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PCAOB Updates

 Statement on Auditing Standard Related to Communications with Audit Committees 

DATE: Aug. 15, 2012 
SPEAKER: Steven B. Harris, Board Member 
EVENT: PCAOB Open Board Meeting 
LOCATION: Washington, DC 

Mr. Chairman, I support the Board's adoption of Auditing Standard No. 16 (AS 16) and the related amendments on Communications with Audit Committees. I believe this standard will benefit investors because it strengthens the audit committee's oversight function by clarifying the types and timing of communications an auditor is required to make to the audit committee.

Justifying a New Standard

AS 16 replaces two standards that, until now, defined the relationship between auditors and the audit committee.  These standards were adopted prior to the passage of the Sarbanes-Oxley Act, when corporate management of a listed company typically hired, retained and had oversight of the work of the auditor.  In those days, the audit committee served a less prominent role, and most communications regarding the scope and specifics of the audit occurred between management and the auditing firm.

During the testimony that led to the passage of the Sarbanes-Oxley Act, Congress heard reports of clear conflicts of interest that led to financial reporting failures by, among others, corporate managements and a self-regulated auditing profession. Congress also heard reports of weak audit committees and ineffective oversight of companies' financial reporting processes. Investors and employees bore the ultimate cost of these failures in lost jobs, lost investments, lost pensions, and lost confidence in our country's securities markets.

The Sarbanes-Oxley Act addressed these conflicts and failures in a variety of ways, including strengthening audit committees by making them independent of management.

The Act requires that each company that has securities listed with a national securities exchange or association have an audit committee composed of independent directors, and that each audit committee have the authority and resources to hire any advisers necessary for the audit committee to perform the duties spelled out in the Act.

Specifically, the Act states that—

 "The audit committee…shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by the issuer…for the purpose of preparing or issuing an audit report…and each such registered accounting firm shall report directly to the audit committee."

The Act also requires audit committees to resolve disagreements between managements of listed companies and the auditors regarding financial reporting matters, and to pre-approve or disapprove all services, both audit and non-audit, provided to any issuer by the auditor. 

To ensure that audit committees have the information necessary to be the check on management and auditors envisioned by Congress, the Act requires the auditor to report various matters directly to the audit committee, including the critical accounting policies and practices to be used, all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management, and certain written communications between the registered public accounting firm and the management of the issuer.

Taken together, the provisions in the Sarbanes-Oxley Act greatly expanded the role and responsibility of audit committees and also made clear the need for timely, consistent and substantive communications between auditors and audit committees. 

The standards we will replace simply do not reflect the responsibilities and communication requirements of auditors and audit committees following the enactment of the Sarbanes-Oxley Act.  For example, they refer to communications by an auditor to an audit committee as merely "incidental" to the audit, and not required before the auditor's report is issued, while the Act makes clear that communications of matters that may pose significant risks for the company are a necessary part of an effective audit and effective audit committee oversight. 

The need for improved communications between auditors and audit committees has only grown since the Act was passed in 2002.  Given today's economic environment, it is vitally important that auditors and audit committees be fully informed about matters that may affect the assumptions, estimates, events, and conditions reflected in a company's financial reports.  The standards we are considering today are designed to assist in achieving that goal.

Investor Benefits

The ultimate beneficiaries of these standards are investors, as better informed audit committees and auditors should enhance both the quality of the audit and the audit committee's oversight of financial reporting.  Though this standard includes a number of requirements that should directly benefit investors, I would like to highlight three in particular.

First, this standard requires auditors to communicate significant unusual transactions to the audit committee on a timely basis. This includes any significant transactions outside the normal course of business for the company, including any transactions that appear to be unusual due to their timing, size, or nature. Investors will benefit because auditors will be required to explain their understanding of the business rationale for such transactions. Communication between the auditor and the audit committee will allow the audit committee to gain insight and take appropriate actions, if necessary, to address the financial statement or disclosure impact of these transactions.

Second, this standard requires the auditor to communicate to the audit committee its opinion on the company's ability to continue as a going concern. Even when the auditor's doubt about the company's ability to continue as a going concern is allayed, the proposal requires the auditor to communicate why the auditor is no longer concerned. Such communications benefit investors because they bolster the independent audit committee's role in overseeing the company's financial reporting process, and because they inform the audit committee of events and conditions that, in the auditor's view, indicate there is substantial doubt about the company's ability to continue as a going concern. 

Third, this standard requires the auditor to inform the audit committee of the auditor's plans to use other firms to perform required audit procedures. This provision is particularly important in today's business environment in which key segments of many audits are conducted in isolated locations around the world. The audit committee should know, for example, which auditing firm is conducting required audit procedures in China, other Asian countries, South America, or any other location.  Knowing that another firm is performing that work may lead to additional questions from the audit committee about the quality of the work performed and, possibly, whether that firm's work has been inspected by the PCAOB.

Finally, this standard encourages robust, two-way communications between the auditor and audit committee which should improve the quality and integrity of the audit. I agree with the view expressed by the International Corporate Governance Network (ICGN) in its comment letter on the proposed standard, which stated,

"We believe both the auditor and the audit committee should be free to raise any matter each deems important. This then would lead to the full and frank discussions the investor community is seeking in the relationship."

As the Board made clear recently in its release titled "Information for Audit Committees about the PCAOB Inspection Process," any "full and frank" discussion between auditors and audit committees should also include a review of the firms' PCAOB inspection reports. Those inspection reports, combined with the new communications required by this standard, should further enhance the role of the independent audit committee, and thereby benefit investors. 

Cost vs. Benefit

As I have said, I believe this standard updates and improves the prior standard and will benefit investors.  But the Board's analysis obviously cannot stop there. The remaining question is—at what cost?

I believe that the costs associated with this standard are likely to be minimal because this standard focuses on communicating the results of audit procedures that the auditor is already required to perform. In addition, the communications under this standard can be scaled up or down to fit the size and complexity of the company being audited. The standard also contains a list of auditor communication requirements in other PCAOB standards, which should make finding those requirements easier. And the standard provides the auditor with the flexibility to communicate orally or in writing so the auditor can determine the most efficient way to discuss an issue with the audit committee.

The value to investors of this improved two-way dialogue, while not easily quantifiable, seems clear. An informed audit committee will be in a much better position to execute its responsibilities to oversee the financial reporting process, more effectively manage the auditor relationship, and enhance investor protection by helping to ensure the integrity of the financial statements.  In addition, a better informed auditor should perform a more effective audit.

Before closing I would like to state that, as a general proposition, I believe that carefully targeted regulation is key to effectively balancing the costs of improving audit quality with the benefits of protecting investors. With this in mind, I believe we must continue to work to explicitly design our standards to address clearly defined problems and, to the extent possible, make them shorter and less complex, while always keeping in mind their economic implications. I believe that AS No. 16 is a step in the right direction.

Closing

Finally I would like to recognize the extraordinary effort of all of the staff who worked on this standard: Jennifer Rand, Jessica Watts, Hasnat Ahmad and Karen Burgess under the direction of our Chief Auditor, Marty Baumann; our General Counsel, Gordon Seymour, and his colleagues, Bob Burns, Nina Mojiri-Azad, and Vince Meehan; and our Chief Economist, Andres Vinelli, and Deputy Chief Economist, Jana Hranaiova.