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Auditing Standard No. 4 

Reporting on Whether a Previously Reported Material Weakness Continues to Exist

APPENDIX B

Background and Basis for Conclusions

Introduction

B1.      This appendix summarizes factors that the Public Company Accounting Oversight Board (the "Board") deemed significant in reaching the conclusions in the standard.  This appendix includes reasons for accepting certain views and not accepting others.

Background

B2.      Section 404 of the Sarbanes-Oxley Act of 2002 (the "Act") requires the management of public companies each year to file an assessment of the effectiveness of their companies' internal control over financial reporting.  The company's independent auditor must attest to, and report on, management's assessment.  Under the Securities and Exchange Commission's (the "SEC" or "Commission") implementing rules, company management may not conclude that internal control over financial reporting is effective if one or more material weaknesses exists. 

B3.      When a company reports a material weakness, investors may be left uncertain about the reliability of the company's financial reporting.  Both companies and report users have recognized the importance of a mechanism for alerting investors that a previously disclosed material weakness no longer exists. 1/  The federal securities laws provide part of that mechanism.  Those laws require the company to disclose to investors any changes in internal control over financial reporting that occurred during the company's most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the company's internal control over financial reporting. 2/ Therefore, investors will learn of material improvements, such as the remediation of a material weakness, on a timely basis through quarterly disclosures. 3/

B4.      When a company determines that a material weakness has been remediated, it may determine that disclosure is sufficient.  Some investors and companies, however, have called for the ability to bolster confidence in management's assertions about those internal control improvements with the added assurance of the company's independent auditor. 4/ 

B5.      The Board reviewed its existing auditing and attestation standards to determine whether adequate standards governing such an engagement already existed.  The Board's interim attestation standards provide requirements for general attest engagements; however, the Board determined that these standards lack sufficient specificity for this purpose. 5/  The Board, therefore, proposed an auditing standard that would be tailored narrowly to an engagement to report on whether a previously reported material weakness continues to exist.

B6.      The Board received 30 comment letters on its proposal, primarily from auditor and investor groups as well as from two issuers.  Those comments led to changes in the standard, intended to make the requirements of the standard clearer and more operational.  This appendix summarizes significant views expressed in those comment letters and the Board's responses. 

Voluntary Nature of Engagement

B7.      The proposed standard explicitly stated that the engagement described by this standard is voluntary and that the standards of the PCAOB did not require an auditor to undertake this engagement when a material weakness was previously reported.  In addition, the Board stressed the voluntary nature of this engagement at the public meeting proposing this standard.

B8.      The value and importance of the Board's standards providing the option of this type of auditor reporting on a material weakness was confirmed unanimously in the comment letters from investors and investor-related parties.  Auditors were also supportive of the standard overall and its voluntary nature.  Both of the issuers who commented indicated that they would be concerned if issuers become compelled to obtain such opinions.  One of these commenters stressed that the disclosure requirements of management, coupled with enhanced criminal penalties, should provide investors with information regarding the continued existence or correction of a material weakness.

B9.      The Board continues to believe that providing for this type of auditor reporting in its standards will serve the public interest.  At the same time, the Board reaffirms that reporting on whether a material weakness continues to exist is a voluntary engagement and is not required by the standards of the PCAOB.  

Form of the Auditor's Opinion

B10.    The proposed standard called for the auditor to express a single opinion directly on the subject matter (i.e., the material weakness itself), rather than on management's assertion, as follows:

In our opinion, XYZ Company has eliminated the material weakness described above as of [ date of management's assertion ] because the stated control objective is met as of [ date of management's assertion ].

B11.    Primarily auditors commented on the form of the opinion in the proposed standard and their comments reflected a wide spectrum of ideas.  Some commenters expressed support for the auditor's report, including the form of the opinion as proposed.  Other comments included a suggestion for two opinions, consistent with Auditing Standard No. 2-one on the subject matter (the elimination of the material weakness) and one on management's assertion.  Other commenters suggested that just one opinion was sufficient, though these commenters were split regarding whether the one opinion should be on management's assertion or on the subject matter.  Other commenters suggested that an opinion stating that the material weakness had been eliminated, without the phrase "because the stated control objective is met" would be a better alternative, while others asked the Board to consider an opinion stating that the identified controls were effective because the stated control objective was met, without stating that the material weakness had been eliminated.

B12.    A number of commenters expressed concern with the phrasing "the material weakness has been eliminated," including the use of that phrase in the auditor's opinion and in the title of the proposed standard.  These commenters believed that terminology such as "elimination" or "eliminated" might be too definite a term that might mislead report users into believing that there were no remaining deficiencies in the internal control over financial reporting in the area related to the specified material weakness, even though control deficiencies of a lesser severity than a material weakness might persist. 

B13.    After considering these suggestions, the Board decided to retain a single opinion on the subject matter and to revise the opinion wording.  The Board continues to believe that a single opinion expressed directly on the subject matter is the simplest and clearest form of communication related to this engagement.  Further, the Board believes that an auditor's opinion directly on the subject matter (i.e., the material weakness itself) will best achieve the overarching objective of this engagement-to clearly communicate as of an interim date auditor assurance about whether a previously reported material weakness continues to exist.

B14.    The Board agreed with commenters that use of the term "elimination" might increase the risk that a report user would misunderstand the assurance provided by an auditor's opinion on a previously reported material weakness.  As a result, the Board changed the form of the opinion to "In our opinion, the material weakness described above no longer exists as of [date of management's assertion]" and the title of the standard to "Reporting on Whether a Previously Reported Material Weakness Continues to Exist."  The text of the standard was modified throughout to delete references to "eliminated" or "elimination" and to reflect wording consistent with the revised opinion and title.

As-of Date of Report

B15.    The proposed standard provided for significant flexibility by allowing the engagement to be undertaken at any time during the year, limited only by implications associated with the nature of the material weakness.  In other words, the proposed standard did not require the engagement to be performed in conjunction with an audit or review of financial statements.  Instead, the proposed standard required the auditor to determine whether management had selected an appropriate date for its assertion and specified several matters for the auditor to consider in making this determination. 

