August 5, 2005

PCAOB’s AS No. 4

The PCAOB recently adopted Auditing Standard No. 4, “Reporting on Whether a Previously Reported Material Weakness Continues to Exist.” The new standard is intended to provide a mechanism by which auditors could express an opinion on the status of a material weakness as of an interim date, rather than waiting for the next year-end audit report.

Although the auditor’s evaluation would be similar to the auditor’s annual evaluation of internal control over financial reporting under Auditing Standard No. 2, the engagement under AS No. 4 is designed to be significantly narrower in scope, as the auditor’s testing is limited to the controls specifically identified by management as addressing the material weakness.

Materiality, in the context of an engagement under AS No. 4, is assessed as of the date management asserts that the material weakness no longer exists. The result is that in certain cases, a material weakness may no longer exist due to a change in the size of the financial statement accounts, rather than as a result of changes in the design or operation of controls. For example, this could occur as a result of an acquisition. AS No. 4 states that in many of these cases, the company will have undergone significant changes, with associated changes in internal control over financial reporting, so that the auditor would need to perform a full audit of internal control over financial reporting in order to have a sufficient basis for assessing materiality, understanding the company’s overall internal control over financial reporting post-acquisition and rendering an opinion about whether a previously reported material weakness continues to exist.

Thus, if a company that has a material weakness engages in an acquisition of sufficient size to impact the materiality analysis, it is unlikely that the company will be able to avail itself of the interim auditor assurance available under AS No. 4 and, instead, would have to wait to for the year-end audit.

AS No.4 will be submitted to the SEC, which will publish the standard for public comment, and will be effective as of the date of SEC approval.