PCAOB SAG Discusses AS2 Amendments, Stock Options Backdating
June 13, 2006
FEI Summary
The Public Company Accounting Oversight Board’s (PCAOB’s) Standing Advisory Group (SAG) opened its two-day meeting June 12-13, 2006 with a discussion of proposed amendments to the PCAOB’s internal control auditing standard (AS2), and closed with calls for further guidance for auditors on stock option backdating. (The proposed amendments to AS2 are listed at the end of this summary.)
The SAG also discussed use of company-level controls, the auditor’s role with respect to management’s assessment of internal control, the PCAOB’s “Research Synthesis Program” – in particular, research on risk assessments and auditing fair value, and heard presentations from Mark Cheffers of Audit Analytics and Terry Baldwin of Glass, Lewis and Company on trends in Section 404 reports and restatements.
Follows is a brief review of the main discussion points.
Company-level controls
The SAG heard from a panel on the use of company-level controls that, while important to a top-down approach, it can be difficult to find linkage between company level controls and transaction processing. This limits the ability to leverage off company controls to make internal control audits more efficient.
Role of auditors re: management’s assessment
There was also a panel on the role of auditors in evaluating and reporting on management’s assessment of internal control. PCAOB Chief Auditor Tom Ray noted in a recent speech at the University of Southern California (USC) that AS2 requires auditors to evaluate management’s process of assessing the effectiveness of internal control, but does not require them to publicly “report” on their assessment of management’s process - only on whether they believe management’s assessment is “fairly stated.” Ray indicated the auditor’s work should be scoped accordingly.
Additionally, SAG discussed whether the two audit opinions on internal control (one audit opinion on management’s assessment, the other on the auditor’s own opinion on internal control) are redundant or confusing to investors. John White, director of the Securities and Exchange Commission’s (SEC) Division of Corporation Finance (an observer at the SAG meeting) noted that Sarbanes-Oxley Section 404(b) (the Act) requires the auditor’s opinion on management’s assertion. “If you have to go to one opinion, the Act is clear which one it will be,” said White. However, PCAOB Deputy Chief Auditor Laura Philips said, “If that were the case, I’d want both.”
Research being conducted on risk assessment, auditing fair value
SAG members were also provided with an update on PCAOB’s “Research Synthesis Program” in which the American Accounting Association (AAA) has teams of professors conducting research on topics of interest to the PCAOB. There are currently nine topics being researched, and preliminary results from two were discussed in detail. Research on risk assessment reviewed over 100 publications, and found mixed evidence of business process focus, a “halo effect,” and that fraud assessment can be enhanced if done separately.
In contrast, on the topic of auditing fair value, the academics noted, “there’s almost zero research that’s been done to date,” with most of the research relating to the relevance of fair value, not reliability. Researchers on this topic suggested areas for further research.
Some preparers noted concern with the movement to fair value accounting, and Damon Silvers of the AFL-CIO noted he was “very strongly opposed to the notion that fair value ought to be the universal way of doing our accounting,” adding: “I think it’s going to make financial statements less useful to investors, and drive poor management decision-making.” Rebecca McEnally of the CFA Institute reiterated that her organization’s 83,000 members believe fair value reporting is most relevant. Silvers said, “I didn’t want to leave the impression there was universal investor approval of this (fair value) trend.”
Data on Section 404 Reporting Trends and Restatements
Data on trends in Section 404 reporting (number and types of adverse opinions or material weaknesses in internal control) and on the level and types of restatements was presented by Mark Cheffers of Ives, Inc./Audit Analytics Inc. and Terry Baldwin of Glass, Lewis & Co. There was some concern with the fact that 404 adverse opinions seemed to be a lagging indicator – following announced restatements – as noted previously by Moody’s. Baldwin noted restatements are up dramatically since the Sarbanes-Oxley Act and stated he believes Section 404 is working, that PCAOB and SEC should “stay the course” and he warned of a “perfect storm” when small companies have to begin 404 reporting, given their current level of restatements and more limited resources.
Cheffers noted that although adverse Section 404 opinions/material weaknesses are down from about 16 percent in 2005 to about 7 percent thus far in 2006 (which he predicts will rise to about 10 percent after restatements), the level of financial statement restatements is still very high. Revenue recognition, tax accounting, inventory (including vendor issues), consolidations (including FIN 46R issues) and leasing were among the leading “GAAP failures” noted in adverse 404 reports, some of which, Cheffers noted, are complex areas. The top internal control material weaknesses, according to Cheffers, were personnel issues, restatements, material year-end adjustments and information technology (IT) processing issues.
Among the top categories of restatements in 2005 were debt and quasi-debt issues (including beneficial convergence features and warrants), share-based payment issues, leasing and other FAS 5 contingency issues, revenue recognition and tax accounting (FAS 109).
