Remediation Standard Proposed; 'Checklists' Acknowledged

As expected, the Public Company Accounting Oversight Board last week agreed to propose an audit standard for reporting on the “elimination” of a material weakness in a company’s internal control over financial reporting. The PCAOB’s Standing Advisory Group had originally discussed the possibility of such a standard back in November, and the Board had recently announced—as covered in Compliance Week on March 29—that it would hold an open meeting to discuss the matter.

As Compliance Week has been reporting in its monthly analysis of internal control disclosures, companies have been reporting that previous material weaknesses have been remediated or completely eliminated (see box at right for sample remediation disclosures).

However, the PCAOB noted that investors “have called for the ability to bolster confidence in management's assertions about those internal control improvements with the added assurance of the company's independent auditor.” As a result, the Board has proposed a standard that auditors would use to assure such judgment.

McDonough

According to PCAOB Chairman William McDonough, the new standard “will offer companies an opportunity to provide the investing public added assurance that previously disclosed weaknesses have been corrected.”

Voluntary

The proposed standard would establish a stand-alone engagement that is voluntary, and would be performed only at the request of the company. “We have no intention of proposing [the standard] in a way that could be perceived as a de facto required auditing service,” McDonough said.

Gillan

PCAOB member Kayla Gillan shared Chairman McDonough’s concern that the voluntary proposal might become de facto mandatory. “I hope that companies consider when it is important to their investors to include the auditor in this mid-year report, and when it is not,” she said.

Goelzer

PCAOB member Daniel Goelzer also hoped the standard would be used sparingly. “It seems to me that, in most cases, investors should be able to accept management’s assurance that it has remediated a weakness without the added support of an interim auditor’s opinion.” That’s especially the case because the auditor would need to consider whether the weakness was eliminated in its next annual audit, anyway. “In many cases,” added Goelzer, “that should be sufficient. “

While the proposal is based on the PCAOB’s internal control auditing standard, it is more narrow in scope. “With the exception of certain general requirements when a new auditor is retained,” added McDonough, “the proposal does not call for any review of internal control as a whole until the next annual assessment.”

Checklists Acknowledged

Interestingly, in releasing comments on the proposed standard, McDonough also acknowledged that some accounting firms have been unreasonably rigid in their Section 404 audits, utilizing an unnecessary “checklist” approach to its Auditing Standard No. 2, officially known as “An Audit of Internal Control Over Financial Reporting Conducted in Conjunction With an Audit of Financial Statements.”

“We have noted anecdotal evidence that auditors are not always using the flexibility in that underlying standard,” said McDonough. “Instead of using judgment to tailor audit programs to the nature and size of an audit client, some auditors are applying a checklist approach to all audit clients, regardless of their complexity.”

McDonough added that auditors should apply the internal control standard in a manner that is proportional to the complexity of the company and its controls. “Untailored checklists, to me, are an early sign of poor quality judgments, which can lead to poor quality auditing.” McDonough warned that the PCAOB would use its inspection process “to assess the effectiveness of registered firms’ implementation of AS 2, including the quality of their judgments about planning audit programs appropriate to the nature of their clients.”

The PCAOB will seek comments on the proposed standard through May 16, 2005; the final standard would be submitted to the Securities and Exchange Commission for approval.

The complete proposal—as well as related resources, disclosures, and contacts—is available in the box above, right.