Document ID: SEC-2007-1038-0001
Agency: sec
Document Type: Notice
Title: Public Company Accounting Oversight Board: Audit of financial statements; audit of internal control over financial reporting; independence rule and conforming amendments
Posted Date: 2007-08-01T04:00Z

[Federal Register: August 1, 2007 (Volume 72, Number 147)]
[Notices]               
[Page 42141-42146]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr01au07-119]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56152; File No. PCAOB-2007-02]

 
Public Company Accounting Oversight Board; Order Approving 
Proposed Auditing Standard No. 5, An Audit of Internal Control Over 
Financial Reporting That Is Integrated With an Audit of Financial 
Statements, a Related Independence Rule, and Conforming Amendments

July 27, 2007.

I. Introduction

    On May 25, 2007, the Public Company Accounting Oversight Board (the 
``Board'' or the ``PCAOB'') filed with the Securities and Exchange 
Commission (the ``Commission'') Proposed Auditing Standard No. 5, An 
Audit of Internal Control Over Financial Reporting that is Integrated 
with an Audit of Financial Statements (``Auditing Standard No. 5''), a 
Related Independence Rule 3525, and Conforming Amendments, pursuant to 
Section 107 of the Sarbanes-Oxley Act of 2002 (the ``Act'') and Section 
19(b) of the Securities Exchange Act of 1934 (the ``Exchange Act''). 
Auditing Standard No. 5 will supersede Auditing Standard No. 2, An 
Audit of Internal Control Over Financial Reporting Performed in 
Conjunction with an Audit of Financial Statements (``Auditing Standard 
No. 2''), to provide the professional standards and related performance 
guidance for independent auditors when an auditor is engaged to perform 
an audit of management's assessment of the effectiveness of internal 
control over financial reporting that is integrated with an audit of 
the financial statements pursuant to Sections 103(a)(2)(A)(iii) and 
404(b) of the Act. Additionally, Rule 3525 further implements Section 
202 of the Act's pre-approval requirement by requiring auditors to take 
certain steps as part of seeking audit committee pre-approval of 
internal control related non-audit services. Finally, the conforming 
amendments update the Board's other auditing standards in light of 
Auditing Standard No. 5, move certain information that was contained in 
Auditing Standard No. 2 to the Board's interim standards, and change 
the existing requirement that ``generally, the date of completion of 
the field work should be used as the date of the independent auditor's 
report'' to ``the auditor should date the audit report no earlier than 
the date on which the auditor has obtained sufficient competent 
evidence to support the auditor's opinion.''
    Notice of the proposed standard, the related independence rule, and 
the conforming amendments was published in the Federal Register on June 
12, 2007,\1\ and a supplemental notice of additional solicitation of 
comments on the rules and amendments was published in the Federal 
Register on June 20, 2007 (``Supplemental Notice'').\2\ The Commission 
received 37 comment letters on the proposed rules and amendments. For 
the reasons discussed below, the Commission is granting approval of the 
proposed standard, the related independence rule, and conforming 
amendments.
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    \1\ Release No. 34-55876 (June 7, 2007); 72 FR 32340 (June 12, 
2007).
    \2\ Release No. 34-55912 (June 15, 2007); 72 FR 34052 (June 20, 
2007); Notice of Additional Solicitation of Comments on the Filing 
of Proposed Rule on Auditing Standard No. 5, An Audit of Internal 
Control Over Financial Reporting That is Integrated with an Audit of 
Financial Statements, and Related Independence Rule and Conforming 
Amendments.
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II. Description

    The Act establishes the PCAOB to oversee the audits of public 
companies and related matters, in order to protect the interests of 
investors and further the public interest in preparation of 
informative, accurate and independent audit reports.\3\ Section 103(a) 
of the Act directs the PCAOB to establish auditing and related 
attestation standards, quality control standards, and ethics standards 
to be used by registered public accounting firms in the preparation and 
issuance of audit reports as required by the Act or the rules of the 
Commission.
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    \3\ Section 101(a) of the Act.
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    Section 103(a)(2)(A)(iii) of the Act requires the Board's standard 
on auditing internal control to include ``testing of the internal 
control structure and procedures of the issuer * * *.'' Under Section 
103, the Board's standard also must require the auditor to present in 
the audit report, among other things, ``an evaluation of whether such 
internal control structure and procedures * * * provide reasonable 
assurance that transactions are recorded as necessary to permit the 
preparation of financial statements in accordance with generally 
accepted accounting principles * * *.'' Section 404 of the Act requires 
that registered public accounting firms attest to and report on an 
assessment of internal control made by management and that such 
attestation ``shall be made in accordance with standards for 
attestation engagements issued or adopted by the Board.''
    The Board's proposed Auditing Standard No. 5, which will supersede 
Auditing Standard No. 2, provides the new professional standards and 
related performance guidance for independent auditors to attest to, and 
report on, management's assessment of the effectiveness of internal 
control over financial reporting under Sections 103 and 404 of the Act.
    The auditor's report on internal control over financial reporting 
issued pursuant to Auditing Standard No. 5 will express one opinion--an 
opinion on whether the company has maintained effective internal 
control over financial reporting as of its fiscal year-end. In order 
for the auditor to render an opinion, Auditing Standard No. 5 requires 
the auditor to evaluate and test both the design and the operating 
effectiveness of internal control to be satisfied that management's 
assessment about

