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PCAOB Proposes Standard to Report Elimination of Material Weaknesses

The PCAOB yesterday proposed a new auditing standard for reporting on the elimination of a material weakness in internal controls. At last November's Standing Advisory Group meeting, the public company representatives agreed that there would be a demand for auditor reassurance that a material weakness had been remediated. Board member Daniel Goelzer said it is key that the PCAOB's standard-setting program has the flexibility to respond promptly to this sort of emerging development, even when it is not on the Board's agenda. The Board members unanimously approved the proposal for a 45-day comment period and agreed that it should become effective upon SEC approval. If the standard is adopted early enough, it will be available for audit engagements to occur before next year's section 404 reporting season.

The proposed standard reflects concerns that, until investors know that a material weakness has been eliminated, they may be unsure about the reliability of a company's financial statements. Currently, management can report the elimination of a material weakness through its quarterly disclosures. The proposed standard establishes requirements for an entirely elective engagement to provide auditor assurance about the elimination of a material weakness. The auditor's objective would be to express an opinion on whether a previously reported material weakness has been eliminated. This engagement would be significantly more narrow in scope than an audit of internal control over financial reporting. The auditor's testing would be limited to those controls identified by management as eliminating the material weakness.

Management and the auditor must agree on the deficient control objective that caused the material weakness. In order to render an unqualified opinion, the auditor would have to obtain evidence about the operations of the identified controls, determine that the material weakness has been eliminated and determine that no scope limitations were placed on the engagement. The engagement could take place any time during the year and would not have to be performed in conjunction with an audit or a review of financial statements. The auditor could report on the elimination of one or more material weaknesses as part of a single engagement. If the auditor determines that the material weakness has not been eliminated, the proposed standard would permit the company to do further remediation work, reset the assertion date and ask the auditor to test the controls again. The auditor would have to report to the audit committee about the initial failure to eliminate the material weakness, however.

PCAOB Chairman William McDonough commended public companies and their auditors for rising to the challenge of the internal control requirements. There is no doubt that the Sarbanes-Oxley Act requirements took corporate responsibilities to an entirely different level, he said. McDonough also acknowledged that Auditing Standard No. 2 changed the nature of auditing in a very short time period. The newly proposed standard answers the calls of companies and investors, McDonough said, but it is not expected to result in a de facto required auditing service.

McDonough also noted anecdotal evidence that auditors are not using the flexibility that was built into Auditing Standard No. 2 in attesting to managements' assessments on internal controls, and are applying a checklist approach to all audit clients rather than tailoring their audits to fit the client. Checklists that are not tailored to fit the nature and size of the client are a sign of poor quality judgments, in his view, and can lead to poor quality auditing. McDonough advised that the staff will assess the effectiveness of firms' implementation of Auditing Standard No. 2 when it conducts inspections beginning in May.

Board member Kayla Gillan also raised concerns about the potential that the proposed standard will become a de facto mandatory standard. She hopes that companies will consider when it is important to investors to include the auditor in this type of mid-year report, and urged those who influence company behavior, such as rating agencies and D&O carriers, not to always demand such auditor engagements, and to take a case-by-case approach.

Goelzer agreed that the option should be used sparingly. In most cases, he said that management's assurance that it has remediated a weakness should be acceptable, without the added support of an interim auditor's opinion. The auditor will consider whether the weakness was eliminated in its next annual audit of internal controls over financial reporting, he noted. It would be unfortunate and contrary to the Board's intent, Goelzer said, if the standard becomes a de facto requirement.