Audit firms will soon have to share more details on how the audit was completed and what they know about a company's financial position with the audit committee.
The Public Company Accounting Oversight Board finalized a new standard last week that requires auditors to inform audit committees about any significant unusual transactions that fall outside the normal course of business that they spot during an audit, whether they have concerns that the company may be headed for failure, and whether they plan to hire outside help to complete the audit work.
The directive, Auditing Standard No. 16, Communications with Audit Committees, makes it twice over the course of two weeks that the PCAOB has inserted itself into the communication process between audit firms and audit committees. In early Aug. the board issued guidance to audit committees meant to arm them with questions to ask audit firms about their regulatory inspections to determine what effect they might have on the company's own audit. The guidances stands at the perimeter of the PCAOB's authority, as the regulator has no jurisdiction over audit committees.
The idea with the new standard, said board member Lewis Ferguson, was not to try to impose backdoor requirements on audit committees, but to assure auditors provide information to audit committees that the board believes they need to effectively oversee the audit. Ferguson, who supports the standard, said during an open meeting that the board has seen through its inspection program that experience varies widely among auditors and audit committees, leading to big differences in audit quality. “Many already routinely communicate [the information required in the new standard] but some auditors don't,” he said. “And some audit committee members don't have the knowledge or experience to inquire on their own. By mandating communication about the areas of critical risk, all audit committees of U.S. public companies will be informed of these matters.”
PCAOB member Jay Hanson emphasized, however, that the board doesn't intend for the standard to become a disclosure-like exercise implemented with boilerplate language. He pointed out the word “with” in the standard's title. “‘With' is an important word to highlight, since the standard is about effective communication, not simply a directive for the auditor to comply with a checklist of requirements,” he said.
Denny Beresford, who currently serves on the audit committee for Legg Mason, says he appreciates the standard and the overall objective to improve communications between auditors and audit firms, but he believes the most effective communication will take place if management is involved in the dialogue. Beresford says he thinks some of the required information, such as significant unusual transactions, should be coming directly from management. “Audit committee members will be interested in that, but frankly they should be hearing about it from the company,” he says. He also worries that there may be questions or problems in practice determining what constitutes a “significant unusual transaction” for purposes of the standard, leading to new hand-wringing over when a transaction crosses the threshold and must be reported.
Fred Lipman, president of the Association of Audit Committee Members, says he has no quarrel with the overall objective of the standard, but he worries it may still miss the mark in unearthing a critical issue that might prevent future failures. He believes auditors and audit committees would be wise to spend more time talking about whistleblower complaints, and he worries they don't get enough attention from the audit committees because many companies still have weak controls over assuring that credible tips reach the audit committee.
“‘With' is an important word to highlight since the standard is about effective communication, not simply a directive for the auditor to comply with a checklist of requirements.”
The proposed standard originally addressed discussion of complaints and tips, but the PCAOB removed it from the final standard because it was already addressed in AS 12: Identifying and Assessing the Risk of Material Misstatement. “Having more conversations between [auditors and audit committees] is great,” Lipman says. “The problem is neither probably have all the right information because of weak internal controls in terms of getting complaints from whistleblowers.”
Auditors at Grant Thornton and BDO USA said their firms have been implementing many of the requirements in AS 16, so they don't anticipate significant changes in future communications between auditors and audit committees as a result of the new standard. “We have embedded most of what's been discussed over the last couple of years,” says Amy Rojick, a director in the national assurance practice at BDO USA. “We don't see anything onerous that will be piled on top of what we are already doing.”
Still, there may be additional activity as a result of the new standard, says Mike Santay, partner in charge of the auditing standards group at Grant Thornton. “To provide more timely communications, it is going to increase our time,” he says. “We are going to need to be a little more aggressive in getting in front of audit committees, so that will require a little more effort than we typically have with quarterly, year-end, or planning meetings. That will be a change in practice, and a good change.”
Below is an excerpt from PCAOB Accounting Standard No. 16 listing what the auditor is required to communicate:
Certain matters regarding the company's accounting policies,
practices, and estimates;
The auditor's evaluation of the quality of the company's financial
Information related to significant unusual transactions, including
the business rationale for such transactions; and
The auditor's views regarding significant accounting or auditing
matters when the auditor is aware that management consulted
with other accountants about such matters and the auditor has
identified a concern regarding these matters.
The board was sensitive to concerns that the standard would create more work for auditors, and therefore increase audit costs. Ferguson says that while the standard requires more timely communications, it doesn't require more audit work.
The board also gave audit firms the flexibility in the standard to achieve the required communication through various means, including verbally, says Maria Manasses, managing director at Grant Thornton. “The notion of getting everyone into a board room and having a formal presentation is difficult, especially for an issue on a short fuse,” she says. “We are going to need to get more creative on how we communicate those kinds of issues more timely, and the standard gives us the flexibility to do that.”
The PCAOB envisions that the standard would take effect for audits of financial statements ending after Dec. 15, 2012. The standard must be approved by the Securities and Exchange Commission before it can take effect. The SEC also must determine if the standard will be effective for “emerging growth companies” as defined under the JOBS Act. Under the JOBS Act, emerging growth companies are not subject to a variety of reporting standards, including new standards written by the PCAOB unless the SEC specifically requires them.