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In this PCAOB Update for the Auditor's Report, we discuss the Public Company Accounting Oversight Board's (PCAOB or Board) standards-setting process, its planned standards-setting priorities for 2005 (with hyperlinks to related PCAOB briefing papers), and the need for research input related to its priorities. However, the views expressed are our own and do not necessarily reflect the views of the Board or other staff members. (Note: Underlined references in this article are hyperlinked to the specific related materials on the PCAOB Web site, www.pcaobus.org.)
Because the PCAOB's mission is central to what makes research relevant and applicable to solving societal problems, we believe the PCAOB potentially can have a significant influence on the nature of research, including the development of meaningful syntheses of relevant existing research and the encouragement of new research in key priority areas in which past research is limited. In this PCAOB Update, we attempt to communicate priorities for research that likely is relevant to PCAOB standards-setting activity in the near future. Our objective is both to encourage academic researchers to develop research synthesis articles in areas for which there is considerable relevant existing research and to conduct new research on relevant issues for which there is little or no existing research.
The Sarbanes-Oxley Act of 2002 directs the Board to adopt or establish
- Auditing and related attestation standards;
- Quality control standards; and
- Ethics and independence standards.
The Board adopted as its interim standards certain existing standards in each of these areas. The Board's interim standards include the following professional standards in existence on April 16, 2003, to the extent not superseded or amended by the Board:
- Interim Auditing Standards: Generally accepted auditing standards, as described in the AICPA's Statement on Auditing Standards (SAS) No. 95.
- Interim Attestation Standards: AICPA Statements on Standards for Attestation Engagements (SSAE) and related interpretations and Statements of Position.
- Interim Quality Control Standards: AICPA Statements on Quality Control Standards (SQCS) and (for firms that were members of the AICPA SEC Practice Section) certain SECPS requirements.
- Interim Ethics Standards: AICPA Code of Professional Conduct Rule 102 on Integrity and Objectivity and interpretations and rulings thereunder.
- Interim Independence Standards: AICPA Code of Professional Conduct Rule 101, interpretations and rulings thereunder, and Independence Standards Board Standards Nos. 1, 2, and 3 and Interpretations 99-1, 00-1, and 00-2.
The PCAOB Standards-setting Process—The Board places a strong emphasis on incorporating feedback from key constituent groups in its process of formulating PCAOB standards. The Board's Standing Advisory Group (SAG) plays an important role in this process and comprises approximately 30 individuals with backgrounds as auditors, preparers, and users of financial information of public companies as well as a few individuals who are current or former professors or regulators. Currently, six organizations have observer status on the SAG and may speak at the meetings. These organizations are (alphabetically) the Auditing Standards Board (ASB), Department of Labor (DOL), Financial Accounting Standards Board (FASB), Government Accountability Office (GAO), International Auditing and Assurance Standards Board (IAASB), and Securities and Exchange Commission (SEC or Commission). The PCAOB has observer status with the IAASB and with the Financial Accounting Standards Advisory Council, User Advisory Council, and Small Business Advisory Group of the FASB.
Prior to the Board's issuance of a proposed standard, the PCAOB staff typically prepares a briefing paper of related issues for the SAG, the SAG discusses the issues at an open meeting, and the Board and its staff consider the SAG discussion when developing a proposed standard. The Standing Advisory Group section of the PCAOB Web site contains information that should be especially helpful to auditing researchers, educators, and students, including SAG meeting agendas and briefing papers related to agenda items. Audio webcasts of each meeting are available from the PCAOB home page at www.pcaobus.org.
The PCAOB standards-setting process is an open, deliberative process that generally includes an opportunity for public comment. Typically:
- The Board issues a proposed standard at an open meeting.
- The Board establishes a public comment period.
- The proposed rule and comments are published on the Board's Web site under Rulemaking.
- The Board considers comments on the proposed standard.
- The Board holds another open meeting to consider adoption of a final standard.
