Current SEC and PCAOB Developments
CPAs Urged to ‘Get Back to the Basics’

By George I. Victor and Moshe S. Levitin

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The Profession’s Role

SEC Commissioner Harvey Goldschmid reminded auditors that the investing public views them as gatekeepers, watching to ensure that companies do not “go over the line.” He expressed satisfaction with the progress made since the enactment of the Sarbanes-Oxley Act of 2002 (SOA) and the resulting SEC rulemaking, and indicated that, over time, the benefits of complying with SOA will outweigh the costs. As an example, he noted that disclosures in financial statements have improved significantly now that CEOs and CFOs must certify those statements.

The SEC’s then–chief accountant, Donald Nicolaisen, explained how the Office of the Chief Accountant operates. A significant part of its operations includes providing useful information to the investing public in a timely and cost-effective manner. He highlighted the issues created by the continued discovery of “failures of business ethics and of disclosures to shareholders” and stated that “while the auditing profession may have turned the corner, its work is not yet done,” adding, “There is still much we can do.”

PCAOB board member Charles D. Niemeier commended accountants for being responsive to the call for needed change: “I am proud to say that the accounting profession has courageously looked at its involvement with [past accounting scandals] and has accepted the need to change. It has faced its shortcomings and is learning from them. And with that acceptance, the accounting profession has moved beyond the problems of the past and entered a new phase where accountants will no longer accept being minimum compliance experts. Instead, accountants are becoming the promoters of best practices, where accountants will no longer allow improper financial reporting just because there is nothing in the rules that says it can’t be done, or just because the issue isn’t an SEC hot button, or just because it involves a substantial client.”

PCAOB Inspections of Audit Firms

George Diacont, PCAOB director of registration and inspection, stated that the goal of the PCAOB inspection process is to identify the cause of any deficiencies identified in a firm’s system of quality control, and to determine if the problem is isolated or systemic. He indicated that if the inspection team finds significant problems in a particular office, it may extend its stay and request additional engagements to inspect, or it may focus on matters such as whether partners are overloaded with work. Diacont also emphasized that the PCAOB may not consider a firm’s substandard audit documentation to be only a document deficiency problem. In such cases, the inspectors may require the firm to prove that the work was actually done.

Diacont stated that, in 2003 and 2004, the PCAOB inspection teams reviewed the following:

• Tone at the top;
• Partner compensation, promotion, and evaluation;
• Independence;
• How firms identify high-risk clients (client acceptance and retention policies);
• Internal inspection programs;
• Correction of deficiencies found by internal quality review;
• Communication within the firm of policies and procedures; and
• Quality assessment of the work of foreign affiliates.

The most pervasive deficiencies that the inspection teams have identified are the failure to properly document significant accounting and audit issues, and the failure to properly document audit evidence, especially concerning contingencies, accruals, and deferred tax assets.

Sarbanes-Oxley Section 404

Management’s assessment report. The SEC staff stated that although there is no standard report format for management’s assessment of the effectiveness of internal controls over financial reporting, the report must contain, at a minimum, the disclosures required by Item 308 of Regulations S-K and S-B.

The SEC staff indicated that if management discloses other information in its report, such as the company’s plan to implement new controls, corrective actions taken after the assessment date, or management’s opinion that the cost of correcting a material weakness would exceed the benefit of implementing new controls, then the auditor should disclaim an opinion on this additional information. The SEC staff also suggested that this type of information should perhaps be part of management’s discussion and analysis (MD&A).

Asked whether management’s assessment report can be qualified with statements like “effective except for …,” or be subject to other qualifications, the SEC staff stated that scope limitations are unacceptable (aside from the limited situations covered in SOA section 404 Q&As 1, 2, and 3). Management’s report may conclude only that internal controls over financial reporting are effective or ineffective. The PCAOB staff noted that PCAOB’s Q&A 28 addresses the effect of a scope limitation on the auditor’s report.

Although the rules do not specify where management’s internal control report should be located in the filing, the SEC staff expects the report to be in close proximity to the auditor’s report, and both reports to be near MD&A.

Material weaknesses. The PCAOB staff urged auditors to communicate any identified material weaknesses to both management and the audit committee on an interim basis, rather than waiting until the conclusion of the audit. That would give the company the opportunity to begin remediation efforts as soon as practicable.

Auditor’s report on management’s assessment. The PCAOB staff noted that the auditor’s report on management’s assessment of the effectiveness of internal control over financial reporting should not focus on the adequacy of management’s assessment process and documentation. Rather, it should address management’s conclusion about the effectiveness of internal control. If the auditor believes management’s assessment process is inadequate, that conclusion should be communicated to management and to the audit committee. The auditor’s report would disclaim an opinion on both management’s assessment and on internal control effectiveness. If the auditor believes management’s process to be inadequate, the auditor must determine if management has fulfilled its responsibilities and complied with SOA section 404.

