The Public Company Accounting Oversight Board (PCAOB) on Nov. 18, 2022, voted unanimously to issue a proposal that would impose a combination of principles-based and prescriptive requirements to make sure that audit firms have a robust system of quality control (QC) to better protect investors.
The board would establish a new quality control standard, QC 1000, A Firm’s System of Quality Control. It would require accounting firms to use risk assessment when establishing its QC system. To do so, firms should set quality objectives, identify and assess quality risks in achieving the objectives, implementing responses to address the quality risks and monitor their QC system.
Moreover, firms that are inspected annually by the PCAOB must establish an oversight function for the audit practice that includes at least one person who is “not a partner, shareholder, member, other principal, or employee of the firm.”
These are firms that have more than 100 public company audit clients, and there were 14 for 2021 inspections.
In addition, the proposal would require accounting firms that have SEC-registered audit clients to fill out annually new Form QC about the effectiveness of their QC systems to their clients’ audit committees and to the PCAOB.
PCAOB officials added that the proposal would build in an extra layer of accountability by requiring two executives to sign Form QC. One would be someone who is ultimately responsible for the firm’s QC. This means that the person would be the highest ranking officer. The other person would be someone who is responsible for the operation of the firm’s QC system.
This is similar to the requirement for chief executive and financial officers’ certifications of financial reports under Sarbanes-Oxley Act of 2002. This law established the PCAOB to prevent recurrence of big accounting frauds that occurred at companies like Enron, WorldCom and Adelphia while their auditors did nothing and ended up costing investors tens of billions of dollars.
However, Form QC will be non-public. This is because there are some statutory constraints in Sarbanes-Oxley related to remediation of quality control problems. But the proposal would expand the auditor’s responsibility to respond to deficiencies on completed engagements.
A firm’s quality control deals with its system of employee training and compliance with professional standards and its standards of quality. The regulatory board believes that strong quality controls are important to audit quality. And the board first issued a preliminary document to solicit comment almost three years ago after the inspections staff continued to find deficiencies in audit engagements as well as problems in firms’ quality control systems in certain areas.
Investors rely on auditors to make sure that their audit clients’ financial statements are presented fairly and accurately. And the PCAOB has a single mission: protecting investors.
“Today’s proposal is a watershed moment for the PCAOB as we propose to make significant changes to our requirements that address firms’ Quality Control systems — requirements that largely look the same today as they did 20 years ago when the PCAOB was founded,” PCAOB Chair Erica Williams said.
The PCAOB currently uses the AICPA’s quality control standards issued in 1997 when the board did not exist. The audit environment has changed dramatically since then, especially with advances in technology.
“Firms’ quality control or QC systems lay the foundation for how they approach audits. When a firm’s QC system operates effectively, audits are performed in accordance with applicable professional and legal requirements,” Williams said. “Simply put: Effective QC systems protect investors, while ineffective QC systems put investors at risk. That is why it is so critical to ensure our QC standards are fit for purpose in today’s capital markets. The world has changed since 2003, and our QC standards must adapt to keep pace.”
The proposal follows the December 2019 publication of Concept Release No. 2019-003, Potential Approach to Revisions to PCAOB Quality Control Standards, which built on an approach taken by the International Auditing and Assurance Standards Board (IAASB), including International Standard on Quality Management 1 (ISQM 1). Comment letters to the concept release largely supported using ISQM1 as a starting point but tailoring it for U.S. capital markets.
While keeping some requirements in ISQM 1 intact, the PCAOB is raising the bar by proposing more sweeping changes.
During a Nov. 16 speech, Williams said that the U.S. board always considers the IAASB’s standards when working on rule proposals to avoid unnecessary differences.
Large firms have audit clients all over the world, and having totally disparate standards may be counterproductive to producing quality audits by creating unnecessary audit execution risks.
“However, some differences cannot be avoided, such as those that are necessary to align with U.S. federal securities law, SEC rules, and other PCAOB standards and rules. In some cases, we may have differences to address specific emerging risks and issues observed through our oversight activities,” Williams said at the PCAOB International Institute on Audit Regulation in Washington. “It is imperative that we are mindful when there are differences and that such differences are justified and do not create unintended consequences.”
The foundational part of the proposal would apply to all firms that are registered with the PCAOB regardless of whether they audit SEC-registered broker-dealers or operation companies. They must establish specific quality objectives, identify and assess risks to achieve the objectives and develop policies to address those risks. About 45 percent of registered firms are smaller auditors.
Comments are due by Feb. 1, 2023 on PCAOB Release No. 2022-006, A Firm’s System of Quality Control and Other Proposed Amendments to PCAOB Standards, Rules, and Forms.
PCAOB officials are considering an effective date of Dec. 15 of the year after a final rule is approved by the SEC, which oversees the PCAOB. Then audit firms must do their first QC system evaluation as of the following Nov. 30.
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