Prepared for The Auditor's Report (Fall 2006)
By Gary Holstrum* and Thomas Ray**
This update addresses selected PCAOB developments since the Summer 2006 update that are likely to be of interest to accounting and auditing researchers, educators, and students. These include developments related to PCAOB Registration and Inspections, audits of internal control, audits of small businesses by small firms, other standards-setting activities, and alternatives for measuring PCAOB success.
Registration and Inspections. As the PCAOB is in its fourth year, having started operations in early 2003, the number of registered firms has currently leveled off at approximately 1700. About 40% of these have no public company clients and are, therefore, not subject to regular inspections, and about 40% are foreign firms.
Since inception, the PCAOB has completed more than 400 domestic inspections and issued more than 350 inspection reports, which are available on the PCAOB web site (www.pcaobus.org). Inspection reports have identified relatively frequent auditing problems related to the following areas:
- Contractual arrangements
- Equity transactions
- Going concern
- Internal control
- Principal auditor
- Concurring partner
Audits of Internal Control. Following the May 20, 2006, SEC-PCAOB Roundtable on second-year issues related to implementing the internal control reporting provisions of the Sarbanes-Oxley Act, the PCAOB announced a four-point plan to improve auditors' implementation of the internal control reporting provisions. The four-point plan includes:
- Amending/refining Auditing Standard No. 2 (AS 2)
- Reinforcing auditor efficiency through PCAOB inspections
- Developing or facilitating the development of guidance and education for auditors of small companies
- Continuing PCAOB Forums on Auditing in the Small Business Environment
Possible Amendments to AS2 include:
- Incorporating key concepts from the guidance previously issued in May 16, 2005, in the form of a Board Policy Statement and Staff Q&As (38-55)
- Revisiting auditor evaluation of management's assessment of internal control
- Clarifying certain definitions in AS2
- Reconsidering "strong indicators" of a material weakness described in AS2
- Clarifying the use of work of others
- Clarifying materiality and scoping decisions
- Allowing for use of experience gained in prior years
While the PCAOB is developing further guidance for auditors of management reports on internal control over financial reporting, the SEC is developing further guidance for management to use in its reporting on internal control, and COSO has issued additional guidance for applying the criteria for reporting on internal control over financial reporting in smaller companies. On July 11, 2006, the SEC issued "Concept Release Concerning Management's Reports on Internal Control over Financial Reporting," [Release No. 34-54122; File No. S7-11 -06], which discusses the proposed concepts it plans to use in developing further guidance for management on reporting on internal control. In addition, in June 2006, COSO issued Internal Control over Financial Reporting—Guidance for Smaller Public Companies, which neither replaces nor modifies the basic COSO "Framework" commonly used as criteria for reporting on internal control over financial reporting, but rather provides guidance on how the "Framework" might be applied in smaller public companies.
Consideration of Small Firms and Audits of Small Businesses. The PCAOB is working to facilitate the development of additional non-authoritative guidance concerning key issues related to audits of internal control over financial reporting for smaller public companies. For example, some key issues that potentially could be addressed include obtaining sufficient competent evidence of internal control effectiveness in less documented environments and evaluating the adequacy of segregation of duties in small companies for which the small number of staff makes adequate segregation of duties especially challenging.
The PCAOB also devoted a session at the October 2006 meeting of its Standing Advisory Group (SAG) to issues related to regional and local registered firms and audits of small businesses (other than issues related to reporting on internal control). The PCAOB web site contains an audio webcast of the SAG discussion and a briefing paper identifying some of the key issues. The PCAOB also is continuing to hold a number Forums on Auditing in the Small Business Environment at various locations throughout the nation, designed to help registered accounting firms and public companies in the small business community learn more about the work of the Board, specifically the PCAOB inspections process and the impact of new auditing standards.
Audit Practice Alert and Staff Q&As on Stock Option Grants. On July 28, 2006, the PCAOB Staff issued "Audit Practice Alert No. 1, Matters Related to Timing and Accounting for Option Grants." This is the first in what is expected to be a series of Audit Practice Alerts, which are designed to highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of PCAOB standards and relevant laws. Audit Practice Alert No. 1 advises auditors that some issuers' practices related to stock options grants may have audit implications and discusses factors that may be relevant to assessing the risks relating to those matters based on existing accounting, auditing, and legal requirements.
In the near future, the PCAOB Staff plans to issue Staff Q&As on auditing the FAS 123R fair value measurements associated with stock compensation. When issued, these Staff Q&As will be available on the PCAOB Web site.
Staff Q&As on Adjustments to Prior-Period Financial Statements Audited by a Predecessor Auditor. On June 9, 2006, PCAOB Staff issued 11 Q&As that address situations in which adjustments are made to prior-period financial statements when there has been a change of auditors. These Q&As provide the staff's views on auditing of the adjustments by the predecessor auditor or the successor auditor and includes guidance on related reporting considerations.
Standards-Setting Priorities. At the October 2006 SAG meeting, Chief Auditor, Tom Ray, presented to the SAG for discussion the Board's standards-setting priorities. The priorities included, but are not necessarily limited to, the items listed below, which are subject to change based on emerging issues:
- AS2 Revision
- Principles of Reporting (to address FASB No. 154 and the GAAP hierarchy)
- Engagement Quality Review
- Risk Assessment, including fraud risk assessment
- Related Parties (including consideration of fraud risk factors)
- Confirmations (including consideration of fraud risk factors)
- Specialists (including how specialists are used in fair value measurements)
The Auditing Section's Research Synthesis Program, which has been discussed in several previous PCAOB Update articles, addressed most of these standards projects. All nine Research Synthesis Teams assembled by the Auditing Section Executive Committee have either completed or are nearing completion of their respective synthesis reports. The nine Research Synthesis teams are shown below, along with hyperlinks to the corresponding PCAOB Briefing Papers containing discussion questions addressed by the synthesis projects:
PCAOB strategic planning—measuring PCAOB success. A significant portion of the October 2006 meeting of the SAG was devoted to PCAOB strategic planning issues, with emphasis on possible future methods of measuring the level of PCAOB success. The Briefing Paper developed for this session discusses issues related to measuring success including the following three broad potential measures of PCAOB success and possible specific metrics related to each:
- High investor confidence in the auditing profession, as indicated by increased reliance on audit reports and strong confidence in audit quality,
- Less involvement by auditors in financial scandals than in the past (or in the alternative, greater frequency with which auditors directly detected or prevented financial scandals from occurring) and
- Stability in the business model of the accounting profession (e.g., lack of volatility in the profession, no large firms on the edge of failure, ability to attract needed talent, absence of artificial barriers to market competition.
*Gary Holstrum is PCAOB Associate Chief Auditor and Director of Research.
**Thomas Ray is PCAOB Chief Auditor and Director of Professional Standards.
¹Note the hyperlinks to the PCAOB Web site (www.pcaobus.org) and to the Auditing Section Web site. A convenient history of PCAOB standards-setting activity and related briefing papers are available through the hyperlinked previous PCAOB Standards-Setting Update articles in the Spring 2005, Summer 2005, Fall 2005, Spring 2006, and Summer 2006 issues of The Auditor's Report. The views expressed in this article are those of the authors and not necessarily those of the Board, individual Board members, or other PCAOB staff. Responses to the article or related research may be emailed to firstname.lastname@example.org.