At an open meeting held on August 15, 2012, the Public Company Accounting Oversight Board ("PCAOB") voted to approve new Auditing Standard No. 16, Communications with Audit Committees. Although the new standard retains most of the preexisting communication requirements, there are a number of new areas that the auditor must discuss with the audit committee, and there are some areas where the auditor must seek specific responses from the audit committee. The new standard, available at http://pcaobus.org/Rules/Rulemaking/Docket030/Release_2012-004.pdf, is intended to benefit investors by enhancing the relevance and quality of communications between the auditor and audit committee, facilitating audit committee oversight of financial reporting and fostering improved financial reporting.

Background and Effective Dates

The PCAOB initially proposed Auditing Standard No. 16 for comment in March 2010 and issued a revised proposal in December 2011 following an initial comment period and feedback received at a September 2010 roundtable. Auditing Standard No. 16 expands on and supersedes existing standards on communications with audit committees (interim standards AU sec. 380, Communication With Audit Committees, and AU sec. 310, Appointment of the Independent Auditor), and makes conforming changes to related standards. The new standard requires SEC approval and, if approved, will apply to audits of public company financial statements for fiscal years beginning on or after December 15, 2012.

Auditing Standard No. 16 is the first standard that the PCAOB has adopted following enactment of the Jumpstart Our Business Startups Act of 2012 (the "JOBS Act"). Under the JOBS Act, a new PCAOB standard will not apply to audits of "emerging growth companies" ("EGCs") unless the SEC determines that the application of the standard is "necessary or appropriate in the public interest, after considering the protection of investors and whether the action will promote efficiency, competition, and capital formation." At its August 15 meeting, the PCAOB expressed its view that the SEC should approve the application of the new standard to EGCs.

Overview

Auditing Standard No. 16 retains many of the existing communication requirements, incorporates other requirements relating to communications with audit committees, such as those required under SEC rules, and requires some important new communications. The PCAOB release notes that as a general matter, the required communications may be written or oral, and may take various forms, including presentations, charts, written reports or discussions, depending on the circumstances. In addition, the new auditing standard sets the minimum level of required communication and does not preclude the audit committee from requesting, or the auditor from providing, additional information.

Auditing Standard No. 16 now requires communications to be made to the audit committee in a timely manner and before the audit report is issued. The specific timing of communications will depend on the circumstances, including the significance of matters to be communicated and any follow-up actions that may be necessary. The change in the timing of communications is intended to enable the audit committee and auditor to take appropriate action to address the matters communicated prior to the issuance of the audit report.

Changes in Communication Requirements

Auditing Standard No. 16 requires the auditor to establish an understanding of the terms of the audit engagement with the audit committee, rather than management. This is intended to reflect, as required by the Sarbanes-Oxley Act of 2002, that the audit committee is responsible for the appointment of the auditor. If the audit committee or its chair does not sign the audit engagement letter, the auditor will need to assure itself that the audit committee has nevertheless acknowledged and agreed to the terms of the engagement.

Auditing Standard No. 16 also requires the auditor to inquire of the audit committee whether it is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations. This requirement is new and expands on Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, which already requires the auditor to inquire about matters relating to the identification and assessment of potentially material misstatements, including fraud risks and tips or complaints regarding the company's financial reporting.

The new standard also updates AU sec. 380 to require that the auditor communicate to the audit committee the following additional matters:

1. Overall Audit Strategy: an overview of the overall audit strategy, including the following:

  • the timing of the audit and the significant risks identified during the auditor's risk assessment procedures;
  • the nature and extent of specialized skill or knowledge needed to perform the planned audit procedures or evaluate the audit results related to significant risks;
  • the extent to which the auditor plans to use the work of the company's internal auditors in an audit of financial statements;
  • the extent to which the auditor plans to use the work of internal auditors, company personnel (in addition to internal auditors) and third parties working under the direction of management or the audit committee when performing an audit of internal control over financial reporting;
  • information about the identity and responsibilities of other independent public accounting firms not employed by the auditor that perform audit procedures during the audit period; and
  • the basis for the auditor's determination that it can serve as principal auditor, if significant parts of the audit will be performed by other auditors.

