The Public Company Accounting Oversight Board's Nov. 15 decision to shelve plans that would have expanded auditors' responsibility to detect and report potentially illegal activities was welcome news.
The proposed changes were untenable. They would have imposed new burdens on auditors to uncover a wide range of possible corporate noncompliance, including violations of regulations that may have only an indirect effect on financial statements. The PCAOB said it would consult with the Securities and Exchange Commission after Jan. 20 before taking further action.
Under today's professional standards, spelled out in AS 2405 and other places, audits involve procedures designed to provide reasonable assurance of detecting illegal acts that have a direct and material effect on the determination of financial statements amounts, such as violations of tax laws affecting accruals.
There is no such obligation to address violations of other laws or regulations unless "specific information comes to the auditor's attention" of possible violations that could have a material effect on the financial statements. When auditors become aware of the possibility of illegal acts, they may rely principally on management to assess the likelihood that such acts have occurred.
The new standard would have changed that. The PCAOB proposal lacked clarity—which alone is a problem. But it appears that the PCAOB would expand the obligation regarding "illegal acts" to include noncompliance with laws and regulations and eliminate the distinction between those that have a direct effect on financial statements amounts and those that don't.
Under the PCAOB's proposal, auditors would have to identify and understand all laws and regulations that apply to a company and consider management's processes for identifying laws and regulations where noncompliance could reasonably have a material effect on financial statements amounts. Auditors then would have to plan and perform procedures to identify all instances of potential noncompliance and whether any noncompliance is material to financial statements amounts.
When the PCAOB proposed these revisions, they learned how unpopular they are—the overwhelming majority of comment letters the board received criticized the proposal. As one accounting firm noted, the revisions would "require auditors to serve effectively as compliance monitors—which has the potential to undermine auditor independence and could result in significant unintended legal consequences for companies and auditors." The proposed procedures are "more akin to a forensic audit" or "assurance on a company's compliance risk management function."
Performing an audit under the new standard would require legal expertise that auditors don't have and aren't authorized to provide. As AS 2405 itself acknowledges, whether an act is illegal "is a determination that is normally beyond the auditor's professional competence." The additional obligations are inconsistent with the long-established framework in which management—not the auditor—is responsible for preparing and fairly presenting the company's financial statements according to applicable reporting rules.
PCAOB's proposal is a departure from Section 10A of the Securities Exchange Act, which requires only "procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts."
AS 2405 further recognizes that the more "removed an illegal act is from the events and transactions ordinarily reflected in the financial statements, the less likely the auditor is to become aware of the act or to recognize its possible illegality." Section 10A also doesn't apply to audits of SEC-registered brokers and dealers, while PCAOB's proposal would.
The proposal also would drive up both costs and the time it takes to conduct an audit. It would expand the amount of information auditors would have to obtain and review to determine, among other things, what laws and regulations apply to a company and to evaluate the effect of any noncompliance.
AS 2405 points out that entities may be affected by other laws or regulations that generally don't directly affect the determination of financial statement amounts, "including those related to securities, trading, occupational safety and health, food and drug administration, environmental protection, equal employment, and price fixing or other antitrust violations."
The auditing standard also notes that auditors typically don't have "sufficient basis for recognizing possible violations of such laws and regulations." There are serious questions about whether auditors could comply with the new standards without unreasonable effort and whether audits could be completed within a public company's reporting period.
Because the SEC's composition will change with the new administration next year, the PCAOB may have recognized that its proposal likely wouldn't be approved. It's puzzling then that the PCAOB issued a staff spotlight report on Nov. 12, just three days before suspending the proposal, reminding auditors that they're responsible for "detecting, evaluating, and making communications about illegal acts."
The overview section and the email circulating the report read more like the shelved proposal than the existing standards, but no email or report can change the existing standard that continues to apply.
Originally published by Bloomberg Tax.
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