PCAOB Proposes Standard on Reporting on the Elimination of a Material Weakness - March 31, 2005

The Public Company Accounting Oversight Board (PCAOB) today proposed for public comment a standard for auditor reporting on an audit client's elimination of a material weakness in internal control over financial reporting (ICFR). The proposed standard establishes a voluntary engagement that would be performed solely at the election of the company. For example, management might elect to ask the auditor to report on the company's remediation of a material weakness, once the remediation process, including the related retesting of the remediated controls, is complete.

The proposed auditing standard (Release No. 2005-002), "Reporting on the Elimination of a Material Weakness," and the related briefing paper are available on the PCAOB website at the following address:

http://www.pcaobus.org/Standards/proposed_standards_and_related_rules.asp

Every public company participating in the U.S. capital markets must perform an assessment of ICFR each year in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (SOA). In addition, the company's independent auditor must attest to, and report on, management's assessment. Now that companies have begun to include these reports in their annual financial statement filings, some are reporting that management's assessment of the company's ICFR may reveal that the company has one or more material weaknesses, resulting in a conclusion that the company's ICFR is ineffective.

Over the last 12 months, hundreds of companies have reported material weaknesses. Many of these companies have subsequently disclosed they have remediated the material weaknesses they previously reported. When a company "eliminates" a material weakness, it may determine that disclosure in the normal course through appropriate periodic and current reports is sufficient to inform investors. However, there may be instances when management may want to increase the confidence of investors in management's assertions that the appropriate improvements in ICFR have taken place. Therefore, the PCAOB has provided an option to management to engage the independent auditor to provide assurance on the elimination of one or more material weaknesses when, in the company's judgment, such assurance would be appropriate. This option is not required by SOA or by any other legislation; however, it provides yet another tool for communicating with the markets.

The proposed standard is much narrower in focus than Auditing Standard No. 2 (AS2), which applies to the audit of ICFR in conjunction with an audit of financial statements. However, the proposal draws from many of the concepts embodied in AS2. Some of the key provisions of the proposal are summarized below:

• The auditor's objective in an engagement to report on the elimination of a material weakness is to express an opinion on whether the previously reported material weakness has been eliminated. The proposed standard would allow the auditor to report on the elimination of one or more material weaknesses as part of a single engagement.



• To perform this work, the auditor must have sufficient knowledge of both the company and its ICFR. This provision, in essence, requires the auditor to have an "audit base."



• The engagement could be performed anytime during the year (limited only by the nature of the material weakness) and would not have to be performed in conjunction with an audit or review of financial statements.



• The auditor's testing would be limited to the controls specifically identified by management as eliminating the material weakness. These are the controls commonly referred to, in practice, as the "remediated controls." The stated control objectives or assertions that were not achieved in determining that a material weakness existed would serve as "the target" for purposes of determining whether the specified "remediated controls" eliminate the material weakness. This means that management and the auditor must reach agreement up-front on the engagement as to this target, because it represents the "deficient control objective" that caused the material weakness in the first place.



• To render an unqualified opinion, the auditor must have (1) obtained evidence about the design and operating effectiveness of the controls that have been specifically identified as eliminating the material weakness, (2) determined that the material weakness has been eliminated and (3) determined that no scope limitations were placed on the auditor's work.



• The auditor may use the work of others, in accordance with the framework established by Auditing Standard No. 2, to alter the nature, timing and extent of the auditor's work.



• The proposed standard would establish a stand-alone engagement that is entirely voluntary, i.e., the engagement is performed only at the request of the company. If the auditor reaches a conclusion that the material weakness has not been eliminated, the auditor would be required to communicate that conclusion to the audit committee. Meanwhile, management is allowed to initiate additional remediation efforts, reset the assertion date and engage the auditor again to begin testing to determine whether the material weakness has been eliminated. According to the Board, this approach is "in keeping with the voluntary nature of this reporting."