[Federal Register Volume 72, Number 147 (Wednesday, August 1, 2007)]
[Notices]
[Pages 42141-42146]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-14858]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-56152; File No. PCAOB-2007-02]
Public Company Accounting Oversight Board; Order Approving
Proposed Auditing Standard No. 5, An Audit of Internal Control Over
Financial Reporting That Is Integrated With an Audit of Financial
Statements, a Related Independence Rule, and Conforming Amendments
July 27, 2007.
I. Introduction
On May 25, 2007, the Public Company Accounting Oversight Board (the
``Board'' or the ``PCAOB'') filed with the Securities and Exchange
Commission (the ``Commission'') Proposed Auditing Standard No. 5, An
Audit of Internal Control Over Financial Reporting that is Integrated
with an Audit of Financial Statements (``Auditing Standard No. 5''), a
Related Independence Rule 3525, and Conforming Amendments, pursuant to
Section 107 of the Sarbanes-Oxley Act of 2002 (the ``Act'') and Section
19(b) of the Securities Exchange Act of 1934 (the ``Exchange Act'').
Auditing Standard No. 5 will supersede Auditing Standard No. 2, An
Audit of Internal Control Over Financial Reporting Performed in
Conjunction with an Audit of Financial Statements (``Auditing Standard
No. 2''), to provide the professional standards and related performance
guidance for independent auditors when an auditor is engaged to perform
an audit of management's assessment of the effectiveness of internal
control over financial reporting that is integrated with an audit of
the financial statements pursuant to Sections 103(a)(2)(A)(iii) and
404(b) of the Act. Additionally, Rule 3525 further implements Section
202 of the Act's pre-approval requirement by requiring auditors to take
certain steps as part of seeking audit committee pre-approval of
internal control related non-audit services. Finally, the conforming
amendments update the Board's other auditing standards in light of
Auditing Standard No. 5, move certain information that was contained in
Auditing Standard No. 2 to the Board's interim standards, and 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'' 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.''
Notice of the proposed standard, the related independence rule, and
the conforming amendments was published in the Federal Register on June
12, 2007,\1\ and a supplemental notice of additional solicitation of
comments on the rules and amendments was published in the Federal
Register on June 20, 2007 (``Supplemental Notice'').\2\ The Commission
received 37 comment letters on the proposed rules and amendments. For
the reasons discussed below, the Commission is granting approval of the
proposed standard, the related independence rule, and conforming
amendments.
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\1\ Release No. 34-55876 (June 7, 2007); 72 FR 32340 (June 12,
2007).
\2\ Release No. 34-55912 (June 15, 2007); 72 FR 34052 (June 20,
2007); Notice of Additional Solicitation of Comments on the Filing
of Proposed Rule on Auditing Standard No. 5, An Audit of Internal
Control Over Financial Reporting That is Integrated with an Audit of
Financial Statements, and Related Independence Rule and Conforming
Amendments.
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II. Description
The Act establishes the PCAOB to oversee the audits of public
companies and related matters, in order to protect the interests of
investors and further the public interest in preparation of
informative, accurate and independent audit reports.\3\ Section 103(a)
of the Act directs the PCAOB to establish auditing and related
attestation standards, quality control standards, and ethics standards
to be used by registered public accounting firms in the preparation and
issuance of audit reports as required by the Act or the rules of the
Commission.
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\3\ Section 101(a) of the Act.
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Section 103(a)(2)(A)(iii) of the Act requires the Board's standard
on auditing internal control to include ``testing of the internal
control structure and procedures of the issuer * * *.'' Under Section
103, the Board's standard also must require the auditor to present in
the audit report, among other things, ``an evaluation of whether such
internal control structure and procedures * * * provide reasonable
assurance that transactions are recorded as necessary to permit the
preparation of financial statements in accordance with generally
accepted accounting principles * * *.'' Section 404 of the Act requires
that registered public accounting firms attest to and report on an
assessment of internal control made by management and that such
attestation ``shall be made in accordance with standards for
attestation engagements issued or adopted by the Board.''
The Board's proposed Auditing Standard No. 5, which will supersede
Auditing Standard No. 2, provides the new professional standards and
related performance guidance for independent auditors to attest to, and
report on, management's assessment of the effectiveness of internal
control over financial reporting under Sections 103 and 404 of the Act.
