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SEC Approves PCAOB's Auditing Standard No. 5

The SEC commissioners yesterday unanimously approved the PCAOB's Auditing Standard No. 5 which governs the audit of internal control over financial reporting, and adopted a definition under the SEC's rules for the term "significant deficiency." The commissioners also unanimously approved the issuance of a concept release on the impact of allowing U.S. companies to prepare their financial statements in accordance with international financial reporting standards as published in English by the International Accounting Standards Board. In a split vote, the commissioners approved the issuance of two separate releases seeking comment on different approaches for handling shareholder proposals under the proxy rules. Chairman Christopher Cox has vowed that the SEC will adopt final rules governing shareholder proposals in time for the 2008 proxy season.

Division of Corporation Finance Director John White observed at yesterday's open meeting that the staff was presenting a much improved auditing standard for the commissioners' consideration. Chief Accountant Conrad Hewitt said that auditors must modify their efforts with respect to internal controls and the PCAOB must realign its inspection process to ensure that it encourages more efficiency in the integrated audit of internal controls and financial statements. Hewitt pledged to monitor the implementation of the new standard and urged audit committees to become more actively involved.

Deputy Chief Accountant Zoe-Vonna Palmrose advised that the PCAOB had addressed all of the key issues raised by commenters and that it was responsive to the SEC's directive. The improvements to the standard are significant, she said. Palmrose responded to a number of the comments that were submitted about AS5, including a few that maintained that the PCAOB had retained the wrong auditor opinion. The staff carefully considered those views, according to Palmrose, but concluded that AS5 requires the appropriate opinion by auditors and the one that is important to the protection of investors. While other commenters asked for additional guidance with respect to materiality, Palmrose said the staff did not believe AS5 was the appropriate vehicle for addressing that issue.

A number of commenters remained concerned about whether AS5 will result in cost reductions, especially for smaller companies. Palmrose noted that the SEC will monitor costs, and the PCAOB is in the midst of a project on smaller company audits. The project will provide the basis for guidance that the PCAOB expects to issue in time for the 2009 effective date for small companies, she said. The SEC has participated in the PCAOB's forums on auditing in the small company environment, she added, where guidance has been provided. The SEC will also monitor the effectiveness of PCAOB inspections. The SEC expects a change in behavior, according to Palmrose.

White added that the Division is working on a brochure for smaller companies on how to apply the SEC's interpretive guidance for management. The Office of Economic Analysis will also study the costs and benefits of the new standard to determine whether they are in line with expectations.

Palmrose noted that the number of comments received in response to the SEC's solicitation on AS5 was relatively low, suggesting that the market place is happy with it. The same inference might be drawn with respect to the definition of significant deficiency, she said.

Commissioner Paul Atkins said that Auditing Standard No. 2 had to be replaced, but now that it has, the SEC cannot sit back and relax. The SEC must be prepared to respond if AS5 fails to deliver, he said. Atkins said that smaller companies should be given an additional year to comply, beginning with the reports for fiscal years ending on or after December 15, 2009, a view that Commissioner Kathleen Casey later echoed.

Atkins asked about comments relating to material weaknesses in relation to interim financial statements. Palmrose said the scoping of the audit is based on an annual materiality perspective, but interim financial reporting is also important to investors. The internal controls must be considered even if the audit is not scoped to find control deficiencies in quarterly reports, she noted. If a deficiency is discovered during an interim period, she said its impact on the interim financials must be considered.

Atkins also asked about concerns raised by the biotech industry that the standard fails to define a small company. Atkins said the industry was concerned that auditors may hide behind complexity and refuse to scale the audit. Palmrose said there is not a quantitative bright line because that could pose an impediment to scaling the audit.

Commissioner Roel Campos believes that with AS5, the SEC and the PCAOB have delivered everything they promised. He expressed confidence that the standard will help companies of all sizes. He asked how soon auditors could begin to rely on AS5. Palmrose replied that the standard is effective for fiscal years ending November 15, 2007, but early adoption is encouraged. Many audit firms have begun to incorporate the standard into their training, she said.

Campos asked whether the staff believes that small companies will have enough time to comply with section 404(b). White said the staff is pretty confident that companies will be able to follow the SEC's management guidance and that no extensions should be needed for either section 404(a) or (b). Small companies have over a year and a half before the section 404(b) reports are due, he noted. However, White said the staff will monitor how the compliance with AS5 is going and will have a season to see how it is working for larger companies, so a final determination can wait.

Additional coverage of the July 25 open meeting will appear in upcoming issues of SEC Today.

Jacquelyn Lumb