SEC Approves New PCAOB Standard on Remediation of Material Weaknesses

On February 6, 2006, the SEC approved the adoption by the Public Company Accounting Oversight Board (“PCAOB”) of Auditing Standard No. 4 (“AS No. 4”), a new auditing standard governing the engagement of an auditor to report on whether a previously reported material weakness continues to exist.

The new standard was proposed to fill a perceived gap in the PCAOB’s existing standards. Under those standards, if a company reports a material weakness as of year-end, and later wants to report that the material weakness has been remediated, it may do so. But until now, there was no standard permitting an auditor to express an opinion on the matter until the next year-end audit report. AS No. 4 prescribes how the auditor may do so, stressing that a company is not required to seek such an interim opinion and the auditor is not required to accept the engagement.

Highlights of AS No. 4

Highlights of AS No. 4 are as follows:

• Scope of engagement. Engagements are narrower in scope than an audit of internal control over financial reporting. An auditor’s testing is limited to the controls specifically identified by management as eliminating the material weakness and uses the company’s stated control objectives as the target for determining whether the material weakness continues to exist. A stated control objective is a specific control objective identified by management that, if achieved, would result in the material weakness ceasing to exist.
• Who performs the audit. To perform the engagement, the auditor must have a sufficient knowledge of the company and its internal control over financial reporting. An auditor that has audited the company’s internal control over financial reporting in accordance with AS No. 2 and has rendered an opinion on the effectiveness of the company’s internal control over financial reporting as of the company’s most recent year-end would have sufficient knowledge to perform the engagement. If the company engages a new, successor auditor for the current year, the new auditor is required to perform specified procedures to obtain a sufficient understanding of the company and its internal control over financial reporting.
• Written report of management. In order for an auditor to express an opinion, management is required to present a written report evaluating the effectiveness of the specific controls that it believes address the material weaknesses and asserting that the specific controls identified are effective in achieving the stated control objective and that the identified material weaknesses no longer exist. Management’s assertions must be supported by sufficient evidence.
• Not all material weaknesses are eligible for reporting under the new standard. Not all material weaknesses lend themselves to reporting whether they continue to exist:
  • Reports are permitted only on material weaknesses that were previously identified in an auditor’s report on internal control over financial reporting as of year-end. A material weakness that is identified for the first time in a quarterly report on Form 10-Q, for example, cannot be the subject of an engagement under AS No. 4 until after it has been reported on in an annual report.
  • The interim engagement contemplated by the standard, with its narrow scope, might not be suitable for auditor reporting on whether certain kinds of material weaknesses continue to exist. For example, when a material weakness has a pervasive effect on the company’s internal control over financial reporting, identifying the control objectives that are not being met may be difficult because of the large number of control objectives affected. A material weakness related to an ineffective control environment is an example of this circumstance.
• Auditor’s opinion. The auditor may render an opinion either that “the material weakness exists” or “the material weakness no longer exists.” To render an opinion that a material weakness no longer exists, the auditor must have obtained evidence about the design and operation of the relevant controls, determined that the material weakness no longer exists and determined that no scope limitations were placed on the auditor’s work. If the auditor concludes that a material weakness exists, the auditor is not required to issue a report. If no report is issued, however, then the auditor is required to communicate in writing its conclusion that the material weakness continues to exist to the audit committee. Qualified opinions are not permitted, and any limitations on the scope of the auditor’s work require the auditor to disclaim an opinion or withdraw.
• Flexibility. The standard permits an engagement to be undertaken at any time during the year, and not necessarily at quarter-end or in conjunction with an audit or review of financial statements. It also permits an engagement covering one material weakness or many, or covering only some of the material weaknesses the company has reported. Despite these elements of flexibility, AS No. 4, like AS No. 2, is conceptually complex and highly prescriptive. Since 12.7% of accelerated filers reported material weaknesses (according to data cited in the PCAOB adopting release), there are many companies that may consider an engagement of this kind, particularly to avoid the risk that the auditor will disagree at year-end with the company’s disclosure during the course of the year that it has remediated a material weakness. However, until the PCAOB outlines the specific audit steps required to prepare a report under AS No. 4, which the SEC has now requested, it is unclear how difficult this exercise will be in practice.

Presentation of Management’s Report and the Auditor’s Opinion in SEC Filings

The SEC release (the “Adopting Release”) approving AS No. 4 provides the following guidance on the presentation of management’s report and the auditor’s report in filings with the SEC:

• No prescribed Exchange Act form. A company can use any Exchange Act form it believes appropriate for the purpose of disseminating management’s report and the auditor’s report. We believe most companies will file these reports under Form 8-K (or, in the case of a foreign private issuer, on Form 6-K) in order to promptly advise the market of the conclusions reached in the applicable reports, and also will make appropriate reference to these matters in their quarterly reports on Form 10-Q.Conclusions reached under Section 404 as of the end of the fiscal year may not be amended. Management cannot amend its previously reported conclusions regarding the effectiveness of internal control over financial reporting as of the end of the prior fiscal year, even if the relevant material weaknesses are subsequently remediated.
• Management conclusions regarding the effectiveness of internal control over financial reporting as of an interim date require a full evaluation. The procedures necessary to support management’s conclusion that an identified material weakness has been remediated are narrower in scope than those required to support a conclusion regarding effectiveness of internal control over financial reporting as a whole. The Adopting Release indicates that management may not express a conclusion that internal control over financial reporting is effective as of an interim date without performing a full (albeit unaudited) assessment of effectiveness as of such date in accordance with the SEC’s rules implementing Section 404.
• Remediation completed between the end of the fiscal year and the filing of the Form 10-K. If a material weakness exists at fiscal year end but is remediated prior to the filing date for the Form 10-K, the Adopting Release indicates that management may include in the Form 10-K a single, combined report on the results of the annual assessment of internal control over financial reporting as of the end of the fiscal year and the subsequent conclusion related to the post-fiscal-year-end remediation of an identified material weakness. A similar approach should apply to Form 20-F after the applicable Section 404 effective date for foreign private issuers.

Additional PCAOB Guidance to Come

Although the Adopting Release concludes that AS No. 4 provides a “reasonable format” for assessing whether a material weakness continues to exist, the Adopting Release directs the PCAOB to issue, within 90 days of the issuance of the Adopting Release, “a clear and concise outline of the affirmative audit steps set forth in the standard.”

The Adopting Release approving AS No. 4 is available on the SEC’s website at:
http://www.sec.gov/rules/pcaob/34-53227.pdf