The auditor's report on internal control over financial reporting
issued pursuant to Auditing Standard No. 5 will express one opinion--an
opinion on whether the company has maintained effective internal
control over financial reporting as of its fiscal year-end. In order
for the auditor to render an opinion, Auditing Standard No. 5 requires
the auditor to evaluate and test both the design and the operating
effectiveness of internal control to be satisfied that management's
assessment about
[[Page 42142]]
whether the company maintained effective internal control over
financial reporting as of its fiscal year-end is correct and,
therefore, fairly stated. Additionally, paragraph 72 of Auditing
Standard No. 5 requires the auditor to evaluate whether management has
included in its annual assessment report all of the disclosures
required by Commission rules.\4\ If the auditor determines that
management's assessment is not fairly stated, Auditing Standard No. 5
requires that the auditor modify his or her audit report on the
effectiveness of internal control over financial reporting.
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\4\ Item 308 of Regulations S-B and S-K.
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III. Discussion
As discussed in detail below, the Commission believes there are
many aspects of Auditing Standard No. 5 that are expected to result in
improvements in both the effectiveness and efficiency of integrated
audits that are currently being conducted in accordance with Auditing
Standard No. 2. For example, Auditing Standard No. 5 focuses the audit
on the matters most important to internal control. Auditing Standard
No. 5 also eliminates unnecessary procedures by, among other things,
removing the requirement to evaluate management's process; permitting
consideration of knowledge obtained during previous audits; refocusing
the multi-location testing requirements on risk rather than coverage;
and removing unnecessary barriers to using the work of others. Further,
Auditing Standard No. 5 encourages scaling of the audit for smaller
companies by directing the auditor to tailor the audit to reflect the
attributes of smaller, less complex companies. Lastly, Auditing
Standard No. 5 simplifies the requirements by reducing detail and
specificity; reflecting more accurately the sequential flow of an audit
of internal control; and improving readability.
The PCAOB received 175 comment letters when it published a draft of
Auditing Standard No. 5 for public comment on December 19, 2006. On
April 4, 2007, the Commission held an open meeting to discuss the
comments received by the PCAOB and by the Commission in connection with
its proposed interpretive guidance for management. At this meeting the
Commission directed its staff to focus on four areas when working with
the PCAOB staff: Aligning the proposed auditing standard with the
Commission's proposed interpretive guidance for management,
particularly with regard to prescriptive requirements, definitions and
terms; scaling the audit to account for the particular facts and
circumstances of all companies, particularly smaller companies;
encouraging auditors to use professional judgment, particularly in
using risk-assessment; and following a principles-based approach to
determining when and to what extent the auditor can use the work of
others.\5\
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\5\ See Commission Press Release dated April 4, 2007, ``SEC
Commissioners Endorse Improved Sarbanes-Oxley Implementation To Ease
Smaller Company Burdens, Focusing Effort On What Truly Matters.''
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The PCAOB addressed these areas, in addition to other matters
raised by commenters, in the version of Auditing Standard No. 5 that
was filed with the Commission. For example, the PCAOB made revisions to
its proposed standard to: Make the auditing standard more principles-
based and reduce prescriptiveness; align definitions and terminology
with the Commission's final interpretive guidance for management;
better incorporate scaling concepts throughout the auditing standard;
further emphasize fraud controls; enhance and align the discussion of
entity-level controls; eliminate the requirement to separately assess
risk at the individual control level; clarify the manner in which the
evidence regarding design of controls can be obtained; and clarify the
framework by which auditors can make judgments regarding whether and to
what extent the auditor can use the work of others, including
management.
The Commission received 37 comment letters in response to its
request for comments on Auditing Standard No. 5, the related
independence rule, and conforming amendments. The comment letters came
from issuers,\6\ registered public accounting firms,\7\ professional
associations,\8\ investors,\9\ and others.\10\ In general, many
commenters expressed support for the proposed standard \11\ and
recommended that the Commission approve the standard and the related
conforming amendments, with some of these commenters requesting that
this approval be done on an expedited basis to enable auditors to
implement the provisions of Auditing Standard No. 5 prior to the
required effective date.\12\ A number of the commenters noted that the
new audit standard includes appropriate investor safeguards, will
facilitate a more effective and efficient approach to the
implementation,\13\ and that the PCAOB appropriately responded to
concerns raised by issuers, auditors, investors and others.\14\
Specifically, some commenters noted that the standard's focus on
principles rather than prescriptive requirements expands the
opportunities for auditors to apply well-reasoned professional
judgment.\15\ Many of these commenters had provided similar
communication directly to the PCAOB during its comment period, and to
the Commission as part of its consideration of its proposed
interpretive guidance for management.