If the auditor disagrees with management’s assessment that internal controls are effective because of the existence of one or more material weaknesses, the auditor should issue an adverse opinion on management’s assessment, because the auditor and management reached different conclusions. The auditor would also issue an adverse opinion on the company’s internal controls over financial reporting, because the auditor believes there is a material weakness in internal control.

According to the PCAOB staff, if management cannot complete its assessment of internal controls by the Form 10-K filing deadline, then the auditor should issue a disclaimer of opinion on both management’s assessment and on the effectiveness of internal control. This also would result in the SEC staff considering the filing deficient.

If the company fixed a control subsequent to its year-end, the auditor may not consider that remediation as part of the year-end internal control audit. However, the SEC staff said that an auditor may continue to document and test pre–year-end data subsequent to the year-end. The company and the auditor should bear in mind that any material weakness that was fixed or remediated prior to year-end must be in place for a “sufficient period of time” prior to year-end so that it can be adequately tested.

Effect of restatement on disclosure controls and procedures. The SEC staff stated that it may closely examine a company’s disclosures of its “controls and procedures” whenever the company restates previously issued financial statements. According to the staff, a restatement calls for a reevaluation by the company’s CEO and CFO of their previous conclusions regarding the effectiveness of the entity’s disclosure controls and procedures.

At a minimum, the SEC staff believes that a company should disclose in its amended filing, if true, why management believes that, even though a restatement was necessary, the company still had effective disclosure controls and procedures. The SEC staff also noted that a company should disclose in its amended filing what problem caused the restatement, and what the company did or will do to fix the internal control deficiencies.

The SEC staff expressed its hope that if registrants and auditors focus on improving internal control, albeit initially at great cost, the benefits, such as fewer restatements, will outweigh the costs over time.

Extension of section 302 and 404 deadlines for nonaccelerated filers and foreign private issuers. Subsequent to the conference, the SEC announced that it had granted nonaccelerated filers and foreign private issuers additional time to comply with the requirements of SOA sections 302 and 404. Nonaccelerated filers and foreign private issuers must comply with the financial reporting internal control requirements in sections 302 and 404 for their first fiscal year ending on or after July 15, 2006. The reason for this one-year extension from the previous compliance date of July 15, 2005, was to offer temporary relief for smaller public companies that had concerns about the significant burdens and additional cost associated with complying with the new rules. In addition, foreign companies faced additional challenges in preparing financial statements following international accounting standards.

In conjunction with the extended deadline, the SEC is pursuing two other initiatives. First, the SEC has established an Advisory Committee on Smaller Public Companies to help the SEC evaluate the current securities regulatory system relating to smaller public companies, including the internal control requirements. Second, the Committee on Sponsoring Organizations (COSO) has established a task force to expand the existing COSO framework and provide more guidance on how it can be applied to smaller companies.

Effect on the PCAOB inspection process. The PCAOB staff noted that during inspections of CPA firms it will focus on the auditor’s explanatory disclosures of any material weaknesses. The SEC staff indicated that these disclosures must be in plain English and must be meaningful, not boilerplate. The company should fully explain the weakness and its actual or potential effect on the financial statements, and describe the company’s plans to fix the problem.

Areas of Increased SEC Scrutiny

The SEC staff stated that it will focus its limited resources on the areas it believes have the greatest potential for accounting abuse.

Transfers into and from the trading account. Companies have been transferring securities to and from the trading category for various reasons, including changes in investment strategy and repositioning the portfolio due to anticipated changes in economic outlook. The SEC staff stated they expect transfers to and from the trading category to be rare, and that the aforementioned reasons are not, in their view, rare. Because rare does not mean prohibited, the SEC staff suggested that the following reasons would be acceptable for such transfers:

• A change in regulatory or statutory requirements;
• A significant business combination or other event that substantially alters the company’s liquidity position or investing strategy; or
• Other facts and circumstances that clearly establish that the event is unusual and highly unlikely to recur in the near future.

Because the SEC staff said it is looking closely at these transactions, companies are well advised to consult the SEC before making any such transfers.

Materiality. Auditors generally use two methods for evaluating the materiality of misstatements or errors in the financial statements: the rollover, also known as the current-period or income-statement method, and the iron curtain, also known as the cumulative or balance-sheet method. The rollover method considers an error to be the amount recorded in the current-period income statement that should not have been recorded. The iron curtain method considers an error to be the total effect of all amounts that have been recorded in the company’s books during the current and prior periods.

