PCAOB Adopts Auditing Standard No. 7

Auditors to Now Focus on Areas Most Likely to Contain

Deficiencies; CFOs More Likely to Have to Correct

Concerns Before Audit Reports Issued

A new audit standard recently adopted by the Public Accounting Oversight Board (PCAOB) will impact public company CFOs because it more clearly focuses the work of their independent audit firms on the areas most likely to contain deficiencies, and thus increases the likelihood that CFOs will have to correct these concerns before the audit report is issued.

On July 28, 2009, the PCAOB voted to adopt Auditing Standard No. 7 – Engagement Quality Review (AS 7). The new auditing standard provides for a rigorous review that will be a meaningful check on the work performed by an audit engagement team. AS 7 should increase the probability that a registered public accounting firm will identify any significant engagement deficiencies before it issues its audit report. More work may be required to meet the new standard, but it should not result in performing a second audit. AS 7 is intended as a review of work already completed.

Per AS 7, the objective of the engagement quality reviewer is to perform an evaluation of the significant judgments made by the audit engagement team and the related conclusions reached in forming the overall conclusion of the engagement and in preparing the engagement report, if a report is to be issued, in order to determine whether to provide concurring approval of issuance. AS 7 is required for audit engagements and reviews of interim financial information. It is not required for other engagements performed according to the standards of the PCAOB.

The engagement quality reviewer must meet specific qualifications. The reviewer can be from within the firm or a qualified individual outside of the firm. In either case, the reviewer must be an associated person of a registered public accounting firm. An in house reviewer must be a partner or an individual in an equivalent position. The reviewer is providing an objective second look and should be able to withstand any pressure from the engagement partner. If the reviewer is from outside the firm, the engagement partner must inquire to insure that the reviewer has the proper qualifications. AS 7 requires the reviewer to possess a level of knowledge and competence relating to accounting, auditing and financial reporting required to serve as the engagement partner on the engagement under review. The appropriate level of knowledge should be based on the circumstances of the engagement.

Consideration should be given to the size and complexity of the business under audit or under interim review. In order for the engagement quality reviewer to be objective, the standard states that the engagement quality reviewer should not make decisions on behalf of the engagement team or assume any of the responsibilities of the engagement team. The engagement partner is responsible for the engagement, its performance and the conclusions met.

Also, AS 7 provides a two year cooling off period for the engagement partner. The engagement partner is prohibited from serving as the engagement quality reviewer for at least two years following his or her last year as engagement partner. However, if an accounting firm qualifies for the SEC small firm exemption, it will also be exempt from the cooling off period.

AS 7 requires separate requirements for reviewing audits and interim reviews. For audits, the reviewer needs to evaluate the engagement team’s responses to significant audit risks identified by the engagement team and by the engagement quality reviewer. The requirement for interim reviews are based on the audit requirements but are tailored to the modified procedures performed for the interim period. Note that the definition of due professional care remains unchanged from the previous standard.

Documentation of the engagement review must contain sufficient information to enable an experienced auditor, having no previous connection with the engagement, to understand the procedures performed by the engagement quality reviewer to comply with the provision of the standard. This provision is similar to the audit documentation requirements of AS 3. Also, the engagement quality review documentation must contain sufficient information to identify the documents reviewed.

Subject to SEC approval, AS 7 will be effective for both the engagement quality review of audits and interim reviews for fiscal years beginning on or after Dec. 15, 2009.