B16.    A number of auditors suggested that the engagement described by the proposed standard should be performed only as of quarterly financial reporting dates instead of as of any date during the year.  These commenters believed that such a requirement would allow the auditor to integrate this work with the auditor's interim review procedures under AU sec. 722, Interim Financial Information, and provide a link between the auditor's report on the material weakness and management's quarterly disclosures of material changes in internal control.  Commenters noted that many of the material weaknesses that have been disclosed to date are related to the period-end financial reporting process and that the auditor would therefore need to test controls in connection with a period-end to determine whether the material weakness continues to exist.  Several commenters linked their suggestion that this engagement be performed only as of a quarterly financial reporting date to the view that the standard's direction on performing substantive procedures as part of this engagement should be bolstered (see separate discussion on performance of substantive procedures beginning at paragraph B51).  One commenter pointed out, however, that if this engagement could be conducted only in connection with a quarterly financial reporting date, special guidance for applying the standard to foreign filers would be necessary because foreign filers are not required to report quarterly in the same manner as domestic filers. 

B17.    The Board believes that the flexibility provided in the proposed standard regarding the timing of the engagement is an important and appropriate feature of the standard.  Although the Board agrees with commenters' observations that many of the material weaknesses disclosed during the past year were related to the period-end financial reporting process, the Board determined that the existing provisions of the proposed standard address this circumstance.  In determining whether management has selected an appropriate date for its assessment, the standard requires the auditor to consider that controls that operate over the company's period-end financial reporting process typically can be tested only in connection with a period-end. 

B18.    Moreover, some material weaknesses-such as those that involve transaction-based controls that operate daily-are well suited for a management assertion and an auditor opinion that the material weakness no longer exists as of almost any date.  Restricting an auditor's reporting on whether a material weakness continues to exist to only quarterly financial reporting dates could impose unnecessary delay on a company seeking auditor assurance that this type of material weakness no longer exists.  For example, assume that a calendar year-end company had previously disclosed a material weakness that was the type that would lend itself well to reporting that it no longer existed as of any date.  Further, management could not yet assert that the material weakness no longer existed as of March 31, but believed that it could make the assertion as of a date in April.  If the standard restricted auditor reporting to a quarterly financial reporting date, the auditor would have to wait until June 30 to be able to attest to whether the material weakness continued to exist (and, presumably, would not be able to issue his or her report until July, at the earliest).  While management could, in this example, provide timely disclosure to investors that the material weakness no longer existed, the Board concluded that structuring the provisions of the standard to potentially result in this kind of delay in auditor assurance would not serve the public interest. 

B19.    In light of these considerations, the Board decided to retain the provisions of the proposed standard that would permit the auditor to report on whether a previously reported material weakness continues to exist as of any date. 

B20.    At least one auditor asked for clarification about whether a report issued pursuant to Auditing Standard No. 2 that identified a material weakness could be issued at the same time as a report pursuant to this standard indicating that the material weakness no longer exists as of a later date.  The degree of flexibility regarding the timing of this engagement would permit the company (depending on the company's ability to assert that a material weakness no longer exists and the auditor's ability to timely audit that assertion) to simultaneously distribute its annual reports and the management assertion and auditor report described in this standard.  Consistent with this flexible approach, nothing in this standard or Auditing Standard No. 2 would preclude the auditor from issuing a single, combined report on the results of an audit of internal control over financial reporting pursuant to Auditing Standard No. 2 and the results of an engagement performed pursuant to this standard. 

Applicability of the Standard to Material Weaknesses Not Previously Reported

B21.    The proposed standard was structured to allow an auditor to report only on a previously reported material weakness.  The proposed standard defined a previously reported material weakness as a material weakness that was previously described by an auditor's report issued pursuant to Auditing Standard No. 2.  A material weakness initially identified after the company's annual assessment date could not, therefore, be the subject of an auditor's report under the proposed standard.

B22.    Virtually all of the investors who submitted comment letters suggested that the standard should allow for auditor reporting on material weaknesses identified subsequent to the company's most recent annual assessment of internal control over financial reporting.  Although some of these commenters expressed concern about the level of work that might be required of the auditor to thoroughly understand a material weakness not previously reported upon by an auditor, they did not believe that the standard should prohibit such reporting.  One commenter stated that if a successor auditor could gain an understanding of a company's internal control sufficient to report on a material weakness that was identified and reported on by a predecessor auditor, an auditor should be able to gain the understanding necessary to report on a material weakness identified by management as of an interim date.

B23.    The majority of the auditors who commented indicated strong opposition to allowing auditors to report in this engagement on material weaknesses not previously reported.  These commenters suggested that the initial identification of a material weakness requires a level of understanding of the company's controls and the specific facts and circumstances surrounding the material weakness that can result only from a complete evaluation of the effectiveness of internal control over financial reporting.  Additionally, at least one commenter expressed concern that the identification of a material weakness subsequent to the annual assessment is a strong indicator of a material change within the company's internal control over financial reporting.  This commenter believed that in such a circumstance the auditor would not have sufficient knowledge of the current state of internal control over financial reporting to be able to consider the interaction and potential implications of the change on other controls.  This commenter also believed that this situation would prevent the auditor, in most cases, from being able to determine whether the newly identified material weakness no longer exists. 

B24.    The Board decided to retain the approach described by the proposed standard.  The Board believes that the issue of a newly identified material weakness being an indicator of a material change within a company's internal control over financial reporting is a valid concern.  Although the change in internal control over financial reporting giving rise to any new material weakness may be confined specifically to the area in which the material weakness originally was identified, the change also could be more far-reaching.  In such circumstances, the auditor may not be able to determine the effect of the change without performing a full audit of internal control over financial reporting.

B25.    The Board also notes that there is an important distinction between material weaknesses previously identified in an auditor's report issued pursuant to Auditing Standard No. 2 and other newly identified material weaknesses.  The primary purpose of the narrow engagement described by this standard is to establish a timely and reasonable mechanism that a company can use to remove any perceived "stain" upon its financial reporting due to an outstanding adverse audit opinion on internal control over financial reporting that identified a material weakness.  In the case of a new material weakness that is identified and addressed by management as of an interim date, an adverse auditor opinion previously attesting to the material weakness would not exist and, therefore, the new material weakness would not be the subject of the same type of market focus.

B26.    There is also a fundamental difference between the auditor reporting on a material weakness not previously reported and a successor auditor reporting on a material weakness that was reported in a predecessor auditor's opinion on internal control over financial reporting.  The fundamental difference is the concept of material change described above.  The successor auditor must obtain a sufficient understanding of the company's internal control over financial reporting to report on the existence of a material weakness that was previously reported.  This successor auditor, however, has the benefit of knowing that the material weakness was identified in the context of an audit of the internal control over financial reporting as a whole and that the predecessor auditor should have adequately described the nature of the material weakness (particularly its pervasiveness and the extent of its effect on the company's financial reporting).  In contrast, in situations in which a material change has taken place and a new material weakness has arisen after the previous annual assessment of internal control over financial reporting, neither the predecessor nor the successor auditor has obtained this level of understanding as it relates to the newly identified material weakness.

