“The audit committee directly oversees management’s reporting of the company’s financial position and results to investors. Auditors validate. Naturally, both agents should support each other’s work with an open dialogue about how to protect investors from misleading or inadequate management reports.
James R. Doty, PCAOB Chairman
PCAOB Open Board Meeting, Aug. 15, 2012
The Public Company Accounting Oversight Board (“PCAOB”) recently issued Auditing Standard No. 16, Communications with Audit Committees (“Standard 16”), to provide a framework for the discussions that an auditor must undertake with the audit committee of its public company clients. Approved by the Securities and Exchange Commission on December 20, 2012, Standard 16 assembles numerous best practices previously followed by first-rate auditors and combines them with new articulations in a single and comprehensive auditing standard. It provides clear guidance not only to auditors, but also to audit committees, regarding the conversations the two parties should be having throughout the course of an audit engagement. Standard 16 applies to audits of fiscal years beginning on or after December 15, 2012.
Standard 16 requires an auditor to provide specified information to audit committees “in a timely manner and prior to the issuance of the auditor's report.” Although certain communications may take place orally, auditors must document those communications in their audit work papers. Standard 16 also references additional securities laws, as well as PCAOB auditing rules and standards, that require auditors to communicate with audit committees. Auditors are not precluded however from communicating additional information. Below is a checklist of the communications Standard 16 requires auditors to have with their clients’ audit committees.1 To read the complete Standard, click here.
Preliminary and general communications. Standard 16 identifies several preliminary and general conversations that an auditor should have with audit committees, including:
- Communicating the objectives of the audit, the responsibilities of the auditor, and the responsibilities of management;
- Establishing an understanding of the terms of the audit engagement through an annual engagement letter to be signed or acknowledged by the audit committee;2
- Inquiring of the audit committee whether it is aware of matters relevant to the audit, including violations or possible violations of laws or regulations;
- Communicating the overall strategy and timing of the audit, including any significant changes to the planned strategy and the reasons for such changes;
- Providing timely observations arising from the audit that are significant to the financial reporting process;
- Communicating significant risks identified during the auditor’ risk assessment procedures; and
- Discussing significant appointment or retention issues discussed with management, including significant discussions regarding the application of accounting principles and standards.
Audit strategy. With respect to communicating overall audit strategy, Standard 16 requires auditors to discuss the following more specific issues with audit committees:
- The nature and extent of specialized skill or knowledge needed to perform audit procedures or evaluate 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 auditing internal controls;
- The names, locations, and planned responsibilities of other independent public accounting firms or other persons, if any, who are not employed by the auditor, that perform audit procedures in the current period audit; and
- The basis for the auditor's determination that the auditor can serve as principal auditor, if significant parts of the audit are to be performed by others.
Results of the audit. Standard 16 requires an auditor to discuss the following items with audit committees regarding the results of an audit:
- Significant accounting policies and practices, including (1) management's initial selection of, or changes in, significant accounting policies or the application of such policies in the current period, and (2) the effect on financial statements or disclosures of significant accounting policies in controversial areas or areas for which there is a lack of authoritative guidance or consensus, or
- diversity in practice;
- Critical accounting policies and practices, including (1) the reasons certain policies and practices are considered critical, and (2) how current and anticipated future events might affect the determination of whether certain policies and practices are considered critical;3
- Critical accounting estimates, including (1) a description of the process management used to develop critical accounting estimates, (2) management's significant assumptions used in critical accounting estimates that have a high degree of subjectivity, and (3) any significant changes management made to the processes used to develop critical accounting estimates or significant assumptions, as well as management's reasons for and and the effects of the changes; and
- Significant unusual transactions, including (1) significant transactions that are outside the normal course of business for the company or otherwise appear to be unusual due to their timing, size, or nature, and (2) the policies and practices management used to account for significant unusual transactions.
