Tuesday, December 20, 2011

PCAOB Re-Proposes Expanded Standard on Auditor Communications with the Audit Committee

The PCAOB has unanimously re-proposed a standard on the outside auditor’s communications with the audit committee. The re-proposed standard will supersede AU sec. 380, the existing PCAOB auditing standard governing communications with audit committees and will apply to auditor communications with issuer and broker and dealer audit committees. The new proposed standard does not impose new performance requirements on auditors but does expand and clarify the nature of communications that the auditor needs to have with the audit committee. It also aligns the auditor's communications more closely with other PCAOB standards governing the auditor's performance requirements. The comment period on the re-proposed standard will end on Feb 29, 2012. According to PCAOB Chief Auditor Marty Baumann, the goal is for the standard to take effect for audits beginning after Dec 15, 2012.

While the re-proposed standard is not fundamentally different from than the original proposal, there have been some significant changes. For example, the requirement in the original proposal that auditors evaluate the two-way communications process between the auditor and the audit committee has been deleted. Further, the requirements concerning auditor communications regarding management's critical accounting estimates have been streamlined. Also, there is a new requirement that the auditor communicate with the audit committee regarding significant transactions not in the ordinary course of business, including any transactions that appear to be unusual due to their timing, size, or nature. The auditor also would be required to explain his or her understanding of the business rationale for such transactions.

PCAOB Chair James Doty said that the new proposed standard is designed to benefit investors by enhancing the relevance and quality of the communications between the auditor and the audit committee. It should also help auditors perform their job by fostering thoughtful and engaged discussions between the auditor and the audit committee that, over time, arm the audit committee with the information it will need when a tough issue arises and the time comes to champion investor interests. The standard should also avoid burdening the audit committee with minutia. He cautioned auditors and audit committees to avoid turning the standard into a mere compliance exercise. The Chair believes that the re-proposed standard moves the auditor's communication with the audit committee away from compliance checklists, and decisively in the direction of meaningful, effective interchange.

Board Member Lewis Ferguson noted that the re-proposed standard now includes a number of specific matters that must be discussed with the audit committee, including the structure and timing of the audit, the auditor's assessment of risk areas including fraud risks, the auditor's use of outside experts and other auditors, difficult or contentious issues that arise in the course of the audit, significant accounting policies, judgments and estimates, going concern issues and other matters. Importantly, the enumerated items in the standard are not exclusive and any other matter that the auditor deems important should also be brought to the audit committee's attention.

For highly experienced and knowledgeable audit committees some of these required communications may seem unnecessary, noted Member Ferguson, but experience levels among audit committees of public companies vary widely and robust communications between an auditor and an audit committee can both educate the audit committee members and assist them in performing their oversight functions.

Board Member Jay Hanson noted that some commenters responding to the original proposed standard were hoping that the Board would require auditors to discuss their assessment of the company's tone at the top. The Board was careful to tie its communications requirements in the proposed standard to existing requirements for audit procedures in order to avoid increasing the substantive audit work that must be performed through the communication standard. As a result, the standard addresses tone at the top only insofar as AS 5 includes audit performance requirements to evaluate management in connection with the control environment.

According to Member Hanson, audit committees are free, however, to expand on these discussions with their auditors by asking for additional information about management's philosophies and priorities, in order to develop a more comprehensive picture of the company's tone at the top.

During Q&A with the staff, Member Hanson, noting that the communications should involve consultations with other accountants not involved with the audit, asked who are these other accountants. Chief Auditor Marty Baumann said that they could be accountants consulted by management with regard to complex accounting issues, or they could also be accountants consulted for opinion shopping purposes. The re-proposed standard clarifies that the auditor should communicate to the audit committee consultations by management with other accountants when the auditor has concerns about the subject matter of those consultations.

Member Ferguson, noting that the re-proposed standard requires documentation of the auditor communications with the audit committee, asked about the level of detail of the documentation. The Chief Auditor said that the general rule is that the documentation must be such that an experienced auditor not having been involved with the audit can look at the documentation and understand the nature of the communications.

Member Steven Harris noted that some have called the standard overly prescriptive: The Chief Auditor observed that the re-proposed standard embodies important requirements for communication between the auditor and the audit committee. He added that the standard does not prescribe the nature of how these communications are to take place. Communications can be in the form of bringing attention to critical matters to the audit, for example. Similarly, Member Dan Goelzer noted that the original proposal had been criticized for being one-size-fits-all. The Chief Auditor responded that the re-proposal provides great flexibility on how the audit committee and the auditor carry out their dialogue.

Member Harris posed a question concerning the difference between the terms must or should as used in the standard and the legal implications of such. The staff replied that the term ``must’’ connotes an unconditional responsibility, such as the auditor must be independent. The term ``should’’ carries the presumption of unconditional responsibility, that the auditor can rebut by showing that an alternative approach would otherwise satisfy the objective of the standard. This would be a rare occurrence, said the staff, since the term ``should’’ leaves little flexibility, is tantamount to a requirement, and is enforceable.

Member Goelzer is concerned about how the re-proposed standard will apply, and indeed be efficacious, to smaller broker-dealers where the same people both manage and oversee the financial reporting process. The staff shares these concerns. The Chief Auditor noted that the re-proposal questions if the standard should apply to all broker-dealers in an effort to elicit feedback from which the staff can learn more about whether the standard should be applicable in all cases.