B27.    These considerations, taken together, resulted in the Board's decision to retain the provisions of the proposed standard that limit this engagement only to material weaknesses that have been previously described in an auditor's report issued pursuant to Auditing Standard No. 2.  The Board also made changes to the standard, as suggested by one commenter, to make these provisions clearer.  These changes included changing the title of the standard to "Reporting on Whether a Previously Reported Material Weakness Continues to Exist" as well as conforming changes to the text of the standard to refer explicitly to a previously reported material weakness as the subject matter of this engagement. 

Focus on Control Objectives

B28.    The proposed standard focused on stated control objectives to determine whether a material weakness continues to exist and posited that if a material weakness has been disclosed previously, a necessary control objective at the company has not been achieved.  Because the term "stated control objective" was not precisely defined elsewhere in the Board's auditing standards, the proposed standard provided a definition as well as examples of stated control objectives.

B29.    A stated control objective in the context of this engagement is the specific control objective identified by management that, if achieved, would result in the material weakness no longer existing.  The stated control objective would provide management and the auditor with a specific target against which to evaluate whether the material weakness continues to exist.  For this reason, the proposed standard required that management and the auditor be satisfied that if the stated control objective were achieved the material weakness would no longer exist. 

B30.    Comments on the proposed standard's focus on control objectives came primarily from auditors.  Many auditors, either explicitly or implicitly, supported the focus on control objectives.  One auditor suggested that, given the importance of control objectives, the proposed standard should explicitly state that documentation of control objectives is required. 

B31.    Several auditors, however, expressed concerns about the proposed standard's focus on control objectives.  A couple of these commenters suggested that the proposed standard's emphasis on control objectives might inappropriately establish a framework for evaluating the effectiveness of internal control over financial reporting that differs from, or otherwise adversely affects the proper application of, the Committee of Sponsoring Organizations of the Treadway Commission's publication Internal Control - Integrated Framework ("COSO"). 

B32.    Most concerned commenters expressed apprehension that report users might be misled by an auditor's opinion that a material weakness had been eliminated because the control objectives had been met.  They believed that this type of opinion might lead report users to mistakenly believe that if the control objectives were met, there were no remaining deficiencies in the internal control over financial reporting in the area related to the material weakness-when, in fact, a significant deficiency or deficiency could continue to exist. 

B33.    Another commenter noted that the examples in the proposed standard illustrated only control objectives for the control activities component of internal control over financial reporting-not for the other components (control environment, risk assessment, monitoring, information and communication).  This commenter suggested that examples of control objectives in the other components would be helpful.  Another commenter suggested that, given the importance of the control objective concept, if the Board's standards were to specifically address the concept, such a definition and discussion should reside in Auditing Standard No. 2.  One concerned auditor concluded that, given the importance of control objectives, more guidance was needed, including clarification that if more than one control is necessary to achieve a stated control objective, all such controls must be identified and tested as part of this engagement. 

B34.    In response to comments, the Board decided to retain the definition of, and focus on, control objectives and provide additional guidance.  The Board views the auditor's use of the concept of control objectives as analogous to the use of the concept of relevant assertions.  The concept of relevant assertions was already familiar to experienced auditors and was specifically defined for the first time in Auditing Standard No. 2 because of that standard's focus on testing controls over all relevant assertions related to all significant accounts.  Similarly, the concept of control objectives is familiar to most experienced auditors and is already used to describe the auditor's responsibilities under Auditing Standard No. 2). 6/ A definition of control objectives (and stated control objectives) is provided in this standard because of the standard's focus on control objectives as a specific measure for determining whether a material weakness continues to exist.  This is consistent with the Board's objective for its standards to be clear as well as the focus on control objectives in the engagement described by this standard.

B35.    The Board believes that the standard's focus on control objectives is sound and helpful and is an appropriate complement to the control criteria, such as COSO, for the purposes of this engagement.  The process of tailoring control objectives to the individual company allows the control criteria (i.e., the evaluation framework) used for management's annual assessment to be applied to the facts and circumstances in a reasonable and appropriate manner.  Accordingly, the emphasis in this standard on control objectives is consistent with, and supports a correct application of, COSO.

B36.    The focus on whether the stated control objectives have been met as the target for determining whether a material weakness continues to exist does accommodate the circumstance in which a deficiency or significant deficiency continues to exist in that area of the company's internal control over financial reporting.  Although several commenters linked this result with the focus on control objectives, this potential result would exist in any case within the overall construct of this standard, completely apart from the focus on control objectives.  The potential for less severe deficiencies to persist in an area in which a previously reported material weakness no longer exists parallels the reporting results of an engagement performed under Auditing Standard No. 2.  According to that standard, only material weaknesses (not less severe weaknesses) are disclosed in an auditor's report and only the existence of a material weakness and not less severe weaknesses affects the auditor's opinion on the effectiveness of the company's internal control over financial reporting.  As an illustration, assume that a company that had previously reported a material weakness in internal control over financial reporting elected to wait until the auditor's next annual report issued pursuant to Auditing Standard No. 2 to obtain auditor assurance related to the existence of the material weakness.  If the control weakness that had previously risen to the level of material weakness were reduced to a significant deficiency or deficiency as of the company's next year-end, the auditor's next report issued under Auditing Standard No. 2 would present an unqualified opinion indicating that the company's internal control over financial reporting was effective.  The Board concluded that the users of an auditor's report on whether a previously reported material weakness continues to exist need only receive auditor assurance that the material weakness no longer exists and not more detailed information about whether less severe control deficiencies continue to persist. 

B37.    The Board notes, however, that paragraph 140 of Auditing Standard No. 2 states (in part) that strong indicators of a material weakness include circumstances in which significant deficiencies that have been communicated to management and the audit committee remain uncorrected after some reasonable period of time.  If management does not plan to correct the significant deficiency within a reasonable period of time, the auditor should evaluate whether the remaining significant deficiency could be indicative of a material weakness in internal control over financial reporting.  An auditor is not required to provide an opinion under this voluntary engagement, and could reasonably decline to provide an opinion under such circumstances. 

