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Ray Describes How PCAOB Will Amend Internal Control Standard

The PCAOB is committed to amending its auditing standard on internal controls pursuant to a framework of recognized objectives, according to Chief Auditor Thomas Ray. He said that amending Auditing Standard No. 2 is the Board's top priority but declined to give a time frame for when the amendments will be effected. In remarks at a recent AICPA conference in Chicago, Ray outlined elements of the Board's amendments.

Ray said that the amendments will focus on improving high risk areas. The amendments will also retain core principles, such as reasonable assurance. Definitions will be clarified, such as material weakness and significant deficiency. The SEC has deferred to the Board to define these important terms.

The concept of materiality will also be clarified. It is not within the Board's purview to change the definition of materiality, Ray noted, but the Board can provide guidance. The Board also intends to reconsider the list of strong indicators of a material weakness, such as ineffective audit committee oversight. The changes will also incorporate key concepts from the Board's May 2005 guidance. For example, the top-down approach mentioned in the guidance will be codified in the standard. The importance of integrating the financial statement audit and the internal controls audit will also be strongly amplified in the amendments. In addition, the Board will provide guidance encouraging auditors to more frequently use the work of others. The amendments will also allow for the reliance on experience gained in prior years.

Ray emphasized that, despite its length, AS2 is principles-based. Because the standard is principles-based, he continued, auditors have tremendous flexibility under the standard. Unfortunately, many auditors have not used this flexibility. Ray advised auditors not to wait for the Board to amend AS2, but to immediately implement the May 2005 guidance.

In a later Q&A session, Ray noted that, in an area of low inherent risk, a well-performed walk-through may be sufficient to test the effectiveness of the internal control so long as the walk-through confirms that there has been no change from earlier years. He advised auditors to use their professional judgment in this area.

When reporting on the audit of internal controls, the auditor expresses two opinions. The first is on whether management's assessment about the internal controls is fairly stated in all material respects and the second is on whether the company maintained effective internal control over financial reporting. Repeating remarks he made in June at the SEC and Financial Reporting Institute, Ray said that there is a misunderstanding in that some people believe that the auditor is expressing an opinion on management's assessment process. That belief, in turn, is fueling unnecessary additional work directed at evaluating the adequacy of management's process.

Ray explained that the auditor's opinion is not given on management's assessment process. The auditor is not required to give an opinion on whether management did a good job, he said. It is on whether management's required statements about the effectiveness of the company's internal controls and its descriptions of any material weaknesses are fairly stated.

While AS2 requires the auditor to obtain an understanding of and evaluate management's assessment process, and provides direction as to what the auditor should look for when performing that evaluation, Ray said that the principal objective of the evaluation of management's assessment process is for the auditor to be satisfied that management has an appropriate basis for its conclusion. The extent of the auditor's work is only that which is necessary to form a conclusion as to whether management's process was sufficiently complete to provide the auditor with a basis to support its reporting, and whether the results of management's testing support its conclusion about internal control effectiveness.