[[Page 42142]]

whether the company maintained effective internal control over 
financial reporting as of its fiscal year-end is correct and, 
therefore, fairly stated. Additionally, paragraph 72 of Auditing 
Standard No. 5 requires the auditor to evaluate whether management has 
included in its annual assessment report all of the disclosures 
required by Commission rules.\4\ If the auditor determines that 
management's assessment is not fairly stated, Auditing Standard No. 5 
requires that the auditor modify his or her audit report on the 
effectiveness of internal control over financial reporting.
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    \4\ Item 308 of Regulations S-B and S-K.
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III. Discussion

    As discussed in detail below, the Commission believes there are 
many aspects of Auditing Standard No. 5 that are expected to result in 
improvements in both the effectiveness and efficiency of integrated 
audits that are currently being conducted in accordance with Auditing 
Standard No. 2. For example, Auditing Standard No. 5 focuses the audit 
on the matters most important to internal control. Auditing Standard 
No. 5 also eliminates unnecessary procedures by, among other things, 
removing the requirement to evaluate management's process; permitting 
consideration of knowledge obtained during previous audits; refocusing 
the multi-location testing requirements on risk rather than coverage; 
and removing unnecessary barriers to using the work of others. Further, 
Auditing Standard No. 5 encourages scaling of the audit for smaller 
companies by directing the auditor to tailor the audit to reflect the 
attributes of smaller, less complex companies. Lastly, Auditing 
Standard No. 5 simplifies the requirements by reducing detail and 
specificity; reflecting more accurately the sequential flow of an audit 
of internal control; and improving readability.
    The PCAOB received 175 comment letters when it published a draft of 
Auditing Standard No. 5 for public comment on December 19, 2006. On 
April 4, 2007, the Commission held an open meeting to discuss the 
comments received by the PCAOB and by the Commission in connection with 
its proposed interpretive guidance for management. At this meeting the 
Commission directed its staff to focus on four areas when working with 
the PCAOB staff: Aligning the proposed auditing standard with the 
Commission's proposed interpretive guidance for management, 
particularly with regard to prescriptive requirements, definitions and 
terms; scaling the audit to account for the particular facts and 
circumstances of all companies, particularly smaller companies; 
encouraging auditors to use professional judgment, particularly in 
using risk-assessment; and following a principles-based approach to 
determining when and to what extent the auditor can use the work of 
others.\5\
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    \5\ See Commission Press Release dated April 4, 2007, ``SEC 
Commissioners Endorse Improved Sarbanes-Oxley Implementation To Ease 
Smaller Company Burdens, Focusing Effort On What Truly Matters.''
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    The PCAOB addressed these areas, in addition to other matters 
raised by commenters, in the version of Auditing Standard No. 5 that 
was filed with the Commission. For example, the PCAOB made revisions to 
its proposed standard to: Make the auditing standard more principles-
based and reduce prescriptiveness; align definitions and terminology 
with the Commission's final interpretive guidance for management; 
better incorporate scaling concepts throughout the auditing standard; 
further emphasize fraud controls; enhance and align the discussion of 
entity-level controls; eliminate the requirement to separately assess 
risk at the individual control level; clarify the manner in which the 
evidence regarding design of controls can be obtained; and clarify the 
framework by which auditors can make judgments regarding whether and to 
what extent the auditor can use the work of others, including 
management.
    The Commission received 37 comment letters in response to its 
request for comments on Auditing Standard No. 5, the related 
independence rule, and conforming amendments. The comment letters came 