B38.    In response to comments that report users will mistakenly believe that an auditor's report issued pursuant to the standard's provisions is communicating auditor assurance that no control deficiencies exist in the area related to the former material weakness, the Board decided that the change in the title of the standard and the form of the auditor's opinion (discussed further in paragraph B14), coupled with this discussion, would sufficiently mitigate any potential for report users to misunderstand the assurance being provided by an engagement conducted under the this standard.  Removing the concept of control objectives from the standard would not address the potential for misunderstanding because this potential exists independently of the focus on control objectives. 

B39.    With regard to the recommendation that the standard provide additional examples of stated control objectives, including stated control objectives related to components of internal control over financial reporting other than control activities, the Board determined that the provisions of the standard should remain largely at the conceptual level and state that the other components of internal control over financial reporting can be expressed in terms of control objectives.  The Board also determined to emphasize, in the note to paragraph 17 of the standard, that when a material weakness has a pervasive effect on the company's internal control over financial reporting, it may be difficult to identify all of the relevant control objectives and the material weakness probably is not suitable for this type of narrow, interim reporting.

B40.    For the purposes of this engagement, a stated control objective need not be more precise than to describe an objective that relates to whether there is a more than remote risk that the company's financial statements are materially misstated in a given area.  For instance, paragraph 14 of the standard includes the example control objective, "The company has legal title to recorded product X inventory in the company's Dallas, TX warehouse."  This example assumes that the product X inventory account related to the company's Dallas, TX warehouse represents a more than remote risk of material misstatement to the company's financial statements taken as a whole and has been identified as a separate significant account.  This example does not suggest that a company should establish separate control objectives for all of its various types of inventory, by inventory location, regardless of materiality.

B41.    Although the Board believes that the proposed standard made clear that in performing this engagement, the auditor should identify and test all controls necessary to achieve the stated control objective, based on the importance of this concept and in response to commenters, the Board concluded that an explicit clarification should be added.  Not only must newly implemented or modified controls be identified and tested in this engagement, but all controls necessary to achieve the stated control objective must be identified and tested.  For example, in a circumstance in which four controls must operate effectively for a given control objective to be achieved, the failure of one of those controls could result in a material weakness.  In the context of this engagement, all four controls necessary to achieve the stated control objective would need to be specifically identified and tested.  This must be the case because of the inherent limitations in internal control over financial reporting.  If three of the four controls were found to be effective as of year-end, they cannot be assumed to be effective as of a later date.  To render an opinion as of a current date about whether the material weakness exists, the auditor must have current evidence about whether all controls (in this example, all four controls) necessary to achieve the control objective are designed and operating effectively.

B42.    Regarding the suggestion to include a requirement that control objectives be documented, the Board notes that neither COSO nor Auditing Standard No. 2 currently contain such a requirement.  As with many aspects of assessing the effectiveness of internal control over financial reporting, the better the documentation, the easier and more efficient the evaluation, especially from the auditor's perspective.  In the context of this engagement, by virtue of creating a stated control objective, the company and the auditor would document the stated control objective, even if that documentation appeared only in their respective reports.  Therefore, documentation is effectively required for the stated control objectives encompassed by an engagement conducted under this standard.  The Board does not believe, however, that establishing a broad requirement for documenting all control objectives related to a company's internal control over financial reporting is needed at this time or would be appropriately placed within this standard.  

Concept of Materiality

B43.    To provide direction on the concept of materiality, the proposed standard largely referred to Auditing Standard No. 2.  The proposed standard stated that the concept of materiality, as discussed in paragraphs 22 and 23 of Auditing Standard No. 2, underlies the application of the general and fieldwork standards in an engagement to report on whether a previously reported material weakness continues to exist.  Therefore, the auditor uses materiality at the financial-statement level, rather than at the individual account-balance level, in evaluating whether a material weakness exists.

B44.    Several auditors commented that the proposed standard should provide additional direction on how the auditor considers materiality in performing this engagement.  Commenters believed that clarification was necessary regarding the appropriate time context for management's and the auditor's materiality judgments.  These commenters asked whether materiality should be assessed as of the date management asserts to be the date at which the material weakness no longer exists, or as of the end of the prior year when the material weakness was originally reported. 

B45.    Most commenters on this issue suggested that the date for assessing materiality should be the date management asserts to be the date at which the material weakness no longer exists.  Commenters noted, however, that this position would allow a material weakness to no longer exist merely as a result of a business acquisition or disposition, for example, because either of those actions would change materiality as of that point in time (and, in the case of a disposition, send the material weakness along with the disposed business). 

B46.    Several auditors suggested that the auditor's opinion should explicitly recognize the concept of materiality.  Commenters suggested the following as alternatives that would recognize materiality:  "Management's assertion that XYZ Company has eliminated the material weakness described above as of [ date of management's assertion ] is fairly stated, in all material respects . . ." and "XYZ Company has eliminated the material weakness with respect to the Company's internal control over financial reporting as described above as of [ date specified in management's assertion ], in all material respects."  These commenters were concerned that the opinion described by the proposed standard misrepresented the precision of the auditor's assessment and neglected the notion of reasonable assurance.

B47.    The Board decided that the provisions in the standard regarding materiality should be clarified to specify that materiality should be assessed as of the date management asserts that the material weakness no longer exists.  The as-of date of management's assertion and the auditor's opinion is fundamental to the auditor's decisions about whether he or she has obtained sufficient evidence to support an opinion and to the auditor's evaluation of that evidence to form an opinion on whether the material weakness exists as of that point in time.  The Board believes that the logical and internally consistent position regarding the time context for assessing materiality is to assess materiality as of the date that management asserts the material weakness no longer exists.  The Board also believes that materiality can be assessed as of a date other than a financial reporting period-end.  This is consistent with the Board's decision, discussed further beginning at paragraph B15, that the standard permit the auditor to report on whether a previously reported material weakness continues to exist as of any date.

B48.    The Board also believes that auditors should exercise caution in circumstances in which the only aspect of a previously reported material weakness that has changed is materiality (in other words, the size of the financial statement accounts has changed due to an acquisition or other activity rather than any changes in the design or operation of controls).  In many such cases, the company will have undergone significant changes, with an associated change in internal control over financial reporting overall.  In this circumstance, the auditor would need to perform procedures beyond the scope of work ordinarily contemplated under this standard to have a sufficient basis for his or her new assessment of materiality and an adequate understanding of the company's internal control over financial reporting overall.  The Board believes that, in many cases in which the company has undergone a change of this magnitude, the auditor would need to perform a full audit of internal control over financial reporting in accordance with Auditing Standard No. 2 to have a sufficient basis for assessing materiality, understanding the company's internal control over financial reporting overall, and rendering an opinion about whether a material weakness continues to exist.  Also, as discussed in paragraph B37, a previously reported material weakness may no longer exist because it has been reduced to a significant deficiency.  In this circumstance, if management does not plan to correct the significant deficiency within a reasonable period of time, the auditor should evaluate whether the remaining significant deficiency could be indicative of a material weakness. 

