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PCAOB Member Goelzer Examines Internal Control Proposal

Noting that the independent auditor will increasingly be seen as, not only an expert on the application of accounting principles, but also as a source of independent advice on corporate governance practices, PCAOB member Daniel L. Goelzer discussed the board's recent proposals implementing the auditor internal control provisions of the Sarbanes-Oxley Act. His remarks were delivered at the University of Wisconsin School of Business.

Section 404(a) of the Sarbanes-Oxley Act requires management to assess the effectiveness of the company's internal control over financial reporting and to include in the annual report to shareholders management's conclusion as a result of that assessment. Section 404(b) directs the PCAOB to establish standards governing the independent auditor's attestation and reporting on management's assessment of the effectiveness of internal control over financial reporting.

The board's proposed standard requires auditors to communicate in writing to the company's audit committee all significant deficiencies and material weaknesses of which the auditor is aware. Auditors are also required to communicate in writing to the company's management all internal control deficiencies of which they are aware and to notify the audit committee that such communication has been made. The proposed auditing standard identifies a number of circumstances that would be, by definition, significant deficiencies and that also would be a strong indicator that a material weakness exists.

One such circumstance would be ineffective oversight of the company's external financial reporting and internal control over financial reporting by the audit committee. In this context, the proposed standard requires the auditor to evaluate factors related to whether the audit committee is effective, including whether committee members act independently from management.

Explaining this provision, Mr. Goelzer emphasized that a primary theme of the Sarbanes-Oxley Act is to strengthen the role of the audit committee in corporate governance. Audit committees are struggling with their newly-enhanced responsibilities, he added, and auditors may be uniquely positioned to help them. The major firms deal with hundreds of audit committees, he reasoned, and therefore have an ability few others share to compare and contrast performance and to develop expertise concerning best practices.

In his view, the board's proposed standard on the audit of internal control builds on this idea. The proposal states that an ineffective audit committee is a significant internal control deficiency and may be a material weakness. Therefore, in order for the auditor to form an opinion on the company's internal control over financial reporting, the auditor must determine whether the audit committee is effectively discharging its oversight responsibility of the company's external financial reporting and internal control over financial reporting.

The proposal lists seven specific factors that the auditor should consider in assessing audit committee effectiveness, including whether audit committee members act independently from management. While conceding that legitimate questions can be raised about whether auditors should be expected to assess the effectiveness of the committee that has the power to hire or fire them, Mr. Goelzer said that the more fundamental point is that the proposal illustrates that auditors are well-positioned to evaluate and monitor the governance processes related to financial reporting of their public company clients. In this context, he predicts that clients and auditors will begin to more clearly realize this and to look to auditors for their recommendations, just as they have with respect to the more traditional aspects of internal control.