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The Public Company Accounting Oversight Board (PCOAB) has approved a new auditing standard designed to encourage robust, two-way communications between auditors and audit committees. Known as Auditing Standard No. 16 (AS 16), the new standard updates older versions that were crafted prior to the passage of the Sarbanes-Oxley Act (SOX), and it expands the requirements in some areas, such as critical accounting policies, that typically draw inquiries from knowledgeable audit committees. AS 16 also incorporates best practices, adds to the questions that auditors are required to ask audit committees, and provides guidance on the interaction of auditor and management communications.

This Messenger explains why auditor communications play a critical role in helping audit committees meet their responsibilities, and it highlights some of the expanded requirements for auditors, along with the steps that audit committees can take now to get the most from the two-way communications.

A critical role in audit committee responsibilities

The primary focus of the PCAOB’s standard is on requirements for external auditors. The Board does not have the authority to set requirements for audit committees. But it recognizes that robust communications with auditors play a critical role in

MAYER HOFFMAN MCCANN P.C. – AN INDEPENDENT CPA FIRM

A publication of the Professional Standards Group

October 2012

MHMMessenger

PCAOB Auditing Standard on Communications with Audit Committees

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audit committee responsibilities that have evolved from SEC rules, SOX requirements, and other developments, including the following.

• SEC rules. Under SEC rules that date back to the years before SOX was enacted, public companies are required to include in their proxy statements a report from the audit committee stating whether it recommends to the board of directors that the audited financial statements be included in the company’s annual report. The rules provide that this recommendation should be based on the disclosures made by the external auditor about its independence and other topics required by auditing standards, as well as a review and discussion of the annual financial statements with management.

• SOX requirements. The Sarbanes-Oxley Act added significantly to the audit committee’s responsibilities. The added duties include: (a) the appointment and compensation of the auditor, (b) oversight of the auditor’s work, including resolution of any disagreements between the auditor and management on financial reporting, (c) reviews of reports from the auditor, including reports on critical accounting policies and practices, alternative treatments discussed with management and their ramifications, and the auditor’s preferred treatment, (d) reviews of reports by management about significant deficiencies in the internal controls over financial reporting and any fraud involving management or others with a significant role in internal controls, and (e) establishment and oversight of procedures to receive and handle

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complaints, including confidential handling of employee complaints known as whistle-blower protection.

• Other developments. Stock exchange rules and voluntary adoption of best practices require or encourage additional responsibilities. These duties include the need for the audit committee to develop or maintain a level of financial literacy or financial expertise, oversee ethical codes of conduct, monitor systems for compliance with legal and regulatory requirements, have the authority to investigate matters when appropriate, and adopt a formal written charter and report on whether or not it has met its responsibilities under the charter.

New and expanded requirements for auditors

AS 16 is designed to work and enhance the existing audit committee responsibilities described above. Currently, AS 16 is awaiting final approval by the SEC. If approved, the major changes in auditing standards would include the following:

• Timing of communications. AS 16 would clarify that all required communications should take place before the issuance of the auditor’s report. In practice, the required communications about many topics, such as an overview of the audit strategy, will likely be made much earlier in the process. But this clarification would help to encourage robust two-way communications by precluding the postponement of any required communications until after the report is issued.

• Inquiries of audit committees. Auditors would be required to ask the audit committee if it is aware of certain matters that relate to the audit, including any awareness of violations (or possible violations) of laws. This represents an expansion

of the existing requirements for auditors to ask if the audit committee is aware of any risks related to the company’s financial reporting, such as tips or complaints that may have been received through the audit committee’s internal whistle-blowing program.

• Interaction with management’s communications. The new standard would clarify the ways the auditor’s communications should interact with management’s communications. Specifically, if management communicates to the audit committee about certain topics, then the auditor does not need to use the same level of detail in its communications about these matters, as long as certain conditions are met. The topics include significant or critical accounting policies and practices, critical accounting estimates, and significant unusual transactions. The necessary conditions include the following: (1) the auditor must have participated in management’s discussion with the audit committee, (2) the auditor must have affirmatively confirmed to the audit committee that management has adequately communicated these matters, and (3) with respect to critical accounting policies and practices, the auditor must have identified for the audit committee the ones that the auditor considers critical.