from issuers,\6\ registered public accounting firms,\7\ professional 
associations,\8\ investors,\9\ and others.\10\ In general, many 
commenters expressed support for the proposed standard \11\ and 
recommended that the Commission approve the standard and the related 
conforming amendments, with some of these commenters requesting that 
this approval be done on an expedited basis to enable auditors to 
implement the provisions of Auditing Standard No. 5 prior to the 
required effective date.\12\ A number of the commenters noted that the 
new audit standard includes appropriate investor safeguards, will 
facilitate a more effective and efficient approach to the 
implementation,\13\ and that the PCAOB appropriately responded to 
concerns raised by issuers, auditors, investors and others.\14\ 
Specifically, some commenters noted that the standard's focus on 
principles rather than prescriptive requirements expands the 
opportunities for auditors to apply well-reasoned professional 
judgment.\15\ Many of these commenters had provided similar 
communication directly to the PCAOB during its comment period, and to 
the Commission as part of its consideration of its proposed 
interpretive guidance for management.
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    \6\ Alamo Group; Pepsico; and XenoPort, Inc.
    \7\ BDO Seidman, LLP; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP; KPMG LLP; and PricewaterhouseCoopers LLP.
    \8\ American Bankers Association; American Bar Association 
Section of Business Law Committees on Federal Regulation of 
Securities and Law and Accounting; America's Community Bankers; 
Biotechnology Industry Organization; Center for Audit Quality; 
Independent Community of Bankers of America; Institute of Chartered 
Accountants in England and Wales; Institute of Internal Auditors 
(IIA); Institute of Management Accountants; Organization for 
International Investment; National Venture Capital Association; New 
York State Society of Certified Public Accountants; The Hundred 
Group of Finance Directors; and U.S. Chamber Center for Capital 
Markets Competitiveness.
    \9\ California Public Employees Retirement System; Centre for 
Financial Market Integrity; and Council of Institutional Investors.
    \10\ Accretive Solutions; Thomas E. Damman; David A. Doney; 
Benjamin P. Foster; Frank Gorrell; Simone Heidema and Erick 
Noorloos; J. Lavon Morton; Monica Radu; Robert Richter; R.G. Scott & 
Associates, LLC; and United States Government Accountability Office.
    \11\ See for example, Accretive Solutions; America's Community 
Bankers; BDO Seidman, LLP; California Public Empolyees Retirement 
System; Center for Audit Quality; Council of Institutional 
Investors; Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton 
LLP; KPMG LLP; Institute of Chartered Accountants in England and 
Wales; New York State Society of Certified Public Accountants; 
PricewaterhouseCoopers LLP; The 100 Group of Finance Directors; and 
United States Government Accountability Office.
    \12\ See for example, America's Community Bankers; BDO Seidman, 
LLP; California Public Employees Retirement System; Council of 
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP; KPMG LLP; and PricewaterhouseCoopers LLP.
    \13\ See for example, American Bankers Association; Accretive 
Solutions; BDO Seidman, LLP; Center for Audit Quality; KPMG LLP; 
PricewaterhouseCoopers LLP; and The 100 Group of Finance Directors.
    \14\ See for example, American Bankers Association; America's 
Community Bankers; Council of Institutional Investors; Ernst & Young 
LLP; Grant Thornton LLP; The 100 Group of Finance Directors; and 
United States Government Accountability Office.
    \15\ See for example, BDO Seidman, LLP; Center for Audit 
Quality; Ernst & Young LLP; Institute of Chartered Accountants in 
England and Wales; PricewaterhouseCoopers LLP; and The 100 Group of 
Finance Directors.
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    A few commenters expressed their continuing concerns that the 
Commission (in its recently approved rule amendments) and the PCAOB had 
retained the wrong auditor opinion, indicating their belief that 
auditors should opine on the assessment made by management in order to 
comply with