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\6\ Alamo Group; Pepsico; and XenoPort, Inc.
\7\ BDO Seidman, LLP; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP; KPMG LLP; and PricewaterhouseCoopers LLP.
\8\ American Bankers Association; American Bar Association
Section of Business Law Committees on Federal Regulation of
Securities and Law and Accounting; America's Community Bankers;
Biotechnology Industry Organization; Center for Audit Quality;
Independent Community of Bankers of America; Institute of Chartered
Accountants in England and Wales; Institute of Internal Auditors
(IIA); Institute of Management Accountants; Organization for
International Investment; National Venture Capital Association; New
York State Society of Certified Public Accountants; The Hundred
Group of Finance Directors; and U.S. Chamber Center for Capital
Markets Competitiveness.
\9\ California Public Employees Retirement System; Centre for
Financial Market Integrity; and Council of Institutional Investors.
\10\ Accretive Solutions; Thomas E. Damman; David A. Doney;
Benjamin P. Foster; Frank Gorrell; Simone Heidema and Erick
Noorloos; J. Lavon Morton; Monica Radu; Robert Richter; R.G. Scott &
Associates, LLC; and United States Government Accountability Office.
\11\ See for example, Accretive Solutions; America's Community
Bankers; BDO Seidman, LLP; California Public Empolyees Retirement
System; Center for Audit Quality; Council of Institutional
Investors; Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton
LLP; KPMG LLP; Institute of Chartered Accountants in England and
Wales; New York State Society of Certified Public Accountants;
PricewaterhouseCoopers LLP; The 100 Group of Finance Directors; and
United States Government Accountability Office.
\12\ See for example, America's Community Bankers; BDO Seidman,
LLP; California Public Employees Retirement System; Council of
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP; KPMG LLP; and PricewaterhouseCoopers LLP.
\13\ See for example, American Bankers Association; Accretive
Solutions; BDO Seidman, LLP; Center for Audit Quality; KPMG LLP;
PricewaterhouseCoopers LLP; and The 100 Group of Finance Directors.
\14\ See for example, American Bankers Association; America's
Community Bankers; Council of Institutional Investors; Ernst & Young
LLP; Grant Thornton LLP; The 100 Group of Finance Directors; and
United States Government Accountability Office.
\15\ See for example, BDO Seidman, LLP; Center for Audit
Quality; Ernst & Young LLP; Institute of Chartered Accountants in
England and Wales; PricewaterhouseCoopers LLP; and The 100 Group of
Finance Directors.
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A few commenters expressed their continuing concerns that the
Commission (in its recently approved rule amendments) and the PCAOB had
retained the wrong auditor opinion, indicating their belief that
auditors should opine on the assessment made by management in order to
comply with
[[Page 42143]]
Section 404(b) of the Sarbanes-Oxley Act.\16\ These commenters
expressed their belief that the auditor's opinion directly on internal
control over financial reporting (as opposed to management's
assessment) entails unnecessary and duplicative work. The Commission
has carefully considered this comment and continues to believe that,
consistent with Sections 103 and 404 of the Sarbanes-Oxley Act, the
Commission's recent rule amendments and Auditing Standard No. 5 require
the appropriate opinion to be expressed by the auditor. The Commission
notes that this view is consistent with the view expressed by the Board
in its release. Further, the Commission believes that an auditing
process that is restricted to evaluating what management has done would
not necessarily provide the auditor with a sufficient level of
assurance to render an independent opinion as to whether management's
assessment about the effectiveness of internal control over financial
reporting is correct.\17\ Finally, the Commission believes that the
expression of a single opinion directly on the effectiveness of
internal control over financial reporting provides clear communication
to investors that the auditor is not responsible for issuing an opinion
on management's process for evaluating internal control over financial
reporting.\18\ In the Commission's view, such an opinion may not only
have the unintended consequence of hindering management's ability to
apply appropriate judgment in designing their evaluation approach, but
also may have the effect of increasing audit costs without commensurate
benefit to issuers and investors.
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\16\ See for example, Alamo Group; Robert Richter; Institute of
Chartered Accountants in England and Wales; Institute of Management
Accountants; and The 100 Group of Finance Directors.
\17\ See Release No. 33-8809 (June 20, 2007), Amendments to
Rules Regarding Management's Report on Internal Control Over
Financial Reporting.
\18\ Ibid.
