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PCAOB Adopts New Standard On Internal Control

The PCAOB yesterday adopted Auditing Standard No. 5 to replace current Auditing Standard No. 2 in governing the audits of internal control over financial reporting. The key changes from the proposed standard include the alignment of terms with the SEC's guidance for management in preparing reports on internal control and the relocation of the section on the detection of fraud to the front of the standard. The standard is effective for audits performed during fiscal years ending on or after November 15, 2007, but auditors may comply with the new standard once it is approved by the SEC. PCAOB Chairman Mark Olson also announced that the Board will adjust its inspection program to ensure that it is consistent with the new standard.

Chief Auditor Thomas Ray explained that the new standard preserves the principles of AS2 while eliminating unnecessary procedures. Ray said the staff responded to complaints that the original proposal was highly prescriptive by removing dozens of references to what an auditor must or should do.

Olson highlighted four aspects of the final standard that he believes will make a genuine difference. He pointed to the standard's principles-based approach, its scalability, the fraud controls and the alignment with the SEC's guidance. He urged those involved with the financial reporting process to start implementing the new audit standard and the SEC's guidance for management in order to improve governance and provide greater assurance that financial reporting is fair and accurate.

Board member Daniel Goelzer said he was satisfied that AS5 retained the organizing principle of a top-down approach to internal control auditing and the need to use judgment rather than follow a roadmap. The final standard also makes clear that walkthroughs are merely a means of acquiring an understanding of possible sources of misstatements, not an end in itself.

The new standard requires that auditors report to the audit committee any control deficiencies identified during the audit that are less severe than material weaknesses but important enough to merit attention. The revised language of the standard should increase the likelihood that material weaknesses serve as an early warning system rather than an after-the-fact acknowledgement that something went wrong, according to Goelzer. The standard also permits more flexibility in using the work of others.

Board member Charles Niemeier noted that the new standard is intended to reduce costs, but pointed out that the benefits of internal control reporting have been significant. Internal control problems have been addressed and the investing public has received warnings that internal controls may not be effective. He believes the benefits have outweighed the costs. Neimeier said his focus with the revised standard was that it retain the core principles necessary to an effective internal control audit, and said he was satisfied that the new standard does so. However, the success of a principles-based standard depends upon how it is implemented, he said.

Associate Chief Auditor Sharon Virag said the transition from AS2 to AS5 should be easy. She believes most auditors will make the change once AS5 is available. If auditors choose to continue to rely on AS2 before AS5 becomes effective, they must comply with the new definition of material weakness in AS5 since it parallels the SEC's new definition.

The PCAOB is also developing tailored guidance for auditors of smaller public companies to assist in their implementation of the new standard. That guidance should be available later this year.