[[Page 42143]]

Section 404(b) of the Sarbanes-Oxley Act.\16\ These commenters 
expressed their belief that the auditor's opinion directly on internal 
control over financial reporting (as opposed to management's 
assessment) entails unnecessary and duplicative work. The Commission 
has carefully considered this comment and continues to believe that, 
consistent with Sections 103 and 404 of the Sarbanes-Oxley Act, the 
Commission's recent rule amendments and Auditing Standard No. 5 require 
the appropriate opinion to be expressed by the auditor. The Commission 
notes that this view is consistent with the view expressed by the Board 
in its release. Further, the Commission believes that an auditing 
process that is restricted to evaluating what management has done would 
not necessarily provide the auditor with a sufficient level of 
assurance to render an independent opinion as to whether management's 
assessment about the effectiveness of internal control over financial 
reporting is correct.\17\ Finally, the Commission believes that the 
expression of a single opinion directly on the effectiveness of 
internal control over financial reporting provides clear communication 
to investors that the auditor is not responsible for issuing an opinion 
on management's process for evaluating internal control over financial 
reporting.\18\ In the Commission's view, such an opinion may not only 
have the unintended consequence of hindering management's ability to 
apply appropriate judgment in designing their evaluation approach, but 
also may have the effect of increasing audit costs without commensurate 
benefit to issuers and investors.
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    \16\ See for example, Alamo Group; Robert Richter; Institute of 
Chartered Accountants in England and Wales; Institute of Management 
Accountants; and The 100 Group of Finance Directors.
    \17\ See Release No. 33-8809 (June 20, 2007), Amendments to 
Rules Regarding Management's Report on Internal Control Over 
Financial Reporting.
    \18\ Ibid.
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    Two commenters noted their belief that there was not sufficient 
incentive for auditors to modify their methods of performing the audit 
of internal control and therefore, were concerned that the benefits 
afforded by Auditing Standard No. 5 would not be fully realized. These 
commenters noted that it was important for the PCAOB to adjust its 
inspection program to align it with the changes in the audit standard 
and to respect the auditors' use of judgment in conducting the 
audit.\19\ Additionally, commenters noted that the PCAOB's inspection 
process should monitor the extent to which, and the expediency with 
which, audit firms implement Auditing Standard No. 5 in the manner 
expected.\20\ This has been an area both the Commission and the PCAOB 
recognize and continue to focus on. For example, it was an area 
specifically identified in the Commission's and the PCAOB's 2006 
announcement of actions following the Commission's second roundtable on 
Section 404 implementation.\21\ The PCAOB has incorporated procedures 
to evaluate the efficiency and effectiveness of audits of internal 
control over financial reporting in their inspection process and, in 
April 2007, issued its second report on auditors' implementation of the 
internal control standard.\22\ The Commission also recognizes this 
concern and, as a result and consistent with its previous 2006 
announcement in this area, will be carefully monitoring the 
implementation, including directing the Commission staff to examine 
whether the PCAOB inspections of registered accounting firms have been 
effective in encouraging changes in the conduct of integrated audits to 
improve both efficiency and effectiveness of attestations on internal 
control over financial reporting.
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    \19\ America's Community Bankers and the Institute of Chartered 
Accountants in England and Wales.
    \20\ See for example, America's Community Bankers, the Institute 
of Chartered Accountants in England and Wales, The 100 Group of 
Finance Directors and U.S. Chamber Center for Capital Markets 
Competitiveness.
    \21\ See for example, SEC Press Release 2006-75 (May 16, 2006).
    \22\ See PCAOB Press Release dated April 18, 2007, ``Board 
Issues Second Year Report On Auditors' Implementation of Internal 
Control Standard''.
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    The Commission received one comment with respect to the indicators 
of a material weakness that are included in Auditing Standard No. 5. 
Under Auditing Standard No. 5, if an auditor determines that a 
deficiency might prevent prudent officials from concluding that they 
have reasonable assurance that transactions are recorded as necessary 
to permit the preparation of financial statements in conformity with 
generally accepted accounting principles, an auditor should regard such 
a determination as an indicator of a material weakness. One commenter 
took exception to this requirement and requested that such a 
determination made by the auditor be regarded as an indicator of a 
deficiency that is at least a significant deficiency rather than an 
indicator of a material weakness; or that Auditing Standard No. 5 be 
revised to use the word ``would'' instead of ``might'' when describing 
the level of assurance that would satisfy prudent officials in the 
conduct of their own affairs.\23\ The Commission notes that the 
commenter's suggestion to change the word ``might'' to ``would'' is not 
necessary or appropriate given that the PCAOB and the Commission both 
stated in their respective releases that the determination of whether 
or not a material weakness exists requires judgment and the presence of 
one or more indicators does not mandate a conclusion that a material 
weakness exists. Moreover, the Commission notes that the indicators are 
not intended to supplant or replace the definition of material 
weakness. This particular indicator is intended as a reminder of the 
requirement in Section 13(b)(2)(B) of the Exchange Act that every 
issuer ``devise and maintain a system of internal accounting controls 
sufficient to provide reasonable assurances'' and of the explanation in 
Section 13(b)(7) of the Exchange Act that the term ``reasonable 
assurances'' in this context means ``such level of detail and degree of 
assurance as would satisfy prudent officials in the conduct of their 
own affairs.'' The Commission agrees with the list of indicators of a 
material weakness included in Auditing Standard No. 5, and agrees with 
the principles in Auditing Standard No. 5, which allow an auditor to 
use his or her judgment.
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    \23\ American Bar Association Section of Business Law Committees 
on Federal Regulation of Securities and Law and Accounting.
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    The Commission received one comment with respect to the PCAOB's 
proposed Independence Rule 3525, which relates to the requirement for 
auditors to obtain audit committee pre-approval of non-audit services 
related to internal control over financial reporting. This commenter 
requested a transition provision in order to clarify that internal 
control-related services pre-approved by audit committees before the 
final rule is approved by the Commission do not require re-approval 
under Rule 3525.\24\ Auditing Standard No. 2 (paragraph 33) required 
specific pre-approval of internal-control related non-audit services. 
The Commission notes that non-audit services that have already been 
pre-approved by audit committees would not require re-approval with the 
communications required by Rule 3525. Accordingly, a transition period 
is not necessary.
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    \24\ KPMG LLP.
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    The Commission did not receive any comments with respect to the 
PCAOB's proposed conforming amendments. In some cases, these proposed 
amendments are administrative in nature, such as updating references in 
the interim standards to the proposed