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Two commenters noted their belief that there was not sufficient
incentive for auditors to modify their methods of performing the audit
of internal control and therefore, were concerned that the benefits
afforded by Auditing Standard No. 5 would not be fully realized. These
commenters noted that it was important for the PCAOB to adjust its
inspection program to align it with the changes in the audit standard
and to respect the auditors' use of judgment in conducting the
audit.\19\ Additionally, commenters noted that the PCAOB's inspection
process should monitor the extent to which, and the expediency with
which, audit firms implement Auditing Standard No. 5 in the manner
expected.\20\ This has been an area both the Commission and the PCAOB
recognize and continue to focus on. For example, it was an area
specifically identified in the Commission's and the PCAOB's 2006
announcement of actions following the Commission's second roundtable on
Section 404 implementation.\21\ The PCAOB has incorporated procedures
to evaluate the efficiency and effectiveness of audits of internal
control over financial reporting in their inspection process and, in
April 2007, issued its second report on auditors' implementation of the
internal control standard.\22\ The Commission also recognizes this
concern and, as a result and consistent with its previous 2006
announcement in this area, will be carefully monitoring the
implementation, including directing the Commission staff to examine
whether the PCAOB inspections of registered accounting firms have been
effective in encouraging changes in the conduct of integrated audits to
improve both efficiency and effectiveness of attestations on internal
control over financial reporting.
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\19\ America's Community Bankers and the Institute of Chartered
Accountants in England and Wales.
\20\ See for example, America's Community Bankers, the Institute
of Chartered Accountants in England and Wales, The 100 Group of
Finance Directors and U.S. Chamber Center for Capital Markets
Competitiveness.
\21\ See for example, SEC Press Release 2006-75 (May 16, 2006).
\22\ See PCAOB Press Release dated April 18, 2007, ``Board
Issues Second Year Report On Auditors' Implementation of Internal
Control Standard''.
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The Commission received one comment with respect to the indicators
of a material weakness that are included in Auditing Standard No. 5.
Under Auditing Standard No. 5, if an auditor determines that a
deficiency might prevent prudent officials from concluding that they
have reasonable assurance that transactions are recorded as necessary
to permit the preparation of financial statements in conformity with
generally accepted accounting principles, an auditor should regard such
a determination as an indicator of a material weakness. One commenter
took exception to this requirement and requested that such a
determination made by the auditor be regarded as an indicator of a
deficiency that is at least a significant deficiency rather than an
indicator of a material weakness; or that Auditing Standard No. 5 be
revised to use the word ``would'' instead of ``might'' when describing
the level of assurance that would satisfy prudent officials in the
conduct of their own affairs.\23\ The Commission notes that the
commenter's suggestion to change the word ``might'' to ``would'' is not
necessary or appropriate given that the PCAOB and the Commission both
stated in their respective releases that the determination of whether
or not a material weakness exists requires judgment and the presence of
one or more indicators does not mandate a conclusion that a material
weakness exists. Moreover, the Commission notes that the indicators are
not intended to supplant or replace the definition of material
weakness. This particular indicator is intended as a reminder of the
requirement in Section 13(b)(2)(B) of the Exchange Act that every
issuer ``devise and maintain a system of internal accounting controls
sufficient to provide reasonable assurances'' and of the explanation in
Section 13(b)(7) of the Exchange Act that the term ``reasonable
assurances'' in this context means ``such level of detail and degree of
assurance as would satisfy prudent officials in the conduct of their
own affairs.'' The Commission agrees with the list of indicators of a
material weakness included in Auditing Standard No. 5, and agrees with
the principles in Auditing Standard No. 5, which allow an auditor to
use his or her judgment.
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\23\ American Bar Association Section of Business Law Committees
on Federal Regulation of Securities and Law and Accounting.
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The Commission received one comment with respect to the PCAOB's
proposed Independence Rule 3525, which relates to the requirement for
auditors to obtain audit committee pre-approval of non-audit services
related to internal control over financial reporting. This commenter
requested a transition provision in order to clarify that internal
control-related services pre-approved by audit committees before the
final rule is approved by the Commission do not require re-approval
under Rule 3525.\24\ Auditing Standard No. 2 (paragraph 33) required
specific pre-approval of internal-control related non-audit services.
The Commission notes that non-audit services that have already been
pre-approved by audit committees would not require re-approval with the
communications required by Rule 3525. Accordingly, a transition period
is not necessary.
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\24\ KPMG LLP.
