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PCAOB Outlines Standard-Setting Priorities in 2006

The PCAOB, at the latest meeting with its Standing Advisory Group, outlined its proposed 2006 standard setting activities and announced plans to issue a report on the effectiveness of Auditing Standard No. 2 and the degree to which firms are addressing the risks associated with fraud. The meeting also constituted the PCAOB's annual meeting. The staff report will reflect its findings during audit firm inspections and will cover problems that were common to multiple audit firms, either in relation to the implementation of section 404, the consideration of the risks of fraud in an audit, or other areas. The Board may issue other generalized reports to describe problems and their appropriate solutions.

The Standing Advisory Group also discussed the emerging issues of indemnification provisions in audit engagement letters, particularly those relating to punitive damages, and the problems that arise with restatements to reflect accounting changes when there is a new auditor and the predecessor auditor is no longer independent based on the previous provision of services that are now prohibited.

The proposed 2006 standard-setting activities include engagement quality reviews, fraud, communications with audit committees, and principles of reporting. The fraud standard will begin with a review of the existing standards. The PCAOB believes it can improve auditor performance in fraud detection by amending the existing interim standards rather than establishing a new standard. The Board anticipates an update of the standard in key areas such as related party transactions and the appropriate use of the confirmation process.

The Board also expects to update the existing standard on auditors' communications with audit committees to reflect the Sarbanes-Oxley Act requirements, such as the discussion of critical accounting policies and alternative treatments of financial information with generally accepted accounting standards.

The Board also plans to consider standards on fair value, risk assessment, quality control, the codification of PCAOB standards and the authority of its interim standards. The fair value project will include a consideration of the use of specialists since they often play a critical role in determining and assessing fair value estimates. The staff plans to issue a Q&A in the near future on auditing fair value measurements relating to stock-based compensation under FAS 123R.

Chief Auditor Douglas Carmichael explained that the projects will not be completed as final standards in 2006, but may result in proposals for public comment. The proposed activities may also change due to emerging issues that arise during the year.

During the SAG meeting, a panel of individuals with smaller public accounting firms that are registered with the PCAOB and a panel of audit committee chairmen described their experiences in the new post-Sarbanes-Oxley regulatory regime. The audit committee chairs were asked whether they ask to see the nonpublic portions of PCAOB staff inspection reports. One of the four panelists said he had requested the information, and the firms were reluctant to release it.

Deputy Chief Accountant Andrew Bailey said the SEC has been warning managements to be careful about the problems posed by adjustments to prior financial statements when the predecessor auditor may no longer be deemed independent. Companies may face this situation for at least three years out if they change auditors, and it is not a simple fix given that the SEC rules require somebody to take responsibility for the financial statements for all periods.

Former SEC chief accountant Lynn Turner, now with Glass Lewis & Co., suggested that if the adjustments to the financials are so pervasive, it raises questions about the integrity of the previous auditor. He said the company should then have to have the financial statements reaudited.

Turner also pointed to what he sees as a problem with the 8-K rules. A company does not have to report why it has changed its auditor. He believes that investors should be told the reason. If a company is changing auditors so that it can use an existing auditor for consulting services, that change may lead to an independence issue that will cost the company. They must think not only about the benefit to the company, but also the cost to investors, in his view.

Bailey added that once the restatement process begins, it may grow. He said he is not impugning any decisions that are being made about changing audit firms, but the problem is mushrooming.