[[Page 42144]]

new standard's paragraph numbers and definitions. In other cases, the 
amendments have been proposed to move information currently contained 
in Auditing Standard No. 2 to the Board's existing standards. Further, 
the Commission notes that the Board addressed the single comment that 
it received on its conforming amendments. The Commission believes that 
the conforming amendments proposed by the Board are appropriate.
    As proposed by the PCAOB, Auditing Standard No. 5, PCAOB Rule 3525, 
and the Conforming Amendments will be effective and required for 
integrated audits conducted for fiscal years ending on or after Nov. 
15, 2007. However, earlier adoption is permitted by the Board. The 
Board has stated that auditors who elect to comply with Auditing 
Standard No. 5 after Commission approval but before its effective date 
must also comply, at the same time, with Rule 3525 and other PCAOB 
standards as amended by this release. The Commission believes the 
effective date allows for appropriate transition time and at the same 
time encourages early adoption. In that regard, the Commission's recent 
amendments to Regulation S-X become effective on August 27, 2007 and 
the Commission will begin accepting the single auditor's attestation 
report on the effectiveness of internal control over financial 
reporting prescribed in Auditing Standard No. 5 in timely filings 
received starting on that date.
    In its Supplemental Notice, the Commission sought comments on seven 
specific questions. The following discussion addresses the comments 
received related to each of those questions.
    (1) Is the standard of materiality appropriately defined throughout 
AS5 to provide sufficient guidance to auditors? For example, is 
materiality appropriately incorporated into the guidance regarding the 
matters to be considered in planning an audit and the identification of 
significant accounts?
    The majority of the commenters who expressed a view on this 
question noted that Auditing Standard No. 5 appropriately addresses the 
concept of materiality when planning and performing an integrated 
audit.\25\ Some commenters elaborated that while application of 
materiality concepts in the context of planning and performing an audit 
requires the use of judgment, Auditing Standard No. 5 specifies the 
basis on which those judgments should be made.\26\
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    \25\ See for example, BDO Seidman, LLP; California Public 
Employees Retirement System; Center for Audit Quality; Deloitte & 
Touche LLP; Ernst & Young LLP; Grant Thornton LLP; Institute of 
Chartered Accountants in England and Wales; KPMG LLP; New York State 
Society of Certified Public Accountants; PepsiCo; 
PricewaterhouseCoopers LLP; and The Hundred Group of Finance 
Directors.
    \26\ See for example, KPMG LLP and PricewaterhouseCoopers LLP.
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    A few commenters expressed a view that some auditors may need 
further and clearer guidance than is provided.\27\ However, one 
commenter indicated its view that the Commission should not provide 
more guidance and interpretation, especially as related to the 
application of quantitative criteria to the definitions of material 
weakness and significant deficiency.\28\ Moreover, another commenter 
noted that although its view was that materiality was not sufficiently 
defined in Auditing Standard No. 5, it recognized that the definition 
of materiality extends to matters beyond just Section 404 of the 
Act.\29\
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    \27\ See for example, Accretive Solutions; The Institute of 
Internal Auditors; Rod G. Scott; National Venture Capital 
Association; and U.S. Chamber Center for Capital Markets 
Competitiveness.
    \28\ The Institute of Chartered Accountants in England and 
Wales.
    \29\ National Venture Capital Association.
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    The Commission agrees that Auditing Standard No. 5 adequately 
addresses materiality throughout the standard. For example, as a number 
of commenters observed, paragraph 20 of Auditing Standard No. 5 states 
that ``in planning the audit of internal control over financial 
reporting, the auditor should use the same materiality considerations 
he or she would use in planning the audit of the company's financial 
statements.'' Further, the Commission does not believe that the 
auditing standard is the appropriate forum to address broader questions 
about materiality, as the concept of materiality is fundamental to the 
federal securities laws.
    (2) Please comment on the requirement in Paragraph 80 that the 
auditor consider whether there are any deficiencies or combinations of 
deficiencies that are significant deficiencies and, if so, communicate 
those to the audit committee. Specifically, will the communication 
requirement regarding significant deficiencies divert auditors' 
attention away from material weaknesses?
    Commenters who expressed a view on this matter overwhelmingly 
observed that the auditor's requirement to communicate significant 
deficiencies would not divert auditors' attention away from material 
weaknesses since Auditing Standard No. 5 clearly directs the auditor to 
identify material weaknesses, with many of the commenters noting the 
importance of communicating significant deficiencies to the audit 
committee.\30\
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    \30\ See for example, American Bar Association Section of 
Business Law Committees on Federal Regulation of Securities and Law 
and Accounting; Accretive Solutions; BDO Seidman, LLP; Center for 
Audit Quality; Centre for Financial Market Integrity; Council of 
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP; Institute of Chartered Accountants in England 
and Wales; KPMG LLP; J. Lavon Morton; New York State Society of 
Certified Public Accountants; PepsiCo; PricewaterhouseCoopers LLP; 
Rod G. Scott; and The 100 Group of Finance Directors, but see The 
Institute of Internal Auditors.
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    The Commission agrees with commenters that the communication 
requirement related to significant deficiencies should not divert 
auditors' attention away from material weaknesses due to the clear 
statement in Auditing Standard No. 5 that in planning the audit, the 
auditor is not required to search for deficiencies that, individually, 
or in combination, are less severe than a material weakness. Further, 
the Commission agrees with the Board that limiting the discussion 
regarding significant deficiencies to the section of the auditing 
standard that relates to communications is appropriate in order to help 
clarify that the audit should not be scoped to identify deficiencies 
that are less severe than a material weakness.
    (3) Is AS5 sufficiently clear that for purposes of evaluating 
identified deficiencies, multiple control deficiencies should only be 
looked at in combination if they are related to one another?
    Most of those commenting on this question agreed that multiple 
control deficiencies should be aggregated for assessment purposes if 
they are related to each other and that Auditing Standard No. 5 is 
sufficiently clear in this regard.\31\ Two commenters disagreed with 
the direction that multiple control deficiencies should only be 
evaluated in combination if they are related to one another given that 
the auditor is expressing an opinion on the effectiveness of internal 
control as a whole.\32\
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    \31\ See for example, Accretive Solutions; BDO Seidman, LLP; 
Center for Audit Quality; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP, Institute of Chartered Accountants in England 
and Wales; PepsiCo; PricewaterhouseCoopers LLP; R.G. Scott; and The 
100 Group of Finance Directors.
    \32\ See California Public Employees' Retirement Systems; and 
United States Government Accountability Office.
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    The Commission agrees with the view of most of the community that 
Auditing Standard No. 5 is sufficiently clear with respect to 
aggregation of control deficiencies and further notes that this 
guidance is appropriately aligned with

