Prepared for The Auditor's Report (Winter 2007)
By Gary Holstrum, Thomas Ray, and Gregory Scates**
This update addresses selected PCAOB developments since the Fall 2006 update that are likely to be of interest to accounting and auditing researchers, educators, and students. These developments include a proposed new auditing standard on internal control to replace Auditing Standard No. 2, a proposed new auditing standard on using the work of others, proposals for conforming amendments and a related new independence rule, a PCAOB report on auditors' implementation of standards on fraud, the status of existing research synthesis projects, and formation of a new Cost-Effectiveness Research Synthesis Team.
Proposed New Internal Control Audit Standard to Replace AS2
On December 19, 2006, the Board issued a proposal for a new standard on auditing internal control over financial reporting, as well as proposals for a new standard on using the work of others, conforming amendments, and a proposed new rule on independence and internal control-related services. The proposed new standard on internal control, which would replace the existing internal control standard, Auditing Standard No. 2, is a principles-based standard designed to focus the auditor on the most important matters, increasing the likelihood that material weaknesses will be found before they cause material misstatements in the financial statements. The proposed standard also eliminates audit requirements that are unnecessary to achieve the intended benefits, provides direction on how to scale the audit for a smaller and less complex company, and simplifies and significantly shortens the text of the standard. The proposed standard would, among other things:
- Direct the auditor to the most important controls and emphasize the importance of risk assessment;
- Revise the definitions of significant deficiency and material weakness, as well as the "strong indicators" of a material weakness;
- Clarify the role of materiality, including interim materiality, in the audit;
- Remove the requirement to evaluate management's process;
- Permit consideration of knowledge obtained during previous audits;
- Direct the auditor to tailor the audit to reflect the attributes of smaller and less complex companies;
- Refocus the multi-location testing requirements on risk rather than coverage; and
- Recalibrate the walkthrough requirement.
Information about this proposal, and about the proposals described below, is found in PCAOB Release No. 2006-007. The Release is available on the PCAOB Web site under Rulemaking Docket 021, which also contains a briefing paper on these proposals as well as the comment letters received.
Proposed New Standard on Using the Work of Others
The Board also proposed for public comment a new auditing standard on considering and using the work performed by internal auditors, management and others in an integrated audit of financial statements and internal control, or in an audit of financial statements only. This proposed standard is intended to further clarify how and to what extent an independent auditor may use that work to reduce the work the auditor otherwise would have to perform. The proposed standard would, among other things:
- Allow the auditor to appropriately use the work of others, and not just internal auditors, for both the internal control audit and the financial statement audit, eliminating a barrier to integration of the two audits;
- Encourage greater use of the work of these others by requiring auditors to evaluate whether and how to use their work to reduce auditor testing;
- Require the auditor to understand the relevant activities of these others and determine how the results of that work may affect the audit;
- Provide a single framework for using the work of others based on the auditor's evaluation of the combined competence and objectivity of others and the subject matter being tested; and
- Eliminate the explicit principal evidence provision previously included in AS No. 2.
Proposals for a Related New Rule and Conforming Amendments
The Board proposed a new independence rule (Proposed Rule 3525) that would replace direction currently contained in AS No. 2 regarding independence and internal control-related services. The proposed rule is intended to ensure that audit committees are provided information relevant for them to make an informed decision on how the performance of internal control-related services may affect auditor independence.
The Board also proposed a number of conforming amendments (in PCAOB Release No. 2006-007). For example, one of the proposed conforming amendments would change the existing requirement that "generally, the date of completion of the field work should be used as the date of the independent auditor's report" (found in AU Section 530, Dating of the Independent Auditor's Report) to "the auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient competent evidence to support the auditor's opinion" (see pages 34, A1-41, and A4-12 of the Release).
Report on Auditors' Implementation of Standards Related to Fraud
On January 22, the PCAOB issued a report that discusses auditors' implementation of PCAOB interim standards related to fraud, including important or recurring observations arising from the Board's inspection of audit work performed by registered public accounting firms. The report addresses several topics, including:
- Auditor's Overall Approach to the Detection of Financial Fraud;
- Brainstorming Sessions and Fraud-Related Inquiries;
- Auditor's Response to Fraud Risk Factors;
- Financial Statement Misstatements; and
- Risk of Management Override of Controls.
In the report, the Board is not changing or proposing to change any existing standard, nor is the Board providing a new interpretation of any existing standards. The Board issued the report both for the purposes of generally focusing auditors on being diligent about their responsibilities as they relate to fraud and providing information that audit committees may find useful in working with auditors. The report is a general report under the Board's Rule 4010 and does not identify any firm or firms to which the inspection observations in the report relate.
Status of the Research Synthesis Projects
Prior PCAOB Update articles have described the nine research synthesis teams formed in 2005 through joint efforts of the Auditing Section's Executive Committee, Research Committee, and Auditing Standards Committee. Eight of these nine teams have completed their research synthesis projects, including completing a preliminary report, receiving comments on the preliminary report, responding to reviewer comments on the preliminary report, and completing the final draft of the report. The ninth team has completed its preliminary report and is in the process of responding to review comments and completing its final report. The PCAOB staff has received all nine of these research synthesis reports and is considering the input from the reports in the related PCAOB standards-setting projects. Of the eight teams that have completed their final research synthesis reports:
- Five teams have had their research synthesis reports accepted for publication. Four of these have been accepted in Accounting Horizons (with two already published and two more accepted for forthcoming issues) and research related to one of the projects has been accepted for publication in Auditing: A Journal of Practice and Theory.
- Two other teams have submitted their reports (or segments of their reports) for publication.
- At the Auditing Section Mid-Year Meeting in January 2007, one team presented a summary of its research synthesis and another team (which had already had its final report accepted for publication) presented results of follow-on research related to its research.
New Cost-Effectiveness Research Synthesis Team Formed
In December 2006, the Auditing Section Executive Committee formed the Cost-Effectiveness Research Synthesis Team, the tenth team in this program. The Cost-Effectiveness Research Synthesis Team was formed in response to the difficult and critically important research issues related to studying cost-effectiveness in an auditing and auditing-standards environment. The team is still in the process of fine-tuning the approach it will take and the specific cost-effectiveness research issues it will address. Members of the team include Joe Carcello (Team Leader-University of Tennessee), Bill Kinney (University of Texas at Austin), Michael Willenborg (University of Connecticut), and Joe Weber (MIT).
The table at the following link describes the status of each of the ten research synthesis teams.
**Gary Holstrum is a consultant in the PCAOB Office of Chief Auditor
(formerly PCAOB Associate Chief Auditor and Director of Research).
Thomas Ray is PCAOB Chief Auditor and Director of Professional Standards.
Gregory Scates is PCAOB Associate Chief Auditor.
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, Summer 2006, and Fall 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.