For example, if a company increases a reserve by $20 more than necessary each year for three years, the rollover method treats the error as being $20 each year. The iron curtain method treats the error as $20 in the first year, $40 in the second, and $60 in the third. Assume that $20 would be immaterial in all periods, but $60 would be material. Under the rollover method, there is no material error unless the company wishes to reverse the accrual in the fourth year, because doing so would put $60 out of period. Thus, under the rollover method, eliminating the overaccrual in the fourth year becomes a material error. Under the iron curtain method, the error would need to be corrected in year 3 because it became material in that year.

Because current accounting and auditing literature does not address this issue, auditors have no guidance as to which method is preferable. Using the dual approach that the SEC staff at this conference recommended would result in a larger misstatement. In the above examples, the iron curtain method yields the larger misstatement.

Under the iron curtain approach, which is balance-sheet biased, the company would consider the impact of the overstatement of $100 in its period-end quantitative evaluation. Under the income-statement rollover approach, the evaluation would consider the net understatement effect of $20, which results from the beginning of the year cut-off issue ($120 understatement) and the end of the year cut-off issue ($100 overstatement). Therefore, the method used could clearly significantly affect the resulting analysis.

Correcting previously immaterial errors. In a related matter, the SEC staff addressed uncorrected misstatements that were immaterial in prior periods but became material in the current period. This may occur, for example, because of a misstatement that accumulated over several reporting periods.

Some maintain that because the misstatement remains immaterial to prior periods, preparers should fix the misstatement in the current period, with adequate disclosure. According to the SEC staff, however, if the reversing or carryover effects of a prior-period misstatement are material to the current period, then the correction of that misstatement should be reported as a prior-period adjustment, resulting in the restatement of the prior-period financial statements. This guidance is consistent with SAB Topic 5.F., “Accounting Changes Not Retroactively Applied Due to Immateriality.”

Using other auditors. The SEC staff provided the following hypothetical situation: A U.S. auditor engages a foreign accounting firm to audit a significant foreign subsidiary of the registrant; the U.S. auditor chose not to make reference to the foreign accounting firm in its audit report. The SEC staff said the foreign accounting firm must be registered with the PCAOB if it performs a substantial portion of the audit. Although representatives of the U.S. audit firm do not need to travel to the foreign location, the firm is nevertheless responsible for the overall audit. The staff also stated that foreign accounting firms must be recognized by the SEC as a having the proper qualifications to practice before the SEC. Those qualifications include knowledge of SEC rules and regulations and independence requirements, U.S. GAAP, and PCAOB standards.

Other-than-temporary impairments of certain investments. Although FASB’s Emerging Issues Task Force (EITF) had recently reached a consensus on Issue 03-1 concerning recognizing and measuring other-than-temporary impairments for certain equity and debt securities, FASB decided to defer the effective date while it attempts to resolve certain controversial issues resulting from that consensus. (The assessment and disclosure provisions of EITF Issue 03-01, however, remain effective. A footnote in the EITF consensus states that during the period of the delay, an entity should continue to apply relevant “other-than-temporary” guidance, such as paragraph 16 of Statement 115, including the guidance referenced in footnote 4 of that paragraph, paragraph 6 of Opinion 18, Issue 99-20, as applicable.)

The SEC staff noted that existing guidance includes SAB Topic 5.M, and that it expects registrants to use a systematic methodology, and to document the factors considered. The SEC staff emphasized that all available evidence should be reviewed when performing an impairment assessment. The SEC staff expects the impairment analysis to become more extensive as the length of time for the needed recovery becomes shorter and the decline in value becomes larger.

Structured payable transactions. In follow-up remarks to the prior year’s discussion on this topic, the SEC staff referred to the classification of payables in structured transactions involving financial intermediaries, noting that: “if a transaction walks, talks, and smells like a short-term borrowing, it probably is.” The SEC staff believes that it is not appropriate to determine if amounts due should be classified as a trade payable or as a borrowing based solely on a set of rules or checklists; rather, consideration of all facts and circumstances is
warranted.

Indeed, the SEC staff has encouraged preparers to consider the following questions when determining whether amounts due may be classified as a trade payable:

• What are the roles, responsibilities, and relationships of each party to the structured payable transaction?
• Is the creditor a trade creditor (i.e., a supplier that has provided the debtor with goods and services in advance of payment)?
• Has the debtor participated in the process of factoring the vendor’s receivables to the financial institution?
• Will there be a rebate or other payment from the financial institution to the debtor?
• Was the amount payable by the debtor/purchaser on the original due date reduced by the financial institution?
• Was the original due date extended by the financial institution?

Clearly, the SEC staff is setting a high threshold to attain trade payable classification for transactions other than the sale of specific products. The SEC staff said it defines trade creditors as suppliers that provide goods and services before receiving payment. In their view, banks do not meet that definition.