PCAOB Proposes Complete Overhaul of Auditing Standards for Internal Control Audits

On December 19, 2006, the Public Company Accounting Oversight Board (PCAOB), the auditing regulatory body created under the Sarbanes-Oxley Act of 2002, proposed a complete overhaul of the rules that govern audits of internal controls under Section 404 of the Act.

Under Section 404 and Securities and Exchange Commission rules, a public company must conduct an annual evaluation of the effectiveness of its internal controls and include in its annual report the results of the evaluation and a report of its auditors on its internal controls. These requirements have been in effect for two full reporting seasons for the largest U.S. issuers and are just taking effect for the largest non-U.S. issuers. Their effectiveness for smaller issuers has been repeatedly delayed, most recently last week, and is now scheduled to be phased in for years ending on or after December 15, 2007.

The SEC and the PCAOB have been making a concerted response since early 2005 to the widespread criticism that their internal control reporting rules have imposed unnecessary cost and complexity, and this proposal is the latest element. Comments on the PCAOB proposal are due by February 26, 2007. The SEC proposed on December 13 to revise its rules governing how a company’s management should conduct its evaluation, and comments will be due 60 days after publication in the Federal Register—probably also in late February. The SEC and PCAOB are aiming to have their proposals effective in time for 2007 annual reports, but not in time for the upcoming reporting season.

The PCAOB proposal would change the rules governing how auditors conduct their audit of internal controls. The centerpiece is a completely new Auditing Standard No. 5, replacing Auditing Standard No. 2, which has been in effect since June 2004. According to the PCAOB proposal, AS No. 5 will focus the audit on the most important matters, eliminate unnecessary procedures, allow the audit to be “scaled” for smaller companies and simplify the requirements. The proposed text runs to 65 pages, and it will require careful study to see how well it meets those objectives. More specific highlights identified by the PCAOB include the following:

• Directing the auditors’ attention to the most important controls
  
  
• Emphasizing the importance of risk assessment
  
  
• Revising the definitions of significant deficiency and material weakness, notably by changing the key standard for material weakness from “more than remote likelihood” to “reasonable possibility”
  
  
• Revising the “strong indicators” of a material weakness, to accommodate a conclusion where appropriate that no deficiency exists
  
  
• Clarifying the role of materiality in the audit
  
  
• Clarifying the role of “interim materiality” (materiality to interim financial statements) in the audit
  
  
• Removing the requirement to evaluate management’s evaluation process
  
  
• Permitting consideration of knowledge obtained during previous audits (without, however, allowing rotation of testing as some have suggested)
  
  
• Refocusing multi-location testing requirements on risk, rather than on coverage
  
  
• Removing barriers to reliance on the work of others, especially internal auditors and company personnel—in this connection, the PCAOB also proposed a new auditing standard on reliance on the work of others
  
  
• Recalibrating the “walkthrough” requirements
  

The PCAOB also proposed a new independence rule, requiring auditors to go through specified steps whenever they request audit committee pre-approval for services related to internal controls. Similar requirements currently appear in AS No. 2.

In addition, the PCAOB proposed to amend auditing standards on interim financial information to clarify the auditor’s responsibility concerning management’s quarterly certification under Section 302 of Sarbanes-Oxley insofar as it concerns internal control.

The PCAOB proposal can be viewed at the following link:

http://www.pcaobus.org/Rules/Docket_021/2006-12-19_Release_No._2006-007.pdf.

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