In order to enhance the quality of reporting and increase investor confidence, Section 404 of the Sarbanes-Oxley Act requires that annual reports filed with the SEC must be accompanied by a statement by company management that management is responsible for creating and maintaining adequate internal controls.

Management must also present its assessment of the effectiveness of those controls.

In addition, the company's auditor must report on and attest to management's assessment of the company's internal controls. The Act specifically provides that the new Public Company Accounting Oversight Board should set the standards for this auditor attestation.

Indicators Of Weaknesses

Under SEC rules implementing Section 404, management cannot say that a company's internal controls are effective if it identifies one or more material weaknesses in them. In the SEC's view, an aggregation of significant deficiencies could constitute a material weakness in a company's internal controls.

The SEC deferred to the definition of material weakness found in the accounting literature, which essentially means deferral to whatever definition emerges from the PCAOB standard when it is adopted. The board proposes to define material weakness as a significant deficiency that — by itself or in combination with other significant deficiencies — results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.

Taking up the mandate of Sarbanes-Oxley, the PCAOB has proposed a standard identifying a number of circumstances that, because of their likely significant negative effect on internal control over financial reporting, are significant deficiencies as well as strong indicators that a material weakness exists.

One of these circumstances is the audit committee's ineffective oversight of the company's external financial reporting and internal control over financial reporting. The board explained the inclusion of this circumstance by stating that effective oversight by the audit committee is essential to the company's achievement of its objectives and is an integral part of the monitoring of internal control.

The Standard In Question

The proposed standard requires the auditor to evaluate factors related to the effectiveness of the audit committee's oversight, including whether audit committee members act independently from management. As part of evaluating the independence of committee members, the board wants auditors to evaluate how audit committee members are nominated and selected.

Other factors to be used in judging the effectiveness of the audit committee are the clarity with which the audit committee's responsibilities are articulated and how well the audit committee and management understand those responsibilities.

In addition, the level of involvement and interaction with the independent auditor should be considered, as well as the level of involvement and interaction with internal audit, including the committee's line of authority and role in appointing and compensating employees in the internal audit function.

Also, the amount of time that the audit committee devotes to control issues, as well as the amount of time that audit committee members are able to devote to committee activity, should be part of the mix.

A Troubling Proposal

The specter of auditors evaluating the effectiveness of the audit committee troubles a number of people and has become a controversial part of the board's proposal.

Sarbanes-Oxley makes the audit committee directly responsible for the appointment, compensation, and oversight of the work of the auditor.

With this in mind, commentators have generally suggested that the requirement that auditors evaluate the audit committee's effectiveness places auditors and audit committees in an untenable conflict since no auditor would dare criticize the audit committee that must approve outside auditors.

Commenters believe that the scheme proposed by the board is contrary to the objectives of Sarbanes-Oxley to strengthen the role of the audit committee. They believe that the audit committee's authority would be diluted if it could be questioned and evaluated by the outside auditor it can hire and fire. Also, commenters said that some of the standards auditors would use to judge audit committee effectiveness are subjective, such as how well the audit committee and management understand audit committee responsibilities.

More broadly, commenters believe that adoption of the standard will lead to a wary relationship between the parties rather than the positive, open communications that are needed and indeed envisioned by Congress.

Positive Aspects

The board itself queries if it is appropriate to require the auditors to evaluate the effectiveness of the audit committee's oversight of internal controls. But recently, the chairman and board members have defended that aspect of the proposal.

In an effort to deflect complaints, board members have spoken out about what they believe are the positive aspects of auditor evaluation of audit committees.

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, PCAOB member Daniel Goelzer said that more fundamentally the proposal illustrates that auditors are well-positioned to evaluate and monitor the governance processes related to the financial reporting of their public company clients.

On this theme, he emphasized that auditors may be uniquely positioned to help audit committees as they struggle with the new duties thrust upon them by Sarbanes-Oxley. The major auditing 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 proposal builds on this idea.

Far from fearing this new standard, the PCAOB's Goelzer predicts that clients and auditors will begin to more clearly realize this and look to auditors for their recommendations, just as they have with respect to the more traditional aspects of internal control.

For his part, PCAOB Chairman William McDonough has warmed to the idea, believing that the proposed standard would empower both auditors and audit committees. Audit committees should welcome an assessment by the auditor it hired, he said, and the auditor should feel comfortable giving a report card on the directors in charge of the appointment.

The board must still adopt the standard, which must then be approved by the SEC.

This column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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