By: Cydney Posner

The PCAOB has posted an interesting speech by board member Kayla Gillan, in which she acknowledges her surprise at the ultra-conservative application of Auditing Standard No. 2 (the auditing standard interpreting SOX 404) and attempts to analyze the reasons underlying that application. The speech was given to the Institute of Internal Auditors, whom she pronounced, quoting another article, "the new rock stars of corporate America."

First she rhetorically asked "Why all the fuss about internal controls?", which have ostensibly been required by the SEC since 1941. Auditors have repeatedly told her that 20 years ago they used to do the same thing as part of their annual financial audits. It's become clear, however, that cost-cutting has led companies to reduce maintenance and to allow internal control systems to lose their currency. At the same time, price pressures continued to force accounting firms to streamline audit procedures, often at the cost of a more comprehensive review of internal control.

While these events were all well known, what Gillan admits she did not know was "the degree of fear that the very existence of the PCAOB had generated within the auditing profession, [nor did she] understand how much this fear would cause so many to behave in such a hyper-conservative manner."

Gillan attributes the auditors' fears and uncertainties to a number of factors related to the shift from self-regulation to independent oversight:

  • The PCAOB did not delegate standard-setting responsibility to an outside professional group, but instead exercised that authority itself, proposing auditing standards that were very different from those expected by the profession--largely principles-based, without safe harbors and bright lines;
  • The PCAOB made changes to the final rules reflecting suggestions not just from auditors, but from issuers and investors as well;
  • The PCAOB inspections were very different from the familiar peer review process because, among other things, there was no advance notice of the issues to be reviewed, previously sacred issues were addressed, including partner compensation and the behaviors that the firms chose to reward, and some of the review comments were "quite strong" and made in a public report.
Gillan believes that, when auditors were faced with exercising judgment under AS2, their uncertainty was manifested by performing more low-level work than was necessary under AS2, and, in some cases, not performing the "right" work. As a result, they sometimes lost sight of those areas that posed the highest risk of potential fraud. These auditors also often caused their audit clients to follow suit. Gillan believes that "this behavior was directly related to auditors’ uncertainty – and the fear that that uncertainty created –regarding how the PCAOB will hold them accountable for compliance with AS2, and the impact that a negative PCAOB assessment might have on the firms’ continued business viability. It also largely contributed to the overriding concern expressed by the business community, that is that Year 1 costs were simply too high to be sustainable, and that they exceeded anticipated benefits."

While Gillan contends that auditors deserve praise for their significant efforts, nevertheless improvements are necessary. Hence, the PCAOB guidance issued in mid-May (see my email of May 17). Gillan stressed that none of the implementation guidance "changes or in any way diminishes" the auditor’s responsibilities: "There is no 'retrenchment'…." Instead, their goals were to:

  • Change overly mechanistic approaches;
  • Correct misunderstandings;
  • Confirm the need for balance, rationally applying AS2 to meet the unique circumstances at each company; and
  • Continue to evaluate whether additional guidance or changes are necessary.
After summarizing the PCAOB's May guidance, Gillan noted the PCAOB's Standing Advisory Group will soon convene to discuss additional implementation issues, including:
  • Implementing the definitions of "deficiency." "significant deficiency" and "material weakness";
  • The decisions that resulted from using the "strong indicators" of material weaknesses;
  • Experiences with the required written communications between the auditor and audit committee; and
  • Strategies for testing controls at companies with many individually insignificant locations (such as a large restaurant chain).
In addition, input from the SOX 404 inspections, which began earlier this month, is expected to contribute to the continuing evaluation.

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