Cheffers reported that stock price movements showed a “catch-up effect” in terms of companies reporting ineffective internal control in Year 1 - followed by a “clean” opinion in Year 2 - virtually caught up in terms of stock price with companies that had “clean opinions” both years. Not surprisingly, said Cheffers, companies with adverse internal control opinions both years appeared to be troubled companies and their stock price movement reflected that. Cheffers’ firm also found a 5 percent reduction in total audit fees for F1000 companies from 2004 to 2005. (The complete Cheffers/Audit Analytics presentation is available here
Emerging Issues: Stock Options Backdating
The SAG meeting closed with a discussion of “Emerging Issues,” specifically the current issue highlighted in the press about companies under investigation about backdating of stock options. “Springloading” or issuing stock options just prior to announcements of positive news was also mentioned. A number of SAG members, including former SEC Chief Accountant Lynn Turner, urged the PCAOB to publish guidance on this issue – soon – similar to the way the American Institute of Certified Public Accountants (AICPA) publishes “practice alerts” on current issues.
SEC Acting Chief Accountant Scott Taub (an observer at the SAG meeting) said, “I have heard there is concern that some legitimate issues will get swept up in the rush to judge those who backdated.” He noted that “not all questions of grant dates are created equal; we have to be sure we’re careful here.” Taub also cautioned against “lumping together various issues that relate to grant date of stock options, but aren’t similar,” such as questions about legitimate use of judgment, versus purposely choosing a time when the stock price was as low as possible and backdating the grant to that date.
Possible Amendments to AS2 Being Contemplated by PCAOB
Following are the possible amendments to AS2 being contemplated by PCAOB, as described by Chief Auditor Tom Ray to SAG on June 12. The amendments to AS2 are the first prong in PCAOB’s four-point plan (announced on May 17) to improve internal control reporting. (The other three prongs relate to the inspection process, small public companies and small audit firms.)
The possible amendments to AS2 currently being contemplated are:
- Incorporate into AS2 key concepts and direction from the PCAOB’s May 16, 2005 guidance, to ensure auditors focus on higher risk of fraud and material error.
- Clarify auditor’s role with respect to management’s assessment process. Paragraphs currently numbered in the 40s in AS2, describing in detail how auditor should evaluate management’s process and documentation, would be eliminated from AS2, and presumably incorporated into SEC guidance. Paragraphs currently numbered in the 20s in AS2, which proscribe auditor from completing audit (i.e. tell auditor to “stop” the engagement) if auditor finds management’s assessment lacking in certain respects, will be lifted. Rather than an absolute bar, it will be left up to auditors judgment whether quality of management’s assessment on an engagement amounts to a scope limitation.
- Clarify definition of “Significant Deficiency (SD)” and “Material Weakness (MW).”
-- incorporate guidance in PCAOB’s Nov. 30 2005 report on AS2 inspections, which clarified that AS2’s definition of MW being “more than remote” meant “at least reasonably possible.” It appears PCAOB may be leaning towards simplifying the definition to just say “reasonably possible” instead of “more than remote.”
4. Continue to provide list of “strong indicators” of control weakness, but will change language in AS2 to allow more judgment as to whether the events are strong indicator of significant deficiency or material weakness.
5. Guide auditors on use of work of others. GAO representative on SAG questioned why PCAOB says “use” of work of others, as opposed to “rely” or “reliance” on work of others, since some people - including SAG members - may commonly (and potentially incorrectly) assume that “rely on” and “use” mean the same thing. However, PCAOB staff noted the ability to rely on work of others depended generally – as set forth in AS2 – on qualitative factors such as the objectivity and competence of who is doing the work. More specifically, the current language in AS2 will be changed to no longer prohibit auditors from use of work of others on the control environment, which AS2 currently prohibits.
6. Clarify materiality and scoping of internal control audit (vis-a-vis financial statement materiality, and interim vs. annual). PCAOB intends to clarify that for “scoping” purposes, materiality should be based on annual, not interim, financial statement materiality. However, PCAOB indicated it is not changing the definition that references both annual and interim materiality, so it is not clear how much impact this change with respect only to “scoping” materiality will have.
7. Emphasize integration of internal control audit and financial statement audit.
8. Use of information gained in prior experience. There was still a lot of debate about the word “rotation” and its appropriateness in the 404 audit. PCAOB’s Laura Philips said PCAOB intentionally did not use the word “rotation” in AS2 due to varying meanings of that term. Based on the discussion, it appears PCAOB may say the auditor can utilize prior-year experience and knowledge when they gained as part of their current year’s risk assessment and for determining nature timing and extent of work, but auditor won’t get a “pass” to “do nothing” about a particular control (presumably, a key control) in a particular year.
Additional Links of Potential Interest to Readers:
PCAOB Standing Advisory Group (SAG) – General information
Agenda and briefing papers for June 12-13 SAG meeting
Webcast of June 12-13 SAG meeting
Audit Analytics’ (Mark Cheffers) June 13 presentation to SAG on Section 404 and restatements
Glass, Lewis & Co. - Restatements Trend Alert - published March 2, 2006
Prepared June 14, 2006 by Edith Orenstein (eorenstein@FinancialExecutives.org), Director, Technical Policy Analysis, Financial Executives International (FEI) based on listening to the webcast of the PCAOB SAG meeting. This summary does not represent FEI opinion, unless specifically noted above.