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The Commission did not receive any comments with respect to the
PCAOB's proposed conforming amendments. In some cases, these proposed
amendments are administrative in nature, such as updating references in
the interim standards to the proposed
[[Page 42144]]
new standard's paragraph numbers and definitions. In other cases, the
amendments have been proposed to move information currently contained
in Auditing Standard No. 2 to the Board's existing standards. Further,
the Commission notes that the Board addressed the single comment that
it received on its conforming amendments. The Commission believes that
the conforming amendments proposed by the Board are appropriate.
As proposed by the PCAOB, Auditing Standard No. 5, PCAOB Rule 3525,
and the Conforming Amendments will be effective and required for
integrated audits conducted for fiscal years ending on or after Nov.
15, 2007. However, earlier adoption is permitted by the Board. The
Board has stated that auditors who elect to comply with Auditing
Standard No. 5 after Commission approval but before its effective date
must also comply, at the same time, with Rule 3525 and other PCAOB
standards as amended by this release. The Commission believes the
effective date allows for appropriate transition time and at the same
time encourages early adoption. In that regard, the Commission's recent
amendments to Regulation S-X become effective on August 27, 2007 and
the Commission will begin accepting the single auditor's attestation
report on the effectiveness of internal control over financial
reporting prescribed in Auditing Standard No. 5 in timely filings
received starting on that date.
In its Supplemental Notice, the Commission sought comments on seven
specific questions. The following discussion addresses the comments
received related to each of those questions.
(1) Is the standard of materiality appropriately defined throughout
AS5 to provide sufficient guidance to auditors? For example, is
materiality appropriately incorporated into the guidance regarding the
matters to be considered in planning an audit and the identification of
significant accounts?
The majority of the commenters who expressed a view on this
question noted that Auditing Standard No. 5 appropriately addresses the
concept of materiality when planning and performing an integrated
audit.\25\ Some commenters elaborated that while application of
materiality concepts in the context of planning and performing an audit
requires the use of judgment, Auditing Standard No. 5 specifies the
basis on which those judgments should be made.\26\
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\25\ See for example, BDO Seidman, LLP; California Public
Employees Retirement System; Center for Audit Quality; Deloitte &
Touche LLP; Ernst & Young LLP; Grant Thornton LLP; Institute of
Chartered Accountants in England and Wales; KPMG LLP; New York State
Society of Certified Public Accountants; PepsiCo;
PricewaterhouseCoopers LLP; and The Hundred Group of Finance
Directors.
\26\ See for example, KPMG LLP and PricewaterhouseCoopers LLP.
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A few commenters expressed a view that some auditors may need
further and clearer guidance than is provided.\27\ However, one
commenter indicated its view that the Commission should not provide
more guidance and interpretation, especially as related to the
application of quantitative criteria to the definitions of material
weakness and significant deficiency.\28\ Moreover, another commenter
noted that although its view was that materiality was not sufficiently
defined in Auditing Standard No. 5, it recognized that the definition
of materiality extends to matters beyond just Section 404 of the
Act.\29\
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\27\ See for example, Accretive Solutions; The Institute of
Internal Auditors; Rod G. Scott; National Venture Capital
Association; and U.S. Chamber Center for Capital Markets
Competitiveness.
\28\ The Institute of Chartered Accountants in England and
Wales.
\29\ National Venture Capital Association.
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The Commission agrees that Auditing Standard No. 5 adequately
addresses materiality throughout the standard. For example, as a number
of commenters observed, paragraph 20 of Auditing Standard No. 5 states
that ``in planning the audit of internal control over financial
reporting, the auditor should use the same materiality considerations
he or she would use in planning the audit of the company's financial
statements.'' Further, the Commission does not believe that the
auditing standard is the appropriate forum to address broader questions
about materiality, as the concept of materiality is fundamental to the
federal securities laws.
(2) Please comment on the requirement in Paragraph 80 that the
auditor consider whether there are any deficiencies or combinations of
deficiencies that are significant deficiencies and, if so, communicate
those to the audit committee. Specifically, will the communication
requirement regarding significant deficiencies divert auditors'
attention away from material weaknesses?