2. Critical Accounting Policies and Practices: all critical accounting policies and practices to be used, including:

  • the reasons that certain policies and practices are considered critical; and
  • how current and anticipated future events may affect whether certain policies and practices are considered critical.

3. Critical Accounting Estimates: the following matters relating to critical accounting estimates:

  • a description of the process management used to develop critical accounting estimates;
  • management's significant assumptions used in critical accounting estimates that have a high degree of subjectivity; and
  • any significant changes made by management to the process used to develop critical accounting estimates or to management's significant assumptions, a description of management's reasons for the changes and the effects of the changes on the financial statements.

4. Significant Unusual Transactions: significant transactions that are outside the normal course of business for the company or that otherwise appear to be unusual because of their timing, size or nature, and the policies and practices used by management to account for significant unusual transactions.

5. Difficult or Contentious Matters: matters that are difficult or contentious for which the auditor consulted outside the engagement team and that the auditor reasonably determined are relevant to the audit committee's oversight of the financial reporting process.

6. Going Concern: the following matters related to the auditor's evaluation of the company's ability to continue as a going concern:

  • if the auditor believes that there is substantial doubt about the company's ability to continue as a going concern for a reasonable period of time, the conditions and events the auditor identified that, when considered in the aggregate, indicate that there is substantial doubt;
  • if, after considering management's plans, the auditor concludes that substantial doubt about the company's ability to continue as a going concern is alleviated, the basis for the conclusion, including elements the auditor identified in management's plans that are significant to overcoming the adverse effects of the conditions and events; and
  • if after considering management's plans, the auditor concludes that substantial doubt about the company's ability to continue as a going concern for a reasonable period of time remains, the effects, if any, on the financial statements and the adequacy of the related disclosure, and the effects on the auditor's report.

7. Uncorrected Misstatements: the basis for the determination that any uncorrected misstatements were immaterial, unless the auditor determines that management has adequately discussed the matter with the audit committee.

8. Material Written Communications: other material written communications between the auditor and management.

9. Departures from the Auditor's Standard Report: the following matters related to modifications of the auditor's standard report:

  • if the auditor expects to modify the opinion in the auditor's report, the reasons for the modification and the wording of the report; and
  • if the auditor expects to include explanatory language in the auditor's report, the reasons for, and the wording of, the explanatory language.

10. Other Matters: other matters arising from the audit that are significant to the oversight of the company's financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor's attention during the audit and the results of the auditor's procedures regarding such matters.

The new standard contemplates that management may make, or take the lead in making, required communications to the audit committee regarding critical accounting policies and practices, critical accounting estimates and significant unusual transactions. In that case, the auditor need not communicate those matters to the audit committee with the same level of detail as management, provided that the auditor: (1) participates in management's discussion with the audit committee; (2) affirmatively confirms to the audit committee that management adequately communicated those matters; and (3) with respect to critical accounting policies and practices, identifies for the audit committee the accounting policies and practices that the auditor considers critical. If management omits or inadequately describes any matters required to be discussed, the auditor should communicate those matters to the audit committee.

What Companies Should Do Now

Subject to SEC approval, Auditing Standard No. 16 will apply to audits of public company financial statements for fiscal years beginning on or after December 15, 2012. In preparation for this, we suggest that companies and their audit committees begin to:

  • Discuss with the auditor the anticipated timing of the required communications and whether changes to meeting agendas will be necessary to accommodate the additional communication requirements.
  • In light of the new requirement for the auditor to obtain information from the audit committee relating to violations or possible violations of laws or regulations, prepare for the possibility of increased auditor requests for formal representation letters from audit committees or audit committee chairs, and assess whether it is appropriate to provide such representations.
  • Also in light of this requirement, if the audit committee is responsible for overseeing compliance matters, the audit committee may wish to take steps to evaluate that its processes for receiving information about investigation and compliance matters are adequate. If another committee oversees compliance matters or shares responsibility for such oversight, the audit committee should take steps to help ensure that communication between that committee and the audit committee with respect to information about violations or possible violations of laws or regulations is coordinated so that the audit committee can make the required communications to the auditor under the new standard.
  • Consider whether to update the audit committee charter and annual calendar, as appropriate, to reflect the new communication requirements if the preexisting requirements are reflected in these documents.