Auditor’s evaluation of financial reporting. Standard 16 also requires an auditor to provide audit committees with the auditor’s evaluation of the quality of the client’s financial reporting, including:
- Qualitative aspects of significant accounting policies and practices, specifically with respect to possible management bias;
- Assessment of management’s disclosure of critical accounting policies and practices, including significant modifications proposed by the auditor that management did not make;
- The basis for the auditor's conclusions regarding the reasonableness of the critical accounting estimates;
- The auditor's understanding of the business rationale for significant unusual transactions;
- The auditor's evaluation of whether the presentation of the financial statements and the related disclosures are in conformity with the applicable financial reporting framework, specifically the form, arrangement, and content of the financial statements and notes, including the terminology used, the amount of detail, the classification of items, and the bases of amounts set forth;
- Situations in which, as a result of the auditor's procedures, the auditor identified a concern regarding management's anticipated future application of accounting pronouncements that are not yet effective and might have a significant effect on future financial reporting; and
- All alternative treatments permissible under the applicable financial reporting framework for policies and practices related to material items that have been discussed with management, including the ramifications of the use of such alternative disclosures and treatments and the treatment preferred by the auditor.
Auditor’s evaluation of going concern. When applicable, the auditor must communicate the following matters to the audit committee concerning the client’s ability to continue as a going concern:
- If the auditor believes there is substantial doubt about the company's ability to continue as a going concern for a reasonable period, the auditor should communicate the conditions and events the auditor identified that indicate there is substantial doubt;
- If the auditor concludes, after consideration of management's plans, that substantial doubt about the company's ability to continue as a going concern is alleviated, the auditor should communicate the basis for the auditor's conclusion, including elements within management's plans that are significant to overcoming the adverse effects of the conditions and events; and
- If the auditor concludes, after consideration of management's plans, that substantial doubt about the company's ability to continue as a going concern for a reasonable period remains, the auditor should communicate (1) the effects, if any, on the financial statements and the adequacy of the related disclosure, and (2) the effects on the auditor's report.
Uncorrected and corrected misstatements. With respect to misstatements, Standard 16 requires an auditor to:
- Provide to the audit committee a schedule of uncorrected misstatements related to accounts and disclosures that the auditor presented to management. The auditor should discuss with the audit committee, or determine that management has adequately discussed with the audit committee, the basis for the determination that the uncorrected misstatements were immaterial, including the qualitative factors considered. The auditor also should communicate that uncorrected misstatements or matters underlying those uncorrected misstatements could potentially cause future-period financial statements to be materially misstated, even if the auditor has concluded that the uncorrected misstatements are immaterial to the financial statements under audit; and
- Communicate to the audit committee those corrected misstatements, other than clearly trivial matters, related to accounts and disclosures that might not have been detected except through the auditing procedures performed, and discuss with the audit committee the implications that such corrected misstatements might have on the company's financial reporting process.
Other significant communications. Finally, in addition to the items above, Standard 16 directs an auditor generally to communicate the following matters to audit committees:
- The auditor’s responsibility under PCAOB rules and standards, any related procedures performed, and the results of such procedures when other information is presented in documents containing audited financial statements;
- Difficult or contentious matters 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;
- Instances in which management consulted with other accountants about significant auditing or accounting matters and about which the auditor has identified a concern;
- Material written communications between the auditor and management;
- The reasons for any modification of the auditor’s standard report or any accompanying explanatory language, if applicable, and the wording of the report or explanation;
- Disagreements with management about matters, whether or not satisfactorily resolved, that individually or in the aggregate could be significant to the company's financial statements or the auditor's report;
- Significant difficulties encountered in performing the audit, including significant delays by management, the unavailability of company personnel, an unwillingness by management to provide information needed, an unreasonably brief time for completing the audit, unexpected extensive effort required to obtain sufficient appropriate audit evidence, unreasonable management restrictions encountered during the audit, and management's unwillingness to make or extend its assessment of the company's ability to continue as a going concern; and
- 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.