Commenters who expressed a view on this matter overwhelmingly
observed that the auditor's requirement to communicate significant
deficiencies would not divert auditors' attention away from material
weaknesses since Auditing Standard No. 5 clearly directs the auditor to
identify material weaknesses, with many of the commenters noting the
importance of communicating significant deficiencies to the audit
committee.\30\
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\30\ See for example, American Bar Association Section of
Business Law Committees on Federal Regulation of Securities and Law
and Accounting; Accretive Solutions; BDO Seidman, LLP; Center for
Audit Quality; Centre for Financial Market Integrity; Council of
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP; Institute of Chartered Accountants in England
and Wales; KPMG LLP; J. Lavon Morton; New York State Society of
Certified Public Accountants; PepsiCo; PricewaterhouseCoopers LLP;
Rod G. Scott; and The 100 Group of Finance Directors, but see The
Institute of Internal Auditors.
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The Commission agrees with commenters that the communication
requirement related to significant deficiencies should not divert
auditors' attention away from material weaknesses due to the clear
statement in Auditing Standard No. 5 that in planning the audit, the
auditor is not required to search for deficiencies that, individually,
or in combination, are less severe than a material weakness. Further,
the Commission agrees with the Board that limiting the discussion
regarding significant deficiencies to the section of the auditing
standard that relates to communications is appropriate in order to help
clarify that the audit should not be scoped to identify deficiencies
that are less severe than a material weakness.
(3) Is AS5 sufficiently clear that for purposes of evaluating
identified deficiencies, multiple control deficiencies should only be
looked at in combination if they are related to one another?
Most of those commenting on this question agreed that multiple
control deficiencies should be aggregated for assessment purposes if
they are related to each other and that Auditing Standard No. 5 is
sufficiently clear in this regard.\31\ Two commenters disagreed with
the direction that multiple control deficiencies should only be
evaluated in combination if they are related to one another given that
the auditor is expressing an opinion on the effectiveness of internal
control as a whole.\32\
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\31\ See for example, Accretive Solutions; BDO Seidman, LLP;
Center for Audit Quality; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP, Institute of Chartered Accountants in England
and Wales; PepsiCo; PricewaterhouseCoopers LLP; R.G. Scott; and The
100 Group of Finance Directors.
\32\ See California Public Employees' Retirement Systems; and
United States Government Accountability Office.
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The Commission agrees with the view of most of the community that
Auditing Standard No. 5 is sufficiently clear with respect to
aggregation of control deficiencies and further notes that this
guidance is appropriately aligned with
[[Page 42145]]
the guidance that is contained in the Commission's interpretive
guidance for management.
(4) Please comment on whether the definition of ``material
weakness'' in Paragraph A7 (which is consistent with the definition
that the SEC adopted) appropriately describes the deficiencies that
should prevent the auditor from finding that ICFR is effective.
The majority of those commenting on this topic expressed agreement
with Auditing Standard No. 5's definition of material weakness and
stated that it appropriately describes those deficiencies that should
prevent the auditor from concluding that internal control over
financial reporting is effective,\33\ while a couple commenters stated
that the definition was not as clear as it could be, thereby
potentially leading to subjective assessments of whether a control
deficiency is a material weakness.\34\ One commenter suggested
providing guidance regarding the period of time to which reasonable
possibility relates,[0] \35\ and another suggested reconsideration of
the likelihood threshold included in the definition.\36\ Two commenters
suggested that the requirement to evaluate deficiencies against interim
results due to the reference to interim financial statements in the
definition of material weakness should be eliminated,\37\ with one of
these two commenters stating that this consideration should not delay
the Commission's prompt approval of Auditing Standard No. 5.\38\
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\33\ See for example, BDO Seidman, LLP; Center for Audit
Quality; California Public Employees Retirement System; Council of
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP; Institute of Chartered Accountants in England
and Wales; New York State Society of Certified Public Accountants;
PepsiCo; PricewaterhouseCoopers LLP; and The 100 Group of Finance
Directors.
\34\ See for example, Accretive Solutions; R.G. Scott; and U.S.
Chamber Center for Capital Markets Competitiveness.
\35\ See The Institute of Internal Auditors.
\36\ See National Venture Capital Association.
\37\ See National Venture Capital Association and
PricewaterhouseCoopers LLP.
\38\ PricewaterhouseCoopers LLP.
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The Commission agrees that the definition of material weakness
included in Auditing Standard No. 5, which is aligned with the
Commission's interpretive guidance for management, appropriately
describes the conditions that, if they exist, should be disclosed to
investors and should preclude a conclusion that internal control over
financial reporting is effective. Regarding the reference to interim
financial statements in the definition of material weakness, the
Commission continues to believe, as it stated in its release adopting
the definition of a material weakness, that:
``* * *[while] annual materiality considerations are appropriate
when making judgments about the nature and extent of evaluation
procedures, the Commission believes that judgments about whether a
control is adequately designed or operating effectively should
consider the requirement to provide investors reliable interim and
annual financial reports. Further, if a deficiency is identified
that poses a reasonable possibility of a material misstatement in
the company's quarterly reports, the Commission believes that the
deficiency should be disclosed to investors and internal control
over financial reporting should not be assessed as effective.'' \39\
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\39\ See Release No. 33-8809 (June 20, 2007), Amendments to
Rules Regarding Management's Report on Internal Control Over
Financial Reporting.
