[Federal Register Volume 77, Number 180 (Monday, September 17, 2012)]
[Notices]
[Pages 57407-57449]
[FR Doc No: 2012-22632]

Vol. 77

Monday,

No. 180

September 17, 2012

Part IV

Securities and Exchange Commission

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Public Company Accounting Oversight Board; Notice of Filing of Proposed
Rules on Auditing Standard No. 16, Communications With Audit Committees
and Related and Transitional Amendments to PCAOB Standards; Notice

Federal Register / Vol. 77, No. 180 / Monday, September 17, 2012 /
Notices

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-67807; File No. PCAOB-2012-001]

Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Auditing Standard No. 16, Communications With Audit
Committees and Related and Transitional Amendments to PCAOB Standards

September 10, 2012.

    Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the
``Sarbanes-Oxley Act''), notice is hereby given that on August 28,
2012, the Public Company Accounting Oversight Board (the ``Board'' or
the ``PCAOB'') filed with the Securities and Exchange Commission (the
``Commission'' or ``SEC'') the proposed rules described in items I and
II below, which items have been prepared by the Board. The Commission
is publishing this notice to solicit comments on the proposed rules
from interested persons.

I. Board's Statement of the Terms of Substance of the Proposed Rules

    On August 15, 2012, the Board adopted Auditing Standard No. 16,
Communications with Audit Committees, related amendments to its interim
auditing standards, and transitional amendments to AU sec. 380,
Communication with Audit Committees, (collectively, ``the proposed
rules''). The text of the proposed rules is set out below.

Auditing Standard No. 16

Communications With Audit Committees
Introduction
    1. This standard requires the auditor to communicate with the
company's audit committee \1\ regarding certain matters related to the
conduct of an audit \2\ and to obtain certain information from the
audit committee relevant to the audit. This standard also requires the
auditor to establish an understanding of the terms of the audit
engagement with the audit committee and to record that understanding in
an engagement letter.
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    \1\ Terms defined in Appendix A, Definitions, are set in
boldface type the first time they appear.
    \2\ For purposes of this standard, an audit is either an audit
of internal control over financial reporting that is integrated with
an audit of financial statements or an audit of financial statements
only.
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    2. Other Public Company Accounting Oversight Board (``PCAOB'')
rules and standards identify additional matters to be communicated to a
company's audit committee (see Appendix B). Various laws or regulations
also require the auditor to communicate certain matters to the audit
committee.\3\ The communication requirements of this standard do not
modify or replace communications to the audit committee required by
such other PCAOB rules and standards, and other laws or regulations.
Nothing in this standard precludes the auditor from communicating other
matters to the audit committee.
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    \3\ See e.g., Section 10A(k) of the Securities Exchange Act of
1934 (``Exchange Act''), 15 U.S.C. 78j-1(k); Rule 2-07 of Regulation
S-X, 17 CFR 210.2-07; and Rule 10A-3 under the Exchange Act, 17 CFR
240.10A-3.
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Objectives
    3. The objectives of the auditor are to:
    a. Communicate to the audit committee the responsibilities of the
auditor in relation to the audit and establish an understanding of the
terms of the audit engagement with the audit committee;
    b. Obtain information from the audit committee relevant to the
audit;
    c. Communicate to the audit committee an overview of the overall
audit strategy and timing of the audit; and
    d. Provide the audit committee with timely observations arising
from the audit that are significant to the financial reporting process.

    Note:  ``Communicate to,'' as used in this standard, is meant to
encourage effective two-way communication between the auditor and
the audit committee throughout the audit to assist in understanding
matters relevant to the audit.

Appointment and Retention
Significant Issues Discussed With Management in Connection With the
Auditor's Appointment or Retention
    4. The auditor should discuss with the audit committee any
significant issues that the auditor discussed with management in
connection with the appointment or retention of the auditor, including
significant discussions regarding the application of accounting
principles and auditing standards.
Establish an Understanding of the Terms of the Audit
    5. The auditor should establish an understanding of the terms of
the audit engagement with the audit committee. This understanding
includes communicating to the audit committee the following:
    a. The objective of the audit;
    b. The responsibilities of the auditor; and
    c. The responsibilities of management.
    6. The auditor should record the understanding of the terms of the
audit engagement in an engagement letter and provide the engagement
letter to the audit committee annually. The auditor should have the
engagement letter executed by the appropriate party or parties on
behalf of the company.\4\ If the appropriate party or parties are other
than the audit committee, or its chair on behalf of the audit
committee, the auditor should determine that the audit committee has
acknowledged and agreed to the terms of the engagement.
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    \4\ Absent evidence to the contrary, the auditor may rely on the
company's identification of the appropriate party or parties to
execute the engagement letter.

