PCAOB Proposes AS2 ‘Repeal’

The board abandons its current, controversial internal-control standard.
Sarah JohnsonDecember 19, 2006

The Public Company Accounting Oversight Board on Tuesday proposed a complete rewrite of Accounting Standard No.2, its guide for auditors in their assessments of corporate internal controls over finance.

In a move characterized by Securities and Exchange Commission Chairman Christopher Cox as the “PCAOB’s proposal to repeal the unduly expensive and inefficient auditing standard under Section 404 of Sarbanes-Oxley,” the PCAOB hopes to encourage auditors to focus on what it considers the bare essentials of a controls audit–and to find material weaknesses before a problem arises.

The PCAOB’s emphasis on materiality as a guideline in choosing what audit work to focus echoes the SEC’s proposed revisions to Section 404 of the Sarbanes-Oxley Act introduced last week.

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The PCAOB wants auditors to use the same measure of materiality for the testing of internal controls that the SEC wants applied by corporate executives to the auditing of annual financial statements. Mirroring the SEC’s planned guidance in terms of smaller corporations, the PCAOB says its new standard uses a “top down” approach and is more scalable for smaller firms whose audits have not yet had to comply with Auditing Standard No. 2.

Promoting the idea of “principles based,” “risk based” audits, the PCAOB unanimously agreed on Tuesday to put the AS2 replacement through a 70-day public comment period.

Under the new standard, which ultimately needs the SEC’s approval, auditors would no longer need to opine on whether management’s assessment of its internal controls is fairly stated. Instead, besides their audits of company financial statements, they would only need to provide an opinion on whether the internal controls themselves are effective. AS2 had required both.

The proposed changes, along with the SEC’s proposed guidance, would make it easier and cheaper for companies to comply with Section 404, according to the oversight board. AS2 has been criticized for encouraging auditors to use the guidance too conservatively.

The new standard—proposed after two financial reporting cycles in which large companies’ auditors used AS2—would “tackle the issue of unnecessary burden head on,” said PCAOB Chairman Mark Olson during board meeting on Tuesday where the proposal was unveiled.

Referred to by board members as AS No. 5, the proposed replacement’s aim is to ease some of AS2’s burdens and costs for smaller companies. In fact, the new standard, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, states that auditors should tailor their work when dealing with companies that are smaller and less complex. A “major driver behind the new standard is the need to make internal-control auditing scaleable for smaller companies,” said board member Daniel Goelzer. “By ‘scalable,’ I mean that the cost of the internal-control audit should be proportionate to the size and complexity of the company.”

The PCAOB has also cut the text of AS2 by a third and simplified some definitions. For example, the term “more than remote” is now “reasonable possibility” for how auditors should measure how likely a misstatement could occur in gauging which controls to scan.

What’s more, a prior mandate that auditors should never refer to the work of internal auditor in controls opinions would be omitted under the proposal. Instead, the PCAOB is proposing a new standard, Considering and Using the Work of Others in an Audit, that advises auditors on how much auditing work they would want to pull from internal auditors, company employees, and third parties and how to evaluate their objectivity and competency.

To further reduce what many have considered unnecessary testing, the PCAOB has also deleted a provision that states that “each year’s audit must stand on its own.” AS5 also explains how to consider the knowledge gathered from previous audits.

Simplifying and finding ways to cut down on unneeded audit work spawned by the original AS2 has been one of PCAOB’s priorities–in fact, it has “overshadowed” much of the board’s work, says Goelzer. The new standard could help non-auditors understand auditors’ controls work as well, board members think. Part of the criticism against AS2 came from its role as de facto guidance for corporate managers in complying with Section 404.

The PCAOB hopes the new standard will clarify the areas auditors should concentrate on. “Particularly at smaller companies, things like the integrity, competency, and diligence of management and the audit committee have more to do with reliable financial reporting then does the perfection of process-level controls over day-to-day transactions,” Goelzer said.

Curbing excessive work will likely lead to cheaper auditing bills, according to Olson. “The types of testing that will no longer be done should reduce the number of hours for auditing,” he said during a conference call with reporters.

The new standard may not be finalized until the end of next year. The public comment period ends at the end of February, and the PCAOB will likely need several months to go through the public comments before proposing a revised standard to the SEC, said Thomas Ray, the chief auditor of the oversight board.

The audits of non-accelerated filers—companies that have a public float of $75 million or less—will start complying with the standard for annual reports filed for fiscal years ending on or after December 15, 2008. The SEC recently extended the deadline to give smaller companies time to consider PCAOB’s changes. “The board is encouraging auditors, investors, issuers, and all others that rely on corporate financial statements to inform us on whether we have clarified our expectations, reduced unnecessary work, yet retained the important benefits of an audit of internal control,” Olson said.