(5) Is AS5 sufficiently clear about the extent to which auditors
can use the work of others?
The majority of those who commented on this question expressed
their view that Auditing Standard No. 5 is clear about the extent to
which auditors can use the work of others to gain efficiencies in the
audit,\40\ with some noting that Auditing Standard No. 5 provides
substantial flexibility in the application of auditor judgment when
determining whether, and to what extent, to use the work of others.\41\
A small number of commenters noted that further clarification regarding
the extent that auditors can rely on the work of others when conducting
walkthroughs would be helpful.\42\ Two commenters recommended that if
the work of others is found to be competent and reliable, then the
standard should require the auditor to utilize it.\43\
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\40\ See for example, Accretive Solutions; BDO Seidman, LLP;
Center for Audit Quality; Council of Institutional Investors;
Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton LLP; KPMG
LLP; PepsiCo; and PricewaterhouseCoopers LLP.
\41\ See for example, Deloitte & Touche LLP; KPMG LLP; and
PricewaterhouseCoopers LLP.
\42\ See for example, The 100 Group of Finance Directors; and J.
Lavon Morton.
\43\ See American Bankers Association and Biotechnology Industry
Organization.
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The Commission agrees that Auditing Standard No. 5 is sufficiently
clear about the extent to which the auditor can use the work of others.
Further, while the Commission would anticipate auditors would use the
work of others under appropriate circumstances, including when the
approach results in greater efficiency, the Commission does not believe
it is necessary or appropriate to preclude the auditor from utilizing
his or her judgment in determining whether or not to use the work of
others based on the particular facts and circumstances of the
engagement.
(6) Will AS5 reduce expected audit costs under Section 404,
particularly for smaller public companies, to result in cost-effective,
integrated audits?
A number of commenters stated their view that Auditing Standard No.
5, as approved by the PCAOB, together with the Commission's guidance
for management on assessing internal control over financial reporting,
will result in a reduction of the total Section 404 compliance
effort.\44\ Some commenters agreed that a cost reduction would occur,
but also noted that the amount of reduced effort and cost associated
with the audit of internal control over financial reporting will vary
by company depending on factors such as size, complexity, the degree of
change from year-to-year, the quality of internal control systems and
documentation, and the extent to which management appropriately applies
the Commission's interpretive guidance for management.\45\ None of the
commenters suggested that costs would increase.
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\44\ See for example, BDO Seidman, LLP; Center for Audit
Quality; Council of Institutional Investors; Deloitte & Touche LLP;
Ernst & Young LLP; KPMG LLP; New York State Society of Certified
Public Accountants; PricewaterhouseCoopers LLP; The 100 Group of
Finance Directors; and The Institute of Internal Auditors.
\45\ See for example, Accretive Solutions; BDO Seidman, LLP;
Center for Audit Quality; Deloitte & Touche LLP; Ernst & Young LLP;
Grant Thornton LLP; and PricewaterhouseCoopers LLP.
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Some of the features of Auditing Standard No. 5 that the Commission
expects will result in improved effectiveness and efficiency include
the direction provided to auditors to focus on what matters most, the
elimination of unnecessary procedures from the audit, the ability to
scale the audit to fit the size and complexity of the company, the
alignment with the Commission's interpretive guidance for management,
and its less prescriptive nature. Consequently, the Commission believes
that Section 404 compliance costs, for both management's evaluation as
well as the external audit, will decrease as a result of the
Commission's efforts and Auditing Standard No. 5.
Some commenters noted that while Auditing Standard No. 5 may
curtail excessive testing of controls and reduce some of the
unnecessary documentation currently required for Section 404 audits,
they still have concerns about the extent to which it will reduce costs
for smaller public companies.\46\ A number of commenters urged the
Commission and PCAOB to monitor
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closely the extent to which the standard as implemented achieves a
reduction in cost, and to take action if there is not an appropriate
reduction.\47\
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\46\ See for example, America's Community Bankers; David A.