    Note:  Appendix C describes matters that the auditor should
include in the engagement letter about the terms of the audit
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engagement.

    7. If the auditor cannot establish an understanding of the terms of
the audit engagement with the audit committee, the auditor should
decline to accept, continue, or perform the engagement.
Obtaining Information and Communicating the Audit Strategy
Obtaining Information Relevant to the Audit
    8. The auditor should inquire of the audit committee about whether
it is aware of matters relevant to the audit,\5\ including, but not
limited to, violations or possible violations of laws or
regulations.\6\
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    \5\ In addition to this inquiry, paragraphs 5.f. and 54-57 of
Auditing Standard No. 12, Identifying and Assessing Risks of
Material Misstatement, describe the auditor's inquiries of the audit
committee, or equivalent (or its chair) regarding the audit
committee's knowledge of the risks of material misstatement,
including fraud risks. These inquiries include, among other things,
whether the audit committee is aware of tips or complaints regarding
the company's financial reporting.
    \6\ See AU sec. 317, Illegal Acts by Clients, for a description
of the auditor's responsibilities when a possible illegal act is
detected. For audits of issuers, see also Section 10A(b) of the
Exchange Act, 15 U.S.C. 78j-1(b), and Rule 10A-1 under the Exchange
Act, 17 CFR 240.10A-1.
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Overall Audit Strategy, Timing of the Audit, and Significant Risks
    9. The auditor should communicate to the audit committee an
overview of the overall audit strategy, including the timing of the
audit,\7\ and discuss with the audit committee the significant risks
identified during the auditor's risk assessment procedures.\8\
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    \7\ See paragraphs 8-9 of Auditing Standard No. 9, Audit
Planning, for a description of the auditor's responsibilities for
establishing an overall audit strategy.
    \8\ Auditing Standard No. 12 requires the auditor to determine
whether identified and assessed risks are significant risks. A
significant risk is defined as a risk of material misstatement that
requires special audit consideration.

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    Note:  This overview is intended to provide information about
the audit, but not specific details that would compromise the
effectiveness of the audit procedures.

    10. As part of communicating the overall audit strategy, the
auditor should communicate the following matters to the audit
committee, if applicable:
    a. The nature and extent of specialized skill or knowledge needed
to perform the planned audit procedures or evaluate the audit results
related to significant risks; \9\
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    \9\ See paragraph 16 of Auditing Standard No. 9 for the
requirement for the auditor to determine whether specialized skill
or knowledge is needed to perform appropriate risk assessments, plan
or perform audit procedures, or evaluate audit results.
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    b. The extent to which the auditor plans to use the work of the
company's internal auditors in an audit of financial statements; \10\
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    \10\ See AU sec. 322, The Auditor's Consideration of the
Internal Audit Function in an Audit of Financial Statements, which
describes the auditor's responsibilities related to the work of
internal auditors.
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    c. The extent to which the auditor plans to use the work of
internal auditors, company personnel (in addition to internal
auditors), and third parties working under the direction of management
or the audit committee when performing an audit of internal control
over financial reporting; \11\
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    \11\ See paragraphs 16-19 of Auditing Standard No. 5, An Audit
of Internal Control Over Financial Reporting That Is Integrated with
An Audit of Financial Statements, which describe the auditor's
responsibilities related to using the work of others in an audit of
internal control over financial reporting.
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    d. The names, locations, and planned responsibilities \12\ of other
independent public accounting firms or other persons, who are not
employed by the auditor, that perform audit procedures in the current
period audit; and
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    \12\ See paragraphs 8-14 of Auditing Standard No. 9, which
discuss the auditor's responsibilities for determining the audit
strategy, audit plan, and extent to which audit procedures should be
performed at selected locations or business units involving multi-
location engagements.

