October 17, 2007
Anxiety on Internal Control
Posted by Lawrence Cunningham

            A political storm is settling down over how much effort auditors should make when testing financial report reliability.  Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB) and told it to have auditors test and report on a company's internal controls as a way to infer how reliable its financial statements are. Under PCAOB's first standard (2004), managers protested that auditors were asking too much at too great a cost.  The SEC intervened to address this criticism by getting PCAOB to withdraw its original standard and replace it with a new one, which the SEC approved this summer.   How do the two compare?

            The original: (1) required auditors to do their own tests of controls, tell investors of any discovered problems, and explain their meaning for financial statement reliability; (2) said auditors had to disclose issues posing more than remote risks of misstatements; (3) let auditors choose what framework to use for the tests; (4) made both quantitative and qualitative problems relevant; and (5) told auditors how to evaluate audit committees.

            The new version: (1) lets auditors rely on management for much of the testing and defer to management's report to investors about any problems; (2) gives investors only information about problems posing a "reasonable possibility" of misstatements; (3) lets management chooses what framework to use and requires auditors to follow management's choice; (4) scraps any notion of qualitative importance; and (5) throws out guidance on how to assess audit committees.

            Proponents of the new version say it is more efficient by lowering costs of this exercise. Critics say audit quality, not efficiency, should guide evaluation of controls and financial statement reliability.  Some defend the new standard by denying that it deviates from the original in substance, saying it is better because it uses "principles" not "rules."  By this they mean it gives auditors and managers flexibility rather than spelling out what is required in detail.

            The jury will be out on the merits for quite some time.   We know that the original generated significant costs and can be fairly certain from the changes that the new version will cost less.  Between the standards, the pendulum swung from one extreme toward the other.  The unknown is whether it is now in the right place.  We will only know that after the next wave of financial reporting fiascos occurs and is diagnosed.  But you can be sure the diagnosis will focus on the quality of internal control.

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