• Critical accounting policies. In addition to identifying the critical accounting policies and practices, auditors would be required to communicate why these policies and practices are considered critical and how current and anticipated future events might affect the determination of what is considered critical. This requirement expands the requirement for communications about significant accounting policies and makes an important distinction between significant and critical policies.1

• Critical accounting estimates. Auditors would also be required to communicate any significant

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scope to matters about which the auditor has identified a concern, and (2) requiring the auditor to communicate its views about these matters.

• Going concern. Auditors would be required to make certain communications if they believe there is substantial doubt about the company’s ability to continue as a going concern or if such a concern is subsequently alleviated. The required disclosures include the conditions and events that in the aggregate indicate substantial doubt; the basis for the auditor’s conclusion that the doubt is alleviated; and the effects, if any on the financial statements, the adequacy of the related disclosure, and the auditor’s report.

• Applicability to broker-dealers. The PCAOB intends for AS 16 to apply to audits of broker-dealers once it is approved by the SEC and takes effect. Currently, audits of broker-dealers are being transitioned to PCAOB standards. In the interim, the applicable auditing standards are those issued by the American Institute of CPAs. To fill any timing gap that might otherwise result, the PCAOB has adopted a transitional amendment under which PCAOB AU Section 380 may apply to audits of broker-dealers until AS 16 is approved and effective.

• Applicability to emerging growth companies. The rules adopted by the PCOAB do not apply to emerging growth companies under the Jumpstart Our Business Startups Act (JOBS Act) unless the SEC determines that such applicability is in the public interest. The PCAOB has requested that the SEC approve the applicability of AS 16 and related amendments to these companies.

changes made by management to the processes used to develop critical accounting estimates, along with management’s reasons for the changes and the effects on the financial statements. If these communications are made by management, then the clarification discussed above about the interaction of auditor’s and management’s communications would apply. AS 16 requires that auditors communicate these matters as a safeguard to help ensure the audit committee is adequately informed.

• Significantunusual transactions. AS 16 would require that auditors provide certain information to audit committees about significant unusual transactions. In effect, these are significant transactions that are outside the normal course of business for the company or otherwise appear to be unusual due to their timing, size or nature. For these transactions, auditors would be required to communicate: (1) the policies and practices used by management to account for these transactions, and (2) the auditor’s understanding of the business rationale for the transactions, which would be conveyed as part of the communications about the quality of financial reporting.

• Difficult or contentiousmatters. AS 16 would require that auditors communicate the nature of any matters that are considered difficult or contentious, if: (1) the auditor consulted with others outside the engagement team about these matters, and (2) the auditor makes a reasonable determination that these matters are relevant to the audit committee’s oversight.

• Management’s consultation with other accountants. AS 16 would modify the requirement for communications about management’s consultations with other accountants on significant accounting or auditing matters by: (1) limiting the

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Steps that audit committees can take now

When AS 16 was released, PCAOB Chairman James Doty noted that many an audit committee has wondered with regret, “Why didn’t the auditors tell us about this?” He expressed the hope that the new standard would eliminate perceived constraints on auditor communications and foster more robust communications. MHM agrees that any steps taken to improve the content and timeliness of the communications between auditors and audit committees will help promote high quality audits. If an audit committee has a better understanding of matters known to auditors, then it will be better equipped to meet its responsibilities to oversee the auditor’s work, resolve any disagreements between the auditor and management on financial reporting, and reach a conclusion as to whether the audited financial statements should be included in the company’s annual report. But more robust two-way communications will not succeed without a determined effort on the part of audit committees to be knowledgeable about specific areas that may expose investors to risks.

Here are some steps that audit committees can take now to get the maximum benefits from two-way communications.

