In a nod to opponents and critics who complained about the costs of internal controls audits, the Public Company Accounting Oversight Board voted unanimously to circulate a proposal that would trim down the amount of testing necessary to evaluate internal controls over the financial reporting process.

The oversight body’s proposal is a principles-based standard designed to focus the auditor’s attention toward the higher-risk internal controls, thereby increasing the likelihood that material weaknesses would be found before a misstatement. It also drops management’s evaluation for assessing their controls, and provides direction on how to scale down the audit for smaller companies..

If passed, the standard,  would replace the board’s existing internal control standard, Auditing Standard No. 2.

Under Sarbanes-Oxley Section 404, executives at publicly traded companies have been required to evaluate their internal controls and have them reviewed by their outside auditors. SEC issuers, particularly the smaller companies, have complained that the process has been exorbitantly expensive and time-consuming.

The standard is about one-third the length of the original, which was drafted in 2002.
Specifically, the new standard would:

• Direct the auditor to the most important controls and emphasize the importance of risk assessment;

  • Revise the definitions of significant deficiency and material weakness, as well as the "strong indicators" of a material weakness;

• Clarify the role of materiality, including interim materiality, in the audit;

 • Remove the requirement to evaluate management's process;

  • Permit consideration of knowledge obtained during previous audits;

  • Direct the auditor to tailor the audit to reflect the attributes of smaller and less complex companies;

   • Refocus the multi-location testing requirements on risk, rather than coverage; and,

   • Recalibrate the walkthrough requirement.

"We believe the new standard will result in audits that are more efficient, risk-based and scaled to the size and complexity of each company," PCAOB Chairman Mark Olson said.

The proposal will be circulated for comment during a 70-day period. After that it will go to the Securities and Exchange Commission for a vote. If adopted, the new standard would be titled AS 5.

“A principal focus in developing this proposal was to retain and strengthen the substantial benefits investors have received from improved internal control over financial reporting," said Tom Ray, chief auditor at the PCAOB. "I believe we have proposed a standard that will achieve that objective while reducing audit effort, especially for smaller companies."

Colleen Cunningham, chief executive at the 15,000-member Financial Executives International, said of the proposal, “We strongly support the overall goals of the new Auditing Standard No. 5 to eliminate unnecessary costs, while maintaining effectiveness and oversight, and its approach to allow for scaling adoption to fit the size of the company. Though likely we will not know until 2008 at the earliest whether costs are truly reduced, FEI will continue to work with the SEC and PCAOB to ensure the spirit of Sarbanes-Oxley is upheld without undue costs.”

Last week, the SEC proposed a similar standard whereupon  executives would evaluate the design of only those financial controls that might carry the risk of having a material impact on financial statements.

For more information on the standard, go to:

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