B49.    Regarding the form of the auditor's opinion and concerns that the opinion suggested by the proposed standard implied an inappropriate degree of precision and neglected the concept of reasonable assurance, the Board concluded that the provisions of the proposed standard were sufficiently clear that the auditor's objective in this engagement was to plan and perform the engagement to obtain reasonable assurance about whether a previously reported material weakness continues to exist as of the date specified by management.  Furthermore, the auditor's report described by the proposed standard included disclosure of this objective.  The Board does not, therefore, believe that report users would mistakenly believe that the auditor's opinion, as proposed, would convey absolute assurance. 

B50.    In addition, the Board believes that including another reference to materiality in the auditor's opinion would not add anything of substance to the auditor's conclusion and could instead impair its readability.  The determination of whether a material weakness exists is inherently linked to materiality.  Stating that the material weakness no longer exists in all material respects would be redundant-the equivalent of saying that the financial statements are not materially misstated in all material respects.  Accordingly, the Board has not added another reference to materiality in the auditor's opinion.

Performance of Substantive Procedures

B51.    The proposed standard, consistent with its reliance on the existing provisions of Auditing Standard No. 2, focused largely on the tests of controls that the auditor must perform to obtain reasonable assurance that a material weakness no longer exists.  The proposed standard additionally recognized that, in some cases, the auditor also would need to perform substantive procedures on account balances to obtain sufficient evidence as to whether a material weakness no longer exists.

B52.    Several auditors believed that the proposed standard was too mild in its wording that the auditor "may determine" that performing substantive procedures was necessary.  Those commenters believed that, to be consistent with the integrated audit concept of Auditing Standard No. 2 and to reflect the fact that identification of many material weaknesses during the past year occurred during the performance of substantive audit procedures, such wording did not adequately convey the importance of performing substantive procedures in an engagement to report on whether a previously reported material weakness continues to exist.  Some commenters recommended that the standard set forth a presumptively mandatory requirement for the auditor to perform substantive audit procedures in all cases, while others suggested that strengthening the language or providing additional guidance about when substantive procedures are necessary would be sufficient.

B53.    The Board continues to believe that in some circumstances, substantive procedures will not be necessary for the auditor to obtain sufficient evidence about whether a material weakness continues to exist.  Like many aspects of this standard, the auditor's judgment in this area will depend on the nature of the material weakness.  An auditor can obtain sufficient evidence to support an opinion on whether some material weaknesses continue to exist without the need for substantive procedures.  Other material weaknesses necessitate substantive procedures for the auditor to obtain sufficient evidence.  Therefore, the Board determined that it would be inappropriate to establish a presumptively mandatory requirement that substantive procedures be performed in all cases. 

B54.    The Board agreed, however, that the proposed standard did not sufficiently stress the potential importance of performing substantive procedures, depending on the nature of the material weakness.  Paragraph 34 of the standard has, therefore, been modified in a manner that the Board believes better articulates the potential need to perform substantive procedures.  An example also has been added to this paragraph of the standard to illustrate a circumstance in which substantive procedures ordinarily would need to be performed. 

Using the Work of Others

B55.    Similar to PCAOB Auditing Standard No. 2, the proposed standard permitted the auditor to use the work of others to alter the nature, timing, and extent of the auditor's performance of this work.  Specifically, the proposed standard applied the framework for using the work of others described in PCAOB Auditing Standard No. 2.  That framework requires the auditor to obtain the principal evidence supporting his or her opinion and to evaluate the nature of the controls being tested, together with the competence and objectivity of the persons performing the work. 

B56.    Under both PCAOB Auditing Standard No. 2 and the proposed standard, the framework measures principal evidence in relation to the overall assurance provided by the auditor.  In PCAOB Auditing Standard No. 2, the principal evidence supporting the auditor's opinion should be evaluated in relation to the auditor's opinion on internal control over financial reporting overall.  In contrast, the evaluation of whether the auditor has obtained the principal evidence supporting his or her opinion as to whether a material weakness no longer exists would need to be applied at the control objective level.

B57.    There were few comments on the provisions for using the work of others in this proposed standard.  Most commenters who commented on these provisions expressed confusion about a passage in the example of proposed paragraph 36, which stated that "the auditor might perform a walkthrough of the reconciliation process himself or herself [emphasis added]."  Commenters believed that walkthroughs were required in the proposed standard in all cases and that walkthroughs must be conducted by the auditor himself or herself. 

B58.    One auditor suggested clarifying within the proposed standard that the auditor will be able to use the work of others only in limited circumstances.  This same commenter also believed that the bank reconciliation example presented in the proposed standard to illustrate how the auditor could use the work of others in this type of engagement was too simplistic and requested additional, more realistic examples.

B59.    The Board continues to believe that the framework for using the work of others that was established in Auditing Standard No. 2 is appropriate for use in this context and, therefore, the provisions for using the work of others in the standard have been retained as proposed.  At the same time, the Board determined that it would be helpful to clarify, through the following discussion, that the evaluation of whether the auditor has obtained the principal evidence supporting his or her opinion on whether a material weakness continues to exist would need to be applied at the control objective level.  A complete understanding of this feature of the standard is important because this provision allows for additional flexibility in the auditor's work.

B60.    The auditor's opinion in this engagement is expressed only on whether the material weakness continues to exist-not on whether the individually identified controls are effective.  As a result, the evaluation as to whether the auditor has obtained the principal evidence supporting his or her opinion should be made at the control objective level-not at the lower level of the controls individually identified in management's assertion and the auditor's report.  

B61.    If, for example, management's and the auditor's reports identify three separate previously reported material weaknesses that no longer exist, the auditor would, in effect, be rendering three separate opinions.  Those opinions would indicate that each of the three individual material weaknesses continues to exist or no longer exists as of the date of management's assertion.  The standard, therefore, would require the auditor to obtain the principal evidence that the control objectives related to each of the three identified material weaknesses were now achieved.  However, the standard would not require that the auditor obtain the principal evidence that each control specifically identified in management's assertion as achieving the control objectives is effective.