[[Page 42145]]

the guidance that is contained in the Commission's interpretive 
guidance for management.
    (4) Please comment on whether the definition of ``material 
weakness'' in Paragraph A7 (which is consistent with the definition 
that the SEC adopted) appropriately describes the deficiencies that 
should prevent the auditor from finding that ICFR is effective.
    The majority of those commenting on this topic expressed agreement 
with Auditing Standard No. 5's definition of material weakness and 
stated that it appropriately describes those deficiencies that should 
prevent the auditor from concluding that internal control over 
financial reporting is effective,\33\ while a couple commenters stated 
that the definition was not as clear as it could be, thereby 
potentially leading to subjective assessments of whether a control 
deficiency is a material weakness.\34\ One commenter suggested 
providing guidance regarding the period of time to which reasonable 
possibility relates,[0] \35\ and another suggested reconsideration of 
the likelihood threshold included in the definition.\36\ Two commenters 
suggested that the requirement to evaluate deficiencies against interim 
results due to the reference to interim financial statements in the 
definition of material weakness should be eliminated,\37\ with one of 
these two commenters stating that this consideration should not delay 
the Commission's prompt approval of Auditing Standard No. 5.\38\
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    \33\ See for example, BDO Seidman, LLP; Center for Audit 
Quality; California Public Employees Retirement System; Council of 
Institutional Investors; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP; Institute of Chartered Accountants in England 
and Wales; New York State Society of Certified Public Accountants; 
PepsiCo; PricewaterhouseCoopers LLP; and The 100 Group of Finance 
Directors.
    \34\ See for example, Accretive Solutions; R.G. Scott; and U.S. 
Chamber Center for Capital Markets Competitiveness.
    \35\ See The Institute of Internal Auditors.
    \36\ See National Venture Capital Association.
    \37\ See National Venture Capital Association and 
PricewaterhouseCoopers LLP.
    \38\ PricewaterhouseCoopers LLP.
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    The Commission agrees that the definition of material weakness 
included in Auditing Standard No. 5, which is aligned with the 
Commission's interpretive guidance for management, appropriately 
describes the conditions that, if they exist, should be disclosed to 
investors and should preclude a conclusion that internal control over 
financial reporting is effective. Regarding the reference to interim 
financial statements in the definition of material weakness, the 
Commission continues to believe, as it stated in its release adopting 
the definition of a material weakness, that:

``* * *[while] annual materiality considerations are appropriate 
when making judgments about the nature and extent of evaluation 
procedures, the Commission believes that judgments about whether a 
control is adequately designed or operating effectively should 
consider the requirement to provide investors reliable interim and 
annual financial reports. Further, if a deficiency is identified 
that poses a reasonable possibility of a material misstatement in 
the company's quarterly reports, the Commission believes that the 
deficiency should be disclosed to investors and internal control 
over financial reporting should not be assessed as effective.'' \39\
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    \39\ See Release No. 33-8809 (June 20, 2007), Amendments to 
Rules Regarding Management's Report on Internal Control Over 
Financial Reporting.