- The Board submits the final standard to the SEC for its approval.
Once the PCAOB has submitted a standard for Commission approval, the Commission follows procedures established in the Securities Exchange Act of 1934 and related Commission rules to publish notice of the standard in the Federal Register, and, except in unusual cases, seek additional public comment. If the SEC approves the standard after this procedure, it becomes effective and is enforceable by the PCAOB and SEC. PCAOB rules do not take effect unless approved by the Commission.
Standards-setting Developments to Date—The PCAOB has issued three auditing standards, a series of staff questions and answers (Q&As), a rule on terms used in the Board's standards, and a proposed rule on independence and contingent fees and tax services. The three final auditing standards are:
Staff Q&As present the staff's opinions in response to questions related to the implementation of PCAOB standards. The staff has issued 37 Q&As related to implementation of Auditing Standard No. 2, on auditing internal control over financial reporting, and 10 Q&As related to audits of financial statements of non-issuers in accordance with PCAOB standards (as of the end of January 2005).
On December 14, the Board proposed ethics and independence rules concerning independence, tax services, and contingent fees. With respect to contingent fees, the proposal indicates that a registered firm is not independent if the firm or any affiliate provides any service or product to an audit client for a contingent fee or commission or receives from the audit client, either directly or indirectly, a contingent fee or commission. With respect to tax services, the proposal indicates that a registered firm is not independent if it provides:
- Any tax service to an officer in a financial reporting oversight role at the audit client or
- Any non-audit service to an audit client related to planning, or opining on the tax treatment of transactions that are
- Listed tax transactions,
- Confidential tax transactions, or
- Certain aggressive tax transactions.
The PCAOB comment period ended on February 14, 2005.
Standards-setting Priorities for 2005—At its November 2004 meeting, the SAG considered the following topics as potential priority projects for 2005.
Financial Fraud (including revenue recognition and significant unusual accruals). The Public Oversight Board's Panel on Audit Effectiveness ("Panel") has recommended providing more definitive guidance with respect to a number of items including related parties and transactions with these parties as well as auditing unusual loss reserves. An important research area is the effect of SAS No. 99, Consideration of Fraud in a Financial Statement Audit, on audit practice, including (1) the question of whether audit quality has improved as a result of SAS No. 99, and (2) the identification of areas in which additional or alternative auditing procedures or other guidance may be necessary. The PCAOB staff prepared a briefing paper on financial fraud detection for the September 2004 SAG meeting. This briefing paper is available on the PCAOB Web site.
GAAS Hierarchy and Codification of auditing standards. These projects are separate, but closely related. The ASB established a hierarchy of auditing standards in 2001 when it issued SAS No. 95, Generally Accepted Auditing Standards. That standard identified three categories of auditing literature: (1) auditing standards, which had the highest level of authority and consisted of the ten generally accepted auditing standards and the Statements on Auditing Standards (SAS); (2) interpretative publications, which had a lower level of authority and consisted of SAS Interpretations, SAS Appendices, Audit and Accounting Guides cleared by the ASB, and AICPA Auditing Statements of Position; and (3) other auditing publications, which had no authoritative status. The underlying basis for authority of auditing literature changed significantly when the Sarbanes-Oxley Act shifted the authority to establish auditing and related professional practice standards for the preparation and issuance of audit reports of public companies to the PCAOB. The PCAOB staff prepared briefing papers for each of these projects for the November 2004 meeting of the SAG.
- Communications with Audit Committees. A PCAOB briefing paper on communications with audit committees was prepared for the June 2004 SAG meeting and is available on the PCAOB Web site.
- Engagement Quality Review. A PCAOB briefing paper on engagement quality reviews (previously called concurring or second partner reviews) was prepared for the June 2004 SAG meeting and is available on the PCAOB Web site.
Related Parties. A PCAOB briefing paper concerning related parties was prepared for the September 2004 SAG meeting and is available on the PCAOB Web site.
