PCAOB Proposes New Standard for Report on Elimination of Material Weakness

By: Cydney Posner

The PCAOB today voted to propose for public comment a new standard that would apply when auditors report on the elimination of a material weakness in a company's internal control over financial reporting. Click here for article. The proposed standard would allow companies to elect voluntarily (we'll have to see how that turns out) to engage their auditors to perform this function.

After companies or their auditors have detected and addressed material weaknesses in internal control, they typically want to reassure investors that the problem has been eliminated. If a company determines that disclosure would be insufficient to assure the public, under this standard, it will be able to call upon its auditors to provide further assurance that the material weakness has been eliminated. Assuming the standard is adopted, it remains to be seen whether this type of engagement will, in effect, become required as a "best practice."

The objective of the engagement would be to express an opinion on whether the company has eliminated a previously reported material weakness. The proposed standard would provide that, for an auditor to provide an opinion on the elimination of a material weakness, the material weakness in question must have been identified in an auditor's previous report on internal control as of year-end. Thus, an auditor could not separately report on a material weakness identified and disclosed in the second quarter and eliminated in the third quarter of that same year.

The auditor's report on the elimination of a material weakness would be based on management's assertion that the material weakness has been eliminated. The auditor would determine whether the material weakness had been eliminated by evaluating management's assertion and performing audit procedures necessary to determine that the controls specified in management's assertion were designed and operated effectively to eliminate the material weakness. This proposed type of engagement would be significantly narrower in scope than Auditing Standard No. 2 because the auditor's testing would be limited to the controls specifically identified by management as eliminating the material weakness. Both management and the auditor would use the company's stated control objectives as the target for determining whether the specified controls eliminate the material weakness. The engagement could be undertaken at any time during the year and would not have to be performed in conjunction with an audit or review of financial statements.

Because the auditor must have sufficient knowledge of both the company and its internal control to perform the engagement, the PCAOB proposal requires that only the company's auditor, of both the financial statements and internal control, should perform this work. In cases in which the company has engaged a new auditor to perform the audit of the financial statements and internal control for the current year, the new auditor may report on the elimination of a material weakness as his or her initial engagement, but will need to gain the appropriate level of understanding.

To render an unqualified opinion, the auditor must have

• obtained evidence about the design and operation of the relevant controls,
• determined that the material weakness has been eliminated, and
• determined that no scope limitations were placed on the auditor's work.

unqualified opinion or an adverse opinion (stating that the material weakness has not been eliminated). Additionally, the auditor would be permitted to disclaim an opinion or withdraw from the engagement.