    (5) Is AS5 sufficiently clear about the extent to which auditors 
can use the work of others?
    The majority of those who commented on this question expressed 
their view that Auditing Standard No. 5 is clear about the extent to 
which auditors can use the work of others to gain efficiencies in the 
audit,\40\ with some noting that Auditing Standard No. 5 provides 
substantial flexibility in the application of auditor judgment when 
determining whether, and to what extent, to use the work of others.\41\ 
A small number of commenters noted that further clarification regarding 
the extent that auditors can rely on the work of others when conducting 
walkthroughs would be helpful.\42\ Two commenters recommended that if 
the work of others is found to be competent and reliable, then the 
standard should require the auditor to utilize it.\43\
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    \40\ See for example, Accretive Solutions; BDO Seidman, LLP; 
Center for Audit Quality; Council of Institutional Investors; 
Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton LLP; KPMG 
LLP; PepsiCo; and PricewaterhouseCoopers LLP.
    \41\ See for example, Deloitte & Touche LLP; KPMG LLP; and 
PricewaterhouseCoopers LLP.
    \42\ See for example, The 100 Group of Finance Directors; and J. 
Lavon Morton.
    \43\ See American Bankers Association and Biotechnology Industry 
Organization.
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    The Commission agrees that Auditing Standard No. 5 is sufficiently 
clear about the extent to which the auditor can use the work of others. 
Further, while the Commission would anticipate auditors would use the 
work of others under appropriate circumstances, including when the 
approach results in greater efficiency, the Commission does not believe 
it is necessary or appropriate to preclude the auditor from utilizing 
his or her judgment in determining whether or not to use the work of 
others based on the particular facts and circumstances of the 
engagement.
    (6) Will AS5 reduce expected audit costs under Section 404, 
particularly for smaller public companies, to result in cost-effective, 
integrated audits?
    A number of commenters stated their view that Auditing Standard No. 
5, as approved by the PCAOB, together with the Commission's guidance 
for management on assessing internal control over financial reporting, 
will result in a reduction of the total Section 404 compliance 
effort.\44\ Some commenters agreed that a cost reduction would occur, 
but also noted that the amount of reduced effort and cost associated 
with the audit of internal control over financial reporting will vary 
by company depending on factors such as size, complexity, the degree of 
change from year-to-year, the quality of internal control systems and 
documentation, and the extent to which management appropriately applies 
the Commission's interpretive guidance for management.\45\ None of the 
commenters suggested that costs would increase.
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    \44\ See for example, BDO Seidman, LLP; Center for Audit 
Quality; Council of Institutional Investors; Deloitte & Touche LLP; 
Ernst & Young LLP; KPMG LLP; New York State Society of Certified 
Public Accountants; PricewaterhouseCoopers LLP; The 100 Group of 
Finance Directors; and The Institute of Internal Auditors.
    \45\ See for example, Accretive Solutions; BDO Seidman, LLP; 
Center for Audit Quality; Deloitte & Touche LLP; Ernst & Young LLP; 
Grant Thornton LLP; and PricewaterhouseCoopers LLP.
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    Some of the features of Auditing Standard No. 5 that the Commission 
expects will result in improved effectiveness and efficiency include 
the direction provided to auditors to focus on what matters most, the 
elimination of unnecessary procedures from the audit, the ability to 
scale the audit to fit the size and complexity of the company, the 
alignment with the Commission's interpretive guidance for management, 
and its less prescriptive nature. Consequently, the Commission believes 
that Section 404 compliance costs, for both management's evaluation as 
well as the external audit, will decrease as a result of the 
Commission's efforts and Auditing Standard No. 5.
    Some commenters noted that while Auditing Standard No. 5 may 
curtail excessive testing of controls and reduce some of the 
unnecessary documentation currently required for Section 404 audits, 
they still have concerns about the extent to which it will reduce costs 
for smaller public companies.\46\ A number of commenters urged the 
Commission and PCAOB to monitor

