Big Four Object to Importing Legal Rule into PCAOB Standard for Audit Engagement Review

The Big Four audit firms have serious concerns about the PCAOB’s proposed standard addressing the responsibility of the audit firm partner that reviews the work of the engagement partner on a public company audit. The proposed standard of performance for engagement quality reviewers requires them to consider not merely what they know, but also what they should know. The Big Four are united in their opposition to injecting this legal standard into a review of the audit engagement. They believe it is an unworkable standard that will force audit engagement reviewers to significantly increase the scope and extent of their work in order to protect themselves from SEC or PCAOB sanctions. It would also conflict with international audit standards at a time when the Board should be aligning with international standards.

Under the proposed standard, the engagement reviewer cannot provide concurring approval of the engagement report if he or she knows or should know that any of four enumerated conditions exist. The four conditions are: 1) the engagement team failed to obtain sufficient competent evidence; 2) the engagement team reached an inappropriate overall conclusion; (3) the firm's report is not appropriate in the circumstances; or (4) the firm is not independent of its client.

In the view of the Big Four, the proposed PCAOB standard departs significantly from current international practice since the engagement reviewer is directed to consider not only what is known, but also those matters the reviewer should have known, possibly to levels approaching those currently applied by the engagement team, in order to avoid being second-guessed after the fact by those who have the benefit of hindsight, including PCAOB inspectors. In its comment to the Board, PricewaterhouseCoopers pointed out that the proposal goes well beyond international audit standards when it should be aligned with them.

Further, it imposes legal standards of conduct on the reviewing partner. By creating new standards of performance for the reviewer and a ``knows or should know’’ level of assurance, the standard is too focused on the adequacy of the engagement review itself and not on assessing the work of the engagement team.

PricewaterhouseCoopers said that the standard works a fundamental change in audit review by importing a legal formulation into an auditing standard. Audit and legal standards are different, reasoned the firm, in that legal standards are rules to assess the legal significance of behavior, often in hindsight, while audit standards guide auditors in carrying out their duties. Auditors are unfamiliar with this legal term in an auditing context.

Engagement reviewers will be overly focused on being second guessed on what they should have known if a problem is identified. Moreover, the phrase creates the potential for post hoc questioning of whether a reviewer should have identified a condition that would have precluded him or her from concurring with the engagement report.

KMPG believes that the standard would impose substantial new burdens on the engagement quality reviewer without a commensurate benefit to audit quality. The objective of the review should be to enhance audit quality by providing an independent, objective review of the significant accounting and auditing judgments and the conclusions reached. The proposed standard, however, would redirect the focus of the engagement quality reviewer away from the work of the engagement team to the work performed to carry out the reviewer’s duties.

In the firm’s view, this will lead engagement quality reviewers to engage in substantial procedures to conclude that they do not know that any of the specified conditions are present. The term ``should know’’ is even more troubling. It inherently creates a potential for post-hoc questioning of whether quality reviewers should have identified a condition that would have precluded them from concurring in the issuance of the engagement report. Thus, KPMG believes that engagement quality reviewers will be overly focused on being second-guessed as to what they should have known if a problem with the audit is later identified, rather than on assisting the engagement team by reviewing significant judgments and conclusions.

The Deloitte firm commented that requiring assurance on what reviewers know or should know represents a significant recasting of their role, which heightens the level of responsibility for reviewers and profoundly affects their conduct. The significance of the shift is illustrated by the fact that this standard is not currently used in PCAOB auditing and professional standards even for the engagement partner.

Deloitte also believes that the “should know” standard is illogical, and thus unworkable, because reviewers cannot reasonably be asked to make a representation and provide a concurring approval based on what they should know as opposed to what they actually know.

In the view of Ernst &Young, the proposed standard would significantly change the nature and scope of the engagement quality review. Since its inception the engagement quality review has been a “fatal flaw” review, said the firm, with the stated objective of identifying potential matters that, if not addressed prior to issuance of the audit report, potentially would require recalling and reissuing the audit report when subsequently discovered. Adoption of the “knows or should know’’ standard would expose engagement quality reviewers to substantial risk of sanctions by the SEC or PCAOB in nearly every occasion where an audit is later found to be deficient.