Doney; Independent Community Bankers of America; National Venture
Capital Association; J Lavon Morton; R.G. Scott; XenoPort, Inc.; and
U.S. Chamber Center for Capital Markets Competitiveness.
\47\ See for example, American Bankers Association; America's
Community Bankers; Biotechnology Industry Organization; Independent
Community Bankers of America; Institute of Chartered Accountants in
England and Wales; Institute of Management Accountants; The 100
Group of Finance Directors; and U.S. Chamber Center for Capital
Markets Competitiveness.
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In response to continued concerns about the extent of cost
reductions, the Commission's staff is planning to analyze and report on
the costs associated with the implementation of the Commission's
interpretive guidance for management as well as the implementation of
Auditing Standard No. 5. The staff will make any recommendations it
believes appropriate to the Commission.
(7) Does AS5 inappropriately discourage or restrict auditors from
scaling audits, particularly for smaller public companies?
With regards to scalability, most commenters who responded to this
question noted that Auditing Standard No. 5 appropriately discusses the
concepts of scalability based on size and complexity without including
inappropriate restrictions on the auditor's ability to scale the
audit.\48\ Other commenters observed that where feasible, Auditing
Standard No. 5 should also provide additional guidance on how to
effectively plan an integrated audit for smaller public companies and a
discussion of related best practices to enhance a broader understanding
of risk-based auditing.\49\ One commenter expressed concern that an
objective definition of ``smaller company'' is necessary in order to
provide meaningful direction in scaling the audit and that the standard
should clarify that both smaller and less complex companies would be
subject to scaled audits.\50\
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\48\ See for example, BDO Seidman, LLP; Center for Audit
Quality; Council of Institutional Investors; Deloitte & Touche LLP;
Ernst & Young LLP; Grant Thornton LLP; PepsiCo;
PricewaterhouseCoopers LLP; and The Institute of Internal Auditors.
\49\ See for example, New York State Society of Certified Public
Accountants.
\50\ Biotechnology Industry Organization.
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The Commission believes that Auditing Standard No. 5 appropriately
discusses the concepts of scalability without including inappropriate
restrictions on the auditor's ability to scale the audit. Further the
Commission agrees with the guidance in Auditing Standard No. 5 that
provides for scaling and tailoring of all audits to fit the relevant
facts and circumstances. The Commission also agrees with the statement
made by the Board in its release to Auditing Standard No. 5 that
``scaling will be most effective if it is a natural extension of the
risk-based approach and applicable to all companies.'' \51\ As a
result, Auditing Standard No. 5 contains not only a separate section on
scaling the audit, but it also contains specific discussion of scaling
concepts throughout the standard. The Commission believes that these
concepts will enable tailoring of internal control audits to fit the
size and complexity of the company being audited rather than the
company's control system being made to fit the auditing standard.
Additionally, as some commenters observed, the PCAOB's project to
develop guidance and education for auditors of smaller public
companies, along with the Committee of Sponsoring Organizations of the
Treadway Commission's (``COSO'') project to develop guidance designed
to help organizations monitor the quality of their internal control
systems and other COSO guidance directed to smaller public companies,
should also facilitate the implementation of Section 404 in an
effective and efficient manner.\52\
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\51\ See PCAOB Release No. 2007-005 (May 24, 2006).
\52\ See for example, Center for Audit Quality, Deloitte &
Touche LLP; and PricewaterhouseCoopers LLP.
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In summary, the Commission believes that Auditing Standard No. 5,
the related independence rule, and the conforming amendments will
enable better integrated, more effective, and more efficient audits
while satisfying the requirements set forth in Sections 103 and 404 of
the Act. Further, the Commission notes that Auditing Standard No. 5 is
appropriately aligned with the Commission's own rules and interpretive
guidance for management.
IV. Conclusion
On the basis of the foregoing, the Commission finds that proposed
Auditing Standard No. 5, the related independence rule, and the
conforming amendments are consistent with the requirements of the Act
and the securities laws and are necessary and appropriate in the public
interest and for the protection of investors.
It is therefore ordered, pursuant to Section 107 of the Act and
Section 19(b)(2) of the Exchange Act, that proposed Auditing Standard
No. 5, An Audit of Internal Control Over Financial Reporting that is
Integrated with an Audit of Financial Statements, the Related
Independence Rule, and Conforming Amendments (File No. PCAOB-2007-02)
be and hereby are approved.
By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E7-14858 Filed 7-31-07; 8:45 am]
BILLING CODE 8010-01-P