[[Page 42146]]

closely the extent to which the standard as implemented achieves a 
reduction in cost, and to take action if there is not an appropriate 
reduction.\47\
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    \46\ See for example, America's Community Bankers; David A. 
Doney; Independent Community Bankers of America; National Venture 
Capital Association; J Lavon Morton; R.G. Scott; XenoPort, Inc.; and 
U.S. Chamber Center for Capital Markets Competitiveness.
    \47\ See for example, American Bankers Association; America's 
Community Bankers; Biotechnology Industry Organization; Independent 
Community Bankers of America; Institute of Chartered Accountants in 
England and Wales; Institute of Management Accountants; The 100 
Group of Finance Directors; and U.S. Chamber Center for Capital 
Markets Competitiveness.
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    In response to continued concerns about the extent of cost 
reductions, the Commission's staff is planning to analyze and report on 
the costs associated with the implementation of the Commission's 
interpretive guidance for management as well as the implementation of 
Auditing Standard No. 5. The staff will make any recommendations it 
believes appropriate to the Commission.
    (7) Does AS5 inappropriately discourage or restrict auditors from 
scaling audits, particularly for smaller public companies?
    With regards to scalability, most commenters who responded to this 
question noted that Auditing Standard No. 5 appropriately discusses the 
concepts of scalability based on size and complexity without including 
inappropriate restrictions on the auditor's ability to scale the 
audit.\48\ Other commenters observed that where feasible, Auditing 
Standard No. 5 should also provide additional guidance on how to 
effectively plan an integrated audit for smaller public companies and a 
discussion of related best practices to enhance a broader understanding 
of risk-based auditing.\49\ One commenter expressed concern that an 
objective definition of ``smaller company'' is necessary in order to 
provide meaningful direction in scaling the audit and that the standard 
should clarify that both smaller and less complex companies would be 
subject to scaled audits.\50\
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    \48\ See for example, BDO Seidman, LLP; Center for Audit 
Quality; Council of Institutional Investors; Deloitte & Touche LLP; 
Ernst & Young LLP; Grant Thornton LLP; PepsiCo; 
PricewaterhouseCoopers LLP; and The Institute of Internal Auditors.
    \49\ See for example, New York State Society of Certified Public 
Accountants.
    \50\ Biotechnology Industry Organization.
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    The Commission believes that Auditing Standard No. 5 appropriately 
discusses the concepts of scalability without including inappropriate 
restrictions on the auditor's ability to scale the audit. Further the 
Commission agrees with the guidance in Auditing Standard No. 5 that 
provides for scaling and tailoring of all audits to fit the relevant 
facts and circumstances. The Commission also agrees with the statement 
made by the Board in its release to Auditing Standard No. 5 that 
``scaling will be most effective if it is a natural extension of the 
risk-based approach and applicable to all companies.'' \51\ As a 
result, Auditing Standard No. 5 contains not only a separate section on 
scaling the audit, but it also contains specific discussion of scaling 
concepts throughout the standard. The Commission believes that these 
concepts will enable tailoring of internal control audits to fit the 
size and complexity of the company being audited rather than the 
company's control system being made to fit the auditing standard. 
Additionally, as some commenters observed, the PCAOB's project to 
develop guidance and education for auditors of smaller public 
companies, along with the Committee of Sponsoring Organizations of the 
Treadway Commission's (``COSO'') project to develop guidance designed 
to help organizations monitor the quality of their internal control 
systems and other COSO guidance directed to smaller public companies, 
should also facilitate the implementation of Section 404 in an 
effective and efficient manner.\52\
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    \51\ See PCAOB Release No. 2007-005 (May 24, 2006).
    \52\ See for example, Center for Audit Quality, Deloitte & 
Touche LLP; and PricewaterhouseCoopers LLP.
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    In summary, the Commission believes that Auditing Standard No. 5, 
the related independence rule, and the conforming amendments will 
enable better integrated, more effective, and more efficient audits 
while satisfying the requirements set forth in Sections 103 and 404 of 
the Act. Further, the Commission notes that Auditing Standard No. 5 is 
appropriately aligned with the Commission's own rules and interpretive 
guidance for management.

IV. Conclusion

    On the basis of the foregoing, the Commission finds that proposed 
Auditing Standard No. 5, the related independence rule, and the 
conforming amendments are consistent with the requirements of the Act 
and the securities laws and are necessary and appropriate in the public 
interest and for the protection of investors.
    It is therefore ordered, pursuant to Section 107 of the Act and 
Section 19(b)(2) of the Exchange Act, that proposed Auditing Standard 
No. 5, An Audit of Internal Control Over Financial Reporting that is 
Integrated with an Audit of Financial Statements, the Related 
Independence Rule, and Conforming Amendments (File No. PCAOB-2007-02) 
be and hereby are approved.

    By the Commission.
Nancy M. Morris,
Secretary.
 [FR Doc. E7-14858 Filed 7-31-07; 8:45 am]

BILLING CODE 8010-01-P