The PCAOB’s “Modest Proposal” to Modernize the Foundations of Auditing

By Dan Goelzer

On March 28, the Public Company Accounting Oversight Board issued for comment a proposed new auditing standard, AS 1000, General Responsibilities of the Auditor in Conducting an Audit. If adopted, AS 1000 would reorganize and consolidate existing PCAOB standards that address the core principles of auditing and the responsibilities of the auditor. According to the PCAOB release announcing the proposal, AS 1000 and related amendments to the existing standards “are designed to streamline and clarify general principles and responsibilities of auditors and provide a more logical presentation, which would enhance the useability of the standards by making them easier to read, understand, and apply.” The Board has requested public comment on the proposal by May 30, 2023.

The basic idea of updating and consolidating the foundational standards is sound. Technology, audit practice, and the standards of other audit regulators have all evolved since the PCAOB adopted the existing standards, on an “interim basis,” in 2003. Twenty years down the road, it makes sense to revisit the foundational standards, and the Board deserves credit for doing so.

But, in presenting this initiative as in essence a matter of housekeeping, the PCAOB may be seriously understating its potential impact. The proposal is not merely a repackaging of existing principles. Some aspects would seem to involve changes to the auditor’s responsibilities that would be more fundamental than the release recognizes and could have far-reaching consequences.

1. Present fairly.

The auditor is required to express an opinion on whether the financial statements “present fairly” in all material respects the company’s financial position and results of operations “in conformity with the applicable financial reporting framework.” AS 3101. While the concept of “fairness” is potentially broad and subjective, AS 2815 explains that the auditor’s judgment concerning fair presentation is made within the framework of generally accepted accounting principles — GAAP. “Without that framework, the auditor would have no uniform standard for judging the presentation of financial position, results of operations, and cash flows in financial statements.”

The proposal would retain the phrase “the financial statements, taken as a whole, are presented fairly, in all material respects, in conformity with the applicable financial reporting framework” in describing the auditor’s objective, but would change what that phrase means. AS 2810 would be amended to require that, in determining whether the financial statements meet the fair presentation test, the auditor should evaluate, among other things, whether “the information in the financial statements is presented and classified appropriately and in a manner that would be informative and not misleading to a reasonable investor” and whether “transactions and relevant events and conditions are appropriately recognized, measured, and disclosed in the financial statements.” AS 2815 would be rescinded.

The PCAOB’s release explains that these amendments would “clarify” that, despite the words of the standard, the auditor’s determination of fairness actually “goes beyond” evaluation of whether the financial statements are presented in conformity with the applicable financial reporting framework. The Board notes that the federal securities laws prohibit financial statements and company disclosures from being materially misleading, which it describes as “a broader concept than “mere compliance” with the applicable financial reporting framework. Accordingly, auditor’s obligation concerning the fairness of the financial statements extends beyond determining “technical compliance” with GAAP.

This broader definition of the auditor’s responsibility and of the meaning of an audit report may be a good idea in concept and may to some extent be inherent in the existing requirement. But explicitly jettisoning GAAP as the context in which the auditor determines the fairness of the financial statement presentation and replacing it with the need to make judgments about what is or is not “presented appropriately” or “informative and not misleading to a reasonable investor” is a change that deserves more discussion and explanation than the PCAOB has provided. At minimum, the Board needs to be clearer about how concepts like “appropriately” and “informative” should be applied in practice. Without more guidance, the PCAOB’s proposal could potentially expose auditors to liability for issuing a clean opinion on financial statements that conform to GAAP but that, in hindsight, did not appropriately inform investors of some risk or of the substance of some or event at the company.

2. Engagement partner responsibility.

The proposal would also make several changes that arguable expand the engagement partner’s responsibilities, increase the scope of his or her review of the work of engagement team members, and decrease the extent to which the engagement partner can rely on the work of other supervisory personnel. For example, AS 1201 currently states that the engagement partner is responsible for the engagement and its performance, including for proper supervision of the work of engagement team members. However, AS 1201 also provides that the engagement partner “may seek assistance from appropriate engagement team members * * * in fulfilling his or her responsibilities pursuant to this standard.” The proposal would modify the engagement partner’s ability to seek assistance by adding two new Notes:

“Even when the engagement partner seeks assistance, the engagement partner retains primary responsibility for the engagement and its performance. The assistance provided by appropriate engagement team members to supervise, including review, the work of other engagement team members does not replace or reduce the engagement partner’s responsibility.” Proposed Note to AS 1201.04

“Notwithstanding assistance from other engagement team members performing supervisory activities, the engagement partner, as the individual primarily responsible for the engagement and its performance, must review sufficient documentation to determine that (i) the engagement was performed as planned; (ii) significant judgments were appropriate and significant findings and issues * * * were appropriately addressed; (iii) the conclusions expressed in the auditor’s report are appropriate and supported by sufficient appropriate evidence; and (iv) matters requiring communication under applicable professional and legal requirements are appropriately identified and communicated * * *. ” Proposed Note 2 to AS 1201.05c.