B62.    Auditing Standard No. 4 follows the same framework for using the work of others as Auditing Standard No. 2.  There may, however, be some circumstances in which the scope of the audit procedures to be performed in this engagement will be so limited that using the work of others will not provide any tangible benefit to the company or its auditor.  The Board believes that no additional specific restriction on the use of the work of others is appropriate or necessary in the context of this engagement.  Such a restriction would diminish the flexibility that the framework otherwise provides and perhaps inhibit the auditor's exercise of the judgment necessary to implement the framework appropriately.  Furthermore, the Board does not believe that auditors need such direction within the standard to make appropriate decisions about using the work of others in this context.

B63.    Similarly, the Board determined that no further examples of using the work of others were needed.  The Board believes that additional examples demonstrating the application of the provisions in the standard for using the work of others to reflect more realistic (i.e., complex, fact-driven) situations is better handled outside of the standard itself and by auditors-in their audit methodology, training courses, and other venues.

B64.    In response to confusion about the requirement for walkthroughs, the Board clarified the standard by adding a note to paragraph 38 and deleted the reference to a walkthrough from the example on using the work of others.  Walkthroughs are required only of a successor auditor when the successor auditor performs this engagement before performing an audit of internal control over financial reporting in accordance with Auditing Standard No. 2.  A continuing auditor that has opined already on the company's internal control over financial reporting in accordance with Auditing Standard No. 2 as of the company's most recent annual assessment and is engaged to conduct this narrow engagement is not required to perform any walkthroughs as part of this engagement. 

Dividing Responsibility

B65.    Due to the narrow scope of an engagement to report on whether a material weakness continues to exist, the provisions of the proposed standard allowed the principal auditor to use the work and reports of another auditor as a basis, in part, for his or her opinion.  The proposed standard also prohibited the principal auditor from dividing responsibility for the engagement with another auditor.

B66.    Very few comments were received on this provision of the proposed standard.  One auditor suggested that, although dividing responsibility may not be appropriate in certain circumstances, the standard should not prohibit it.  Another auditor expressed confusion about whether the principal auditor could refer to the report of the other auditor but not divide responsibility with the other auditor.

B67.    The Board continues to believe that, based on the nature of the engagement described by the standard, the principal auditor should be prohibited from dividing responsibility for the engagement with another auditor.  The Board's consideration of the nature of this engagement included recognition of the narrow scope of the work (i.e., whether a previously reported material weakness continues to exist), that the engagement would be voluntary, and that the assignment would be non-recurring (unlike the recurring nature of the audit of the financial statements or the audit of internal control over financial reporting).  The Board notes that three appropriate alternatives exist in the circumstance in which another auditor is involved and the company wants to obtain auditor assurance that a previously reported material weakness no longer exists:

  • The principal auditor could report on whether a previously reported material weakness continues to exist according to this standard by performing all of the testing required for this engagement himself or herself.
  • The principal auditor could report on whether a previously reported material weakness continues to exist according to this standard by using the work and reports of another auditor as a basis, in part, for his or her opinion, and by taking responsibility for the work performed by the other auditor.  In this case, the auditor may not make reference to the other auditor in his or her report on whether a previously reported material weakness continues to exist.
  • The company could wait until year-end when the principal auditor would report on the effectiveness of internal control over financial reporting overall under the provisions of Auditing Standard No. 2.

B68.    The Board concluded that the standard was sufficiently clear that the principal auditor could not divide responsibility with another auditor and, therefore, that the auditor also could not refer to the other auditor in his or her report.  Accordingly, no change has been made to the standard in this regard.

New Material Weaknesses Identified

B69.    The proposed standard was silent regarding the auditor's responsibilities if, during the performance of this engagement, he or she became aware of a new material weakness not previously reported on by an auditor.

B70.    Several commenters requested that the standard address the auditor's responsibilities for new material weaknesses identified during this engagement and suggested what these responsibilities should be.  One investor suggested that the standard should require the auditor to include disclosure of any new material weaknesses of which the auditor was aware in his or her report.  This commenter stated that, otherwise, the auditor's report would become a way of telling investors the good news while concealing the bad news.  Another commenter suggested that management should be required to include the new material weakness in management's assertion that would accompany the auditor's report and the auditor should then disclaim an opinion on the new material weakness. 

B71.    Both the identification of material weaknesses and the remediation of such weaknesses will be captured by management's voluntary and required reporting under the SEC's rules.  Accordingly, the provisions of this standard do not facilitate management's ability to conceal from investors the emergence of a new material weakness at the company.  Nevertheless, the Board agreed that when an auditor identifies a new material weakness during the performance of this engagement, the auditor should not simply remain silent.  Accordingly, the Board modified the standard to require the auditor to communicate, in writing, to the audit committee any material weaknesses identified during this engagement that the auditor had not previously communicated, in writing, to the audit committee.

B72.    The existing provisions of Auditing Standard No. 2 contain responsibilities for the auditor if (1) information comes to the auditor's attention during this engagement that leads him or her to believe, while performing quarterly procedures required by Auditing Standard No. 2, that management's quarterly disclosures are materially misleading, or (2) the auditor becomes aware of conditions that existed at the date of his or her last report issued under Auditing Standard No. 2. 

B73.    Paragraphs 202-206 of Auditing Standard No. 2 establish certain requirements for the auditor related to management's quarterly and annual certifications with respect to the company's internal control over financial reporting.  If matters come to the auditor's attention during this engagement that lead him or her to believe, while fulfilling these quarterly requirements, that modification to the disclosures about changes in internal control over financial reporting is necessary for the certifications to be accurate and to comply with the requirements of Section 302 of the Act and the SEC's rules, these provisions of Auditing Standard No. 2 require the auditor to take action.  Such actions escalate from auditor communications with management and then to the audit committee, culminating in the auditor considering his or her additional responsibilities under AU sec. 317, Illegal Acts by Clients, and Section 10A of the Securities Exchange Act of 1934.

