB adopts the standard by June 30, she said most commenters believe its implementation for the 2007 audits is reasonable. Phillips added that the Board could choose to let auditors voluntarily comply in 2007 but not require compliance until 2008.

Goelzer reviewed the Board's inspection program which absorbs over half of its resources. The inspections use a risk-based approach in selecting audits for review rather than taking a representative sample. For instance, he said the inspection staff will look for a troublesome accounting issue or problems with a partner or office, and may expand the review where appropriate. The inspection reports are not report cards, he said.

The PCAOB has not issued a report on its findings overall with respect to smaller firms, but Goelzer said his own analysis suggests that independence issues are often a problem. Other problem areas include engagement letters with indemnification clauses, revenue recognition, loan loss reserves and a tendency to "just check the math." With thinly-traded stocks, some auditors over-rely on management in determining the value of a transaction. Other problem areas include going-concern qualifications and inadequate concurring partner reviews.

Congress directed the Board to adopt quality control standards. Goelzer said the Board has not done so yet, but it remains a priority.

The nonpublic parts of the inspection reports can be made public after a year if the problems that were identified are not remediated. Goelzer said that a few small firms have simply defaulted by not responding with a plan for remediation. Accordingly, a few small firm inspection reports on the PCAOB's Web site contain the full reports.

Goelzer reviewed the Board's report that was issued in January regarding the consideration of fraud in planning and conducting an audit. During the brainstorming session, firms should consider how management would commit fraud if it intended to do so. Goelzer said that some firms are not conducting brainstorming sessions while others are run by junior members of the firms. Some do not appear to follow up on issues that are raised during the brainstorming sessions.

Goelzer acknowledged that an unintended consequence of the internal control process was that it drove auditors to do more work than necessary to avoid criticism by the inspection staff. The inspection program now has a component to look at how efficiently the firms conducted their audits. In a report issued in April, the Board found some problems with firms integrating the audit of internal control with the audit of financial reporting, the failure by some to use the work of others to the fullest extent available under the standard and the failure to take a top-down approach. The inspection staff will continue to look at efficiency this year, according to Goelzer, and will likely issue another report next year.

Modesti said one of the challenges in enforcement is when to defer to professional judgment and when to investigate further. Enforcement tries to determine where the outliers are, he said. The staff looks for the improper alteration of documents that can impede the internal inspection process. If an audit firm learns of misconduct, the staff looks at whether the conduct was reported and action was taken to preserve the relevant documents.

Modesti advised firms that receive an inquiry from the staff to think about how to preserve emails and relevant documents if they have knowledge of the person who is the focus of the inquiry. The firm may avoid misunderstandings with the staff if it ensures that proper locations are searched. The staff will look at how a firm responds to a failure to meet certain audit quality standards or whether there are other problems with meeting the standards. The staff will also look at departures from GAAP in which the firm accommodates the treatment and is insufficiently skeptical.

Modesti used a rip tide analogy where, before a firm knows it, it is way offshore and in trouble. The way a firm responds to a problem matters, he said.

The staff refers some of its findings to the SEC. Approximately 30 to 40 referrals have been sent to the SEC, some of which have resulted in enforcement actions. Modesti said the PCAOB focuses on auditor conduct while the SEC focuses on the others. They may both be looking at the auditor, but that is fairly rare, he said. If a production of documents has already been made to the SEC, Modesti said the firm should let the staff know. However, each agency often has a different scope of interest, so the document production may not be identical.

In response to a question about the speed of the issuance of inspection reports, Goelzer advised that some things are built into the system that make it difficult to speed up very much. Firms have a period of time to comment on the staff's findings and changes are made. If problems arise, many firms begin to address them before the report is issued.

In response to a suggestion that the April 4 SEC meeting at which PCAOB representatives appeared was rather extraordinary, Phillips said the votes on actions the Board should take to revise Auditing Standard No. 5 were not surprising based on the comments that had been received. She said nothing changed much, given the interaction the PCAOB has with the SEC staff. With the SEC as PCAOB's overseer, it makes no sense to operate in a vacuum, she said. The PCAOB wants to get section 404 right and knows this is its last shot, according to Phillips. She said the April 4 meeting was helpful to the process and very collegial.