It is hard to predict what these changes would mean in practice and how the PCAOB’s inspections and enforcement staffs would apply them. The implication that the engagement partner should not rely on the work of other supervisory members of the engagement team seems unrealistic in large, complex audits of multinational companies. At a minimum, the Board’s views on the extent to which the engagement partner can properly rely on the work of other supervisors, and the extent to which it intends to change existing practice, should be spelled out. The PCAOB’s release simply states: “We believe this amendment [proposed AS 1201.05c.Note 2] clarifies the engagement partner’s existing obligations for supervision and review as the engagement team member with primary responsibility for the engagement.” Like the change in the description of what it means to determine that financial statements are “presented fairly”, treating this aspect of the proposal as merely a clarification of existing responsibilities may understate the impact of what the Board is proposing. A more in-depth discussion of the Board’s views of the relationship between engagement partners and senior engagement team supervisory personnel would be helpful.

3. Reasonable assurance.

Current AS 1015.10 provides that the exercise of due professional care allows the auditor to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud, or whether any material weaknesses in internal control over financial reporting exist as of the date of management’s assessment. AS 1015 observes that absolute assurance is not attainable “because of the nature of audit evidence and the characteristics of fraud. Although not absolute assurance, reasonable assurance is a high level of assurance.” AS 1015 describes in some detail the extent of, and limitations on, the concept of reasonable assurance.

The proposal would rescind AS 1015. With respect to reasonable assurance, it would replace the discussion in AS 1015 with this statement:

“Reasonable assurance is a high level of assurance and is obtained by reducing audit risk to an appropriately low level through the application of due professional care, including by obtaining sufficient appropriate audit evidence. The auditor is able to obtain reasonable, but not absolute, assurance that (1) misstatements are detected that, individually or in combination, would result in material misstatement of the financial statements; and (2) in an audit of internal control over financial reporting, material weaknesses are detected.” Proposed AS 1000.14 (footnote omitted).

The PCAOB’s release explains, without any specific discussion, that the Board proposes to delete the “limitations” in existing AS 1015 on the concept of reasonable assurance. Below are examples of some of the deletions:

• “Therefore, an audit conducted in accordance with the standards of the [PCAOB] * * * may not detect a material weakness in internal control over financial reporting or a material misstatement to the financial statements.” (AS 1015.10)
• “As a result of these factors, in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing.” (AS 1015.11)
• “Because of the characteristics of fraud, a properly planned and performed audit may not detect a material misstatement. * * * Collusion may cause the auditor who has properly performed the audit to conclude that evidence provided is persuasive when it is, in fact, false. * * * Finally, management has the ability to directly or indirectly manipulate accounting records and present fraudulent financial information by overriding controls in unpredictable ways.” (AS 1015.12)
• “Therefore, the subsequent discovery that either a material misstatement, whether from error or fraud, exists in the financial statements or a material weakness in internal control over financial reporting exists does not, in and of itself, evidence (a) failure to obtain reasonable assurance, (b) inadequate planning, performance, or judgment, © the absence of due professional care, or (d) a failure to comply with the standards of the [PCAOB] * * * .” (AS 1015.13)

Some of the text that is being eliminated may not have much effect on audit practice, but it is important in defining the scope of the auditor’s responsibilities, especially when audit work is challenged. If these points are to be deleted, the Board should explain whether, by the deletion, it intends to indicate disagreement with their substance. If it does disagree with the substance, it should explain how and why. The significance of these deletions is likely to be an issue in future litigation against auditors. The Board should clarify its intent, rather than leaving it to the courts to determine whether the concept of reasonable assurance is changing and what the impact is.

* * *

As noted at the beginning, modernizing the PCAOB’s auditing standards is completely appropriate, and the Board deserves credit for undertaking this task. But the proposal the Board has published may have consequences that are not fully analyzed in the release. In the areas described above, the Board has proposed to restate the auditing standards in ways that could have significant effects on how audits are performed and on when auditors are exposed to liability. The Board should explain in greater detail than it has offered in its release what it intends and how it expects auditors to change their behavior in response. To label these changes as merely clarifications and then leave it to the PCAOB’s inspections and enforcement staffs (and the courts) to fill in the details does a disservice to the profession and hampers the ability of auditors to comply with the Board’s objectives.