Expert Group Seeks Changes to PCAOB Internal Control Standard

Against the backdrop of impending SEC-PCAOB proposed revisions, the report of the Committee on Capital Markets Regulation emphasized that reform of the Sarbanes-Oxley section 404 internal control regime should begin with a revision to the materiality standard in Auditing Standard No. 2. While acknowledging that the PCAOB and SEC are already moving down this path, the committee noted that many commenters trace the root of the problem with the internal controls mandates to the standard set for auditor attestation in AS2 which, in the absence of direct SEC guidance for issuers, is also the de facto standard for management reviews under sec. 404.

Although the SEC and PCAOB have issued guidance on 404 audits encouraging auditors to adopt a top-down, risk-based approach, noted the report, these principles have not been implemented due to the breadth and vagueness of AS2. In the committee’s view, the material weakness standard in AS2 establishes a low threshold. Currently, a material weakness exists if there is more than a remote likelihood that a misstatement of the company’s financial statements will not be prevented or detected. This is a PCAOB definition, but the SEC staff has indicated that they will apply the PCAOB definition when interpreting SEC internal control rules.

The committee suggests a revision so that a material weakness will exist if it is reasonably possible that a material misstatement in the financial statements will not be prevented or detected. The committee said that changing the probability threshold for the detection of control weaknesses from the current more than remote likelihood standard to a reasonably possible standard conforms to SEC Chairman Cox’ wish that the PCAOB adopt a reasonably possible standard.