1. Know what communications are required from auditors under current auditing standards. Appendix B of AS 16 provides a good starting point for audit committees of public companies. (See excerpts on appendix to this Messenger)

2. Monitor current accounting, auditing and regulatory developments.

3. Compile a list of probing questions for the executive sessions held by your audit committee. Depending on the company’s structure and organization, these sessions may be held periodically with key

members of the executive management team, leaders of the financial management team, and the head of internal audit, as well as the independent auditor.

4. Keep the list of questions current by considering the dynamics of the industry in which the company operates, the current economic climate, any potential changes in the competitive, legislative, or regulatory environments, and any new risks or uncertainties.

5. Develop threshold criteria for defining the types of issues, estimates and judgments about which your committee wants to receive issues reports from management.

6. Establish a format and system for tracking the status of any complaints or tips received.

7. If you are the audit committee chair, take steps to ensure that you and other committee members are receiving adequate training on topics ranging from accounting and financial reporting developments to corporate governance and legal developments.

8. Make time to avail yourself of other ways to build your knowledge of the company, including visits to company plants and facilities, meetings with business unit leaders, and listening to management’s calls with analysts.

Questions that may be asked of or by auditors

As the demands on audit committees have grown over the years, so has the need for efficient and focused executive sessions. In some respects, the questions are easier to ask when the risks are raised first in written communications from auditors. This way, the audit committee can develop its own views

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about potential risks, such as the appropriateness of assumptions used in critical accounting estimates, before discussing these risks further in an executive session with the independent auditor.

Here are a few examples of questions that knowledgeable audit committees might ask of auditors or that auditors might ask of the audit committee:

1. In your view, is the company making appropriate use of third-party specialists for its fair value measurements and does the company have adequate support for its disclosures about balance sheet offsetting?

2. Is the company’s presentation of other comprehensive income as clear as it could be? Are there any details you would have reported differently, if you were preparing the financial statements?

3. There was a large adjustment to revenue in the fourth quarter. Have you reviewed this adjustment to ensure the business rationale is appropriate?

4. Are you aware of any “close calls” involved in the company’s tests for impairment of goodwill or indefinite-lived intangibles? Do you feel there is sufficient audit evidence to support these calls?

5. Are you aware of any SEC comment letters that could potentially have relevance for the company’s policies for revenue recognition, segment reporting, or other areas of accounting?

6. Do you think the accounting changes being considered now for revenue recognition and/or other areas will change the accounting policies that are considered critical?

7. How subjective are the assumptions underlying the reserve for uncertain tax positions? Do you feel any of these assumptions are open to challenge?

8. In your experience, is the company’s use of the term “realizable pay” in its disclosures about executive compensation clear and consistent with the usage of the term by other companies? Do you feel these disclosures are consistent with the intent of the Dodd-Frank Act?

9. In your experience, are the systems and procedures established by management to comply with the SEC’s new rule on conflict minerals adequate and appropriate?

For more information

The SEC’s comment period ends on October 9, 2012. If you would like additional information about audit committee communications in general, or if you have any specific questions, comments or concerns about AS 16, please contact Rich Howard of MHM’s Professional Standards Group or your MHM service professional. You can reach Rich directly at rhoward@cbiz.com or 949-450-4402.

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MHMMessenger

The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please contact your MHM service provider to further discuss the impact on your financial statements.

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1 AS 16 uses the following definitions:

Critical accounting estimate. An accounting estimate where (a) the nature of the estimate is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and (b) the impact of the estimate on financial condition or operating performance is material.

Critical accounting policies and practices. A company’s accounting policies and practices that are both most important to the portrayal of the company’s financial condition and results, and require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Audit committee. AS 16 defines audit committee as a committee (or equivalent body) established by and among the board of directors of a company for the purpose of overseeing the accounting and financial reporting processes of the company and audits of the financial statements of the company; if no such committee exists with respect to the company, the entire board of directors of the company. For audits of nonissuers, if no such committee or board of directors (or equivalent body) exists with respect to the company, the person(s) who oversee the accounting and financial reporting processes of the company and audits of the financial statements of the company.