Consistency of Application of GAAP. The FASB issued an exposure draft in December 2003 that, among other things, would require companies to restate their financial statements when implementing a newly effective FASB accounting standard. To ensure that investors understand whether a restatement is due to a new accounting standard or to an error, AU sec. 420, which requires a separate explanatory paragraph in the auditor's report when a company makes certain changes in accounting principles, could be amended to require explanatory paragraphs about restatements, when applicable. The PCAOB staff has not developed a separate briefing paper on consistency of application of GAAP, but an abbreviated discussion of the issue is included in a briefing paper on "Prioritization and Review of Existing Standards, Including Consideration of New Standards," which was prepared for the June 2004 SAG meeting and is available on the PCAOB Web site.
- Confirmations. The PCAOB briefing paper on confirmations was prepared for the September 2004 SAG meeting and is available on the PCAOB Web site.
- Auditing Fair Value. A briefing paper on auditing fair value was prepared for the September 2004 SAG meeting and is available on the PCAOB Web site.
- Quality Control. The PCAOB staff discussed quality control issues in two briefing papers. The first briefing paper, an overview of quality control issues, was prepared for June 2004 SAG meeting and the second briefing paper, specifically addressing the elements of quality control, was prepared for the November 2004 SAG meeting. To locate the first briefing paper on the PCAOB Web site, click "Standards," "Standing Advisory Group," "June 21-22, 2004 SAG Meeting," "Quality Control." To locate the second briefing paper, click "Standards," "Standing Advisory Group," "November 17-18, 2004 SAG Meeting," "Elements of Quality Control."
Risk Assessment. The auditing standards related to risk assessment have not been revised substantively in many years. The IAASB and ASB had a joint project on risk assessment for several years, with the IAASB issuing its risk assessment standards in 2003 and the ASB currently working to re-expose its proposed risk assessment standards.
Some key risk assessment issues that may be appropriate for research include:
- The nature of the audit risk model and appropriate adjustments for fraud risk and for auditor knowledge of the business.
- The reliability of auditor assessments of risk model components.
- The effect of various audit approaches on the reliability of audit risk assessments.
- The ability of various substantive analytical review procedures to detect (or signal a higher likelihood) of material fraud or other material misstatement.
- Whether auditor knowledge of the business is a valid, empirically justifiable substitute for audit evidence gained from substantive tests of details and, if so, the extent to which such substitution is valid and empirically justifiable.
A briefing paper on risk assessment was prepared for the February 2005 SAG meeting and is available on the PCAOB Web site.
- Auditor's Reporting Model. A briefing paper on the auditor's reporting model was prepared for the February 2005 SAG meeting and is available on the PCAOB Web site.
The PCAOB and Research—Relevant academic research can be a powerful force to inform and enhance the quality of standards-setting decisions. The future role that academic research will play in the PCAOB standards-setting process depends on a number of factors, including the extent to which:
- Issues that may be the subject of PCAOB standards-setting are transparent to academic researchers and others who are in a position to identify, evaluate, summarize and meaningfully synthesize relevant extant research.
- Academic researchers or others with appropriate research background are motivated to identify, evaluate, summarize, and meaningfully synthesize existing research that is relevant to standards-setting priorities and communicate the synthesized findings to those who make the critical policy decisions regarding future standards.
- Editors of leading academic journals are willing to publish well-researched and well-written syntheses of research that is relevant to future standards-setting priorities, or other mechanisms are found and used to publicize the research syntheses.
In this PCAOB Update, we have attempted to communicate priorities for research that likely is relevant to PCAOB standards-setting activity in the near future and hope the information is useful to auditing researchers, educators, students, and others who have an interest in the standards-setting process.
*Douglas R. Carmichael is Chief Auditor and Director of Professional Standards at the PCAOB.
**Gary L. Holstrum is Associate Chief Auditor and Director of Research at the PCAOB.
Comments about the article or related research may be emailed to holstrumg@pcaobus.org.
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