B74.    In addition, a continuing or predecessor auditor would have responsibilities under paragraph 197 of Auditing Standard No. 2 if the existence of a new material weakness came to the auditor's attention.  This paragraph effectively extends the responsibilities in AU sec. 561, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report, to reports on the effectiveness of internal control over financial reporting issued pursuant to Auditing Standard No. 2.  The identification of a new material weakness in the current year would cause the auditor, in fulfilling these responsibilities, to determine whether the facts relating to the material weakness existed at the date of the auditor's report pursuant to Auditing Standard No. 2 and, if so, (1) whether those facts would have changed the auditor's report issued under Auditing Standard No. 2 if he or she had been aware of them and (2) whether there are persons currently relying on or likely to rely on the auditor's report.  If the auditor determined that the new material weakness identified in the current year actually existed as of the date of his or her previous report under Auditing Standard No. 2 and that it was not adequately identified and disclosed in that report, the auditor would need to take steps such as recalling and reissuing the previous report to ensure that investors did not continue to rely on the previously issued (erroneous) report.

B75.    Including newly identified material weaknesses in the auditor's report could potentially mislead investors into believing that the assurance provided by this type of engagement is broader than it actually is.  If report users were provided with disclosure (covered by the auditor's opinion) of new material weaknesses of which the auditor was aware, report users might incorrectly believe that the auditor's report captured all new material weaknesses that had arisen at the company.  Similarly, a requirement for the auditor to disclose any new material weaknesses could lead report users to conclude, incorrectly, that no such disclosure means that there is current auditor assurance over the whole of internal control over financial reporting at the company.  The objective of this engagement is to provide auditor assurance about whether a previously reported material weakness continues to exist-nothing broader.  The only way for investors to obtain a more complete report from the auditor would be for the auditor to audit internal control over financial reporting in accordance with Auditing Standard No. 2. 

Specific Identification of All Previously Reported Material Weaknesses

B76.    The proposed standard required the auditor to modify his or her report if the auditor provides assurance on less than all of the material weaknesses previously reported.  The proposed standard did not, however, require the auditor to specifically identify all of the previously reported material weaknesses not covered. 

B77.    All investors who commented on this issue suggested that all material weaknesses previously reported either should be referred to or specifically included in the auditor's report.  They indicated that failure to identify the additional material weaknesses might lead some users to erroneously conclude that they no longer exist.  Auditors, on the other hand, agreed that complete specific identification of the previously reported material weaknesses not covered by the auditor's opinion should not be included, primarily because they believe that it may increase the risk of confusion about the scope of the engagement and what is being covered in the auditor's opinion.  Several commenters who agreed that specific identification was not necessary suggested that in addition to the report modification included in the proposed standard, the auditor's report on this engagement should specifically direct the reader to the previous auditor's report (issued under Auditing Standard No. 2), by either attaching a copy of the audit report or by providing direction as to where the report could be obtained.

B78.    The Board believes that including a complete specific identification of the previously reported material weaknesses not covered by this engagement would prove problematic.  As noted by many commenters, it is possible that including this detail would confuse report readers regarding the scope of this narrow engagement and could imply that, unless told otherwise, a report user should assume that those other material weaknesses do continue to exist.  In some of the material weakness descriptions included in management's and the auditor's reports on the effectiveness of the company's internal control over financial reporting as of year-end, the description of multiple material weaknesses covered several pages.  That level of detail in an auditor's report specifically targeted at whether just one material weakness continues to exist could easily overwhelm the rest of the audit report, making the report prone to various kinds of misinterpretations. 

B79.    The Board concluded that report readers would be better served by requiring the auditor to provide information regarding where to obtain the previously issued audit report-either by attaching it or referring to where it could be publicly obtained. 

Other Reporting Matters

B80.    No Requirement to Issue a Report.  The proposed standard required that the auditor, if he or she concluded that the material weakness continues to exist, communicate that conclusion in writing to the audit committee.  The proposed standard, however, did not require the issuance of a report.  Rather, the proposed standard recognized that the auditor must consider this knowledge in connection with the auditor's responsibilities under Auditing Standard No. 2 to determine whether management's quarterly disclosures about internal control over financial reporting are not materially misleading.

B81.    Several auditors who commented recommended that the proposed standard should require the auditor to issue an adverse report in the event that the auditor concludes that the material weakness continues to exist.  One suggested that issuance of an adverse report would be necessary only if the auditor believed that the company had previously publicly disclosed that the material weakness had been addressed. 

B82.    The Board continues to believe that requiring the issuance of an adverse report to the company would serve no useful purpose in this circumstance because the company might not make such a report public.  The Board believes, therefore, that requiring the auditor to communicate, in writing, with the audit committee his or her conclusion that a material weakness that was the subject of this engagement continues to exist would serve the same purpose as requiring the issuance of an adverse report.  At the same time, such a requirement would provide the auditor with additional flexibility as to the form of communication that would be most meaningful to the audit committee.  Regarding the potential for management to lead investors to incorrectly believe that the material weakness no longer exists in its public disclosures, the Board believes that the federal securities laws, as well as auditor's existing responsibilities related to management's quarterly disclosures, are adequate safeguards to protect investors from misleading information.

B83.    No Distinction in Standard Between Unqualified and Adverse Opinion.   As discussed in the note to paragraph 43 of the standard, the standard no longer distinguishes between an unqualified and an adverse opinion.  The auditor's opinion was revised to state that the material weakness exists or no longer exists.  This revision is discussed further in the section "Form of Auditor's Opinion" and is now referred to in the standard as the auditor's opinion. 

B84.    Inherent Limitations.  The inherent limitations paragraph of the auditor's report provided in the proposed standard discussed the inherent limitations of internal control over financial reporting overall, rather than the inherent limitations of the controls related to the material weakness being reported on. 

B85.    One commenter suggested that the inherent limitations paragraph was too broad for this engagement and needed to be modified to more accurately reflect the narrow focus of this type of engagement. 

B86.    The Board agreed that the inherent limitations paragraph, in this context, should be targeted to the specific controls identified in this auditor report.  In addition, the Board continues to believe that the broader concept of inherent limitations in internal control over financial reporting overall is equally applicable.  The inherent limitations paragraph in the auditor's report has been modified to reflect both of these conclusions.

B87.    Obtaining an Understanding of Internal Control Over Financial Reporting.  The proposed standard included a required report element stating that "the engagement includes obtaining an understanding of internal control over financial reporting, examining evidence supporting management's assertion, and performing such other procedures as the auditor considered necessary in the circumstances."  This language also was included in the example report included in the proposed standard.

B88.    Several auditors expressed concern that the phrase, "the engagement includes obtaining an understanding of internal control over financial reporting," implies that, as a part of the current engagement, the auditor spent a significant amount of time understanding internal control over financial reporting overall rather than carrying forward his or her understanding from the prior annual audit.  These commenters believed this implication conflicted with the direction in the body of the proposed standard that an auditor who has audited the company's internal control over financial reporting within the past year in accordance with Auditing Standard No. 2 would be expected to have obtained a sufficient knowledge of the company and its internal control over financial reporting to perform this engagement.  One commenter acknowledged that the proposed wording may be appropriate in cases in which a successor auditor is performing this engagement without previously gaining that understanding.

