When the Auditing Standards Board met in mid-January, it resolved to propose a new standard on auditor communication. The board also started a discussion on whether quality control should be linked to compensation control.While the proposal on communication was the biggest product of the meeting, the concept of a cause-and-effect connection between auditor compensation and audit quality may ultimately have greater reverberations in the profession.

The board is far from reaching any decisions on amending the existing standard on quality control, but Chuck Landes, director of auditing and attestation at the American Institute of CPAs, said that the board would like to pursue further discussion on the idea.

"If you look back at lessons learned over the last several years, there are arguments that could be made that there were situations where quality may have suffered because the engagement partner was compensated for the wrong things - not necessarily for the quality of their work, but because of new business they brought in, how happy they kept the client, and so on," Landes said.

Landes emphasized that the board is not about to set how-to rules on compensation, let alone limitations. Rather, the board hopes to establish a principle that would guide audit firms to use compensation to provide incentives for quality, rather than to discourage it.

"We aren't looking at why one guy got $200,000 and another guy got $300,000," Landes said. "We want to understand how audit partners are compensated, what the incentive is that drives their behavior, and whether they are being given incentives on the quality of the work they do, rather than just on, for example, the amount of new business they bring in. We want to figure out how to build this into a standard where compensation becomes an important factor in motivating audit partners to do the right thing."

Lines of communication

The proposal on auditor communication will be issued as an exposure draft in February. If eventually approved as proposed, it would result in a simple but crucial change in communication between auditors and the audited. Currently, under Statement on Auditing Standards 61, auditors are required to report certain findings to a client's audit committee or an equivalent group.

Since the ASB began writing standards only for audits of nonpublic companies, however, few audited companies have actual audit committees. The board has therefore proposed that such communications be made to "those charged with governance" of the audited company - often the company's owners or partners.

"This wasn't very controversial, and we think this will be good practice," Landes said. "Management may not always want to know this information, but as auditors, we shouldn't be putting ourselves in the position of determining what they should know. We should communicate to those charged with governance and then let them do with that information what they best see fit."

Landes said that the proposed statement did not change the nature of the required communications, which are typically reports on any significant difficulties in completing the audit, such as employees who were not cooperative or any disagreements between auditors and management.

Comments on the proposal are requested by May 31, 2006. Depending on the response, a final statement is likely to be issued by the end of the year, with the standard going into effect for fiscal years beginning after Dec. 15, 2006.

Questions of quality

The project on quality control follows a revision of an international standard that was promulgated by the International Audit and Assurance Standards Board. The ASB is looking for opportunities to conform the U.S. standard to the international standard wherever possible and appropriate. At the January meeting, the board considered seven issues on quality control that will help the board decide what direction to take.

Harold Monk, vice chair of the board and a partner with Davis, Monk & Co. in Gainesville, Fla., said that some changes to current practice are likely but that they probably wouldn't be onerous.

"This project is in the early stages, but it looks like it would require firms to have a documented quality control system," Monk said. "I don't think it would require anything really significant in extensive documentation for smaller firms, not by any means, but it would require something," Monk said. "I think most firms already have something in place, even if it's just filling out a questionnaire when they get their peer review done. That essentially creates documentation of their quality control system."

A majority of the board tentatively agreed with the IAASB that audit firms, no matter how small, should document their quality control policies and procedures. The board declined to agree, however, that the same policies and procedures should apply to all audit engagements. The board felt that it did not have jurisdiction over engagements with public companies.

The ASB's jurisdiction has been limited to nonpublic companies and organizations since the Public Company Accounting Oversight Board took on the responsibility of setting standards for public companies.

The board also considered whether every partner should provide a written independence confirmation every year. The board apparently leaned toward such a requirement, because it is already a benchmark practice at most audit firms.

In what may become a significant change to common practice, the board considered requiring audit firms to not only monitor the quality of their audits but also periodically conduct formal inspections. The board seemed to be leaning toward simply requiring firms to look for the best way to monitor quality in their practice, with inspections as an option when appropriate.

"In a huge firm if you need an inspection at a point in time, well, great," Landes said. "If you're another size firm and monitoring on a real-time [basis] works best, then great. Whatever works best within your size firm."

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