B89.    The Board continues to believe that an auditor who has audited the company's internal control over financial reporting as of the company's most recent annual assessment in accordance with Auditing Standard No. 2 would be expected to have obtained a sufficient knowledge of the company and its internal control over financial reporting to perform an engagement to report on whether a previously reported material weakness continues to exist.  To require a continuing auditor to update and document his or her understanding of internal control over financial reporting overall (to the full measure required by Auditing Standard No. 2) would be unnecessarily burdensome and costly.  The Board modified the report element for a continuing auditor to clarify that the auditor previously obtained an understanding of internal control over financial reporting overall at the company and updated that understanding as it specifically relates to changes in internal control over financial reporting associated with the specified material weakness.

B90.    The Board continues to believe, however, that a successor auditor that has not yet audited the company's internal control over financial reporting in accordance with Auditing Standard No. 2 would need to obtain a current understanding of internal control over financial reporting in connection with this engagement.  Therefore, the report element described in the proposed standard is appropriate and has been retained for a successor auditor's reporting. 

B91.    Example Reports.  The proposed standard included only one example report, which illustrated reporting on one material weakness by a continuing auditor when no additional material weaknesses were reported previously.  Several commenters requested modification of the standard to address circumstances that the Board believed were already addressed by the proposed standard but were not illustrated in the single example report.  Some commenters also made specific requests for additional example reports.

B92.    The Board determined, after considering the nature of the comments, that additional example reports, while not covering all possible situations, would provide additional clarity to the various reporting situations.  The Board selected three reports to illustrate most facets of the reporting provisions of the standard.  Appendix A includes those reports.

Conforming Amendments to AT sec. 101

B93.    The proposed standard contained a proposed conforming amendment to AT sec. 101, Attest Engagements.  The proposed conforming amendment would have required the proposed standard to be used, rather than AT sec. 101, for any engagements in which the subject matter is whether a material weakness continues to exist.  This conforming amendment would have precluded the auditor from performing an agreed-upon procedures or review engagement (using AT sec. 101) when the subject matter of the engagement was whether a material weakness continues to exist.

B94.    The Board received few comments related to the proposed conforming amendment.  One auditor agreed that a conforming amendment to preclude a review-level attestation was appropriate when the subject matter was whether a material weakness continues to exist.  This commenter went on to suggest, however, that there could be appropriate uses for an agreed-upon procedures engagement and that the Board should not preclude agreed-upon procedures from being performed under the Board's standards.  Such reports, the commenter noted, would be restricted to the use of the specified parties who take responsibility for the sufficiency of the agreed-upon procedures for their purposes and, therefore, these reports would not generally be available to investors.  Thus, these reports would not be a substitute for the engagements addressed in the proposed standard.  Another commenter separately suggested broadly retaining the ability for the auditor to perform a review engagement when the subject matter is a previously reported material weakness.

B95.    The Board continues to believe that investors and other report users in the public domain will be best served by the Board's standards permitting only positive assurance (i.e., an examination-level attestation) from the auditor when the subject matter is whether a material weakness continues to exist.  The Board agrees, however, that private parties (such as audit committees) who wish to engage the auditor to perform specified procedures when the subject matter is whether a material weakness continues to exist should be allowed to negotiate such a private arrangement, as long as the results are not intended for public use.  The Board, therefore, decided to modify the conforming amendment to AT sec. 101 of the Board's interim standards.  As adopted, an auditor may not use AT 101 to report on whether a material weakness in internal control over financial reporting continues to exist for any purpose other than the company's internal use.

1/ The Board's Standing Advisory Group ("SAG") discussed possible auditor involvement with the elimination of a material weakness at its November 18, 2004, public meeting.  The webcast of the November 18, 2004 SAG discussion and the related briefing paper on this topic, "Reporting on the Correction of a Material Weakness," are available on the Board's Web-site at www.pcaobus.org.

2/ See Item 308(c) of Regulation S-K, 17 C.F.R. § 229.308(c).

3/ In addition, even if internal control over financial reporting is effective as of the end of a company's fiscal year, investors also could potentially learn if it deteriorates materially during the year through these quarterly disclosures. 

4/ The Standing Advisory Group's November 18, 2004 discussion included this type of encouragement. 

5/ See AT sec. 101, "Attest Engagement" of the Board's interim standards.  Effective April 16, 2003, the PCAOB adopted, on an initial, transitional basis, five temporary interim standards rules (PCAOB Rules 3200T, 3300T, 3400T, 3500T, and 3600T) that refer to pre-existing professional standards of auditing, attestation, quality control, ethics, and independence  (the "interim standards").  These rules were approved by the SEC on April 25, 2003.  See SEC Release No. 33-8222.  On December 17, 2003, the Board approved technical amendments to the interim standards rules indicating that, "when the Board adopts a new auditing and related professional practice standard that addresses a subject matter that also is addressed in the interim standards, the affected portion of the interim standards will be superseded or effectively amended.  Accordingly, the Board approved adding the phrase 'to the extent not superseded or amended by the Board' to each of the interim standards rules."  Technical Amendments to Interim Standards Rules , PCAOB Release No. 2003-26 (Dec. 17, 2003); Exchange Act Release No. 49624 (Apr. 28, 2004) (SEC Approval).  The interim standards are available on the Board's Web-site at www.pcaobus.org.

6/ For example, paragraph 12 of Auditing Standard No. 2 states, "Therefore, effective internal control over financial reporting often includes a combination of preventive and detective controls to achieve a specific control objective."  Paragraph 85 of Auditing Standard No. 2 elaborates on this idea, including the example that, when performing tests of preventive and detective controls, the auditor might conclude that a deficient preventive control could be compensated for by an effective detective control and, therefore, not result in a significant deficiency or material weakness.  That paragraph concludes with the statement, "When determining whether the detective control is effective, the auditor should evaluate whether the detective control is sufficient to achieve the control objective to which the [deficient] preventive control relates."  Perhaps most notably, paragraph 88 of Auditing Standard No. 2 requires the auditor to identify the company's control objectives in each area and identify the controls that satisfy each control objective to evaluate whether the company's internal control over financial reporting is designed effectively.