    Note: The term ``other independent public accounting firms'' in
the context of this communication includes firms that perform audit
procedures in the current period audit regardless of whether they
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otherwise have any relationship with the auditor.

    e. The basis for the auditor's determination that the auditor can
serve as principal auditor, if significant parts of the audit are to be
performed by other auditors.\13\
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    \13\ See AU sec. 543, Part of Audit Performed by Other
Independent Auditors, which discusses the professional judgments the
auditor makes in deciding whether the auditor may serve as principal
auditor.
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    11. The auditor should communicate to the audit committee
significant changes to the planned audit strategy or the significant
risks initially identified and the reasons for such changes.\14\
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    \14\ See paragraph 15 of Auditing Standard No. 9, which
discusses changes in audit strategy and the audit plan during the
course of the audit.
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Results of the Audit
    Accounting Policies and Practices, Estimates, and Significant
Unusual Transactions
    12. The auditor should communicate to the audit committee the
following matters:
    a. Significant accounting policies and practices.\15\
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    \15\ See, e.g., Financial Accounting Standards Board Accounting
Standards Codification, Topic 235, Notes to Financial Statements,
paragraph 235-10-50-1, which requires the entity to disclose a
description of all significant accounting policies as an integral
part of the financial statements, and paragraph 235-10-50-3, which
describes what should be disclosed.
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    (1) Management's initial selection of, or changes in, significant
accounting policies or the application of such policies in the current
period; and
    (2) The effect on financial statements or disclosures of
significant accounting policies in (i) controversial areas or (ii)
areas for which there is a lack of authoritative guidance or consensus,
or diversity in practice.
    b. Critical accounting policies and practices. All critical
accounting policies and practices to be used, including: \16\
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    \16\ See also Section 10A(k) of the Exchange Act, 15 U.S.C. 78j-
1(k), and Rule 2-07(a)(1) of Regulation S-X, 17 CFR 210.2-07(a)(1).
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    (1) The reasons certain policies and practices are considered
critical; and
    (2) How current and anticipated future events might affect the
determination of whether certain policies and practices are considered
critical.

    Note:  Critical accounting policies and practices, as defined in
Appendix A, are a company's accounting policies and practices that
are both most important to the portrayal of the company's financial
condition and results, and require management's most difficult,
subjective, or complex judgments, often as a result of the need to
make estimates about the effects of matters that are inherently
uncertain. Critical accounting policies and practices are tailored
to specific events in the current year, and the accounting policies
and practices that are considered critical might change from year to
year.

    c. Critical accounting estimates.
    (1) A description of the process management used to develop
critical accounting estimates; \17\
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    \17\ See AU sec. 342, Auditing Accounting Estimates, which
discusses the auditor's responsibilities to obtain and evaluate
sufficient appropriate audit evidence to support significant
accounting estimates in an audit of financial statements.
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    (2) Management's significant assumptions used in critical
accounting estimates that have a high degree of subjectivity; \18\ and
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    \18\ Id.
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    (3) Any significant changes management made to the processes used
to develop critical accounting estimates or significant assumptions, a
description of management's reasons for the changes, and the effects of
the changes on the financial statements.\19\
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    \19\ Id.
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    d. Significant unusual transactions.
    (1) Significant transactions that are outside the normal course of
business for the company or that otherwise appear to be unusual due to
their timing, size, or nature; \20\ and
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    \20\ See paragraph 71.g. of Auditing Standard No. 12.
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    (2) The policies and practices management used to account for
significant unusual transactions.

    Note:  As part of its communications to the audit committee,
management might communicate some or all of the matters in paragraph
12. If management communicates any of these matters, the auditor
does not need to communicate them at the same level of detail as
management, as long as the auditor (1) participated in management's
discussion with the audit committee, (2) affirmatively confirmed to
the audit committee that management has adequately communicated
these matters, and (3) with respect to critical accounting policies
and practices, identified for the audit committee those accounting
policies and practices that the auditor considers critical. The
auditor should communicate any omitted or inadequately described
matters to the audit committee.

Auditor's Evaluation of the Quality of the Company's Financial
Reporting
    13. The auditor should communicate to the audit committee the
following matters:
    a. Qualitative aspects of significant accounting policies and
practices.
    (1) The results of the auditor's evaluation of, and conclusions
about, the qualitative aspects of the company's significant accounting
policies and practices, including situations in which the auditor
identified bias in management's judgments about the amounts and
disclosures in the financial statements; \21\ and
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    \21\ See paragraphs 24-27 of Auditing Standard No. 14,
Evaluating Audit Results, which describe the auditor's
responsibilities related to evaluating the qualitative aspects of
the company's accounting practices.
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    (2) The results of the auditor's evaluation of the differences
between (i) estimates best supported by the audit evidence and (ii)
estimates included in the financial statements, which are

individually reasonable, that indicate a possible bias on the part of
the company's management.\22\
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    \22\ See paragraph 27 of Auditing Standard No. 14.
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    b. Assessment of critical accounting policies and practices. The
auditor's assessment of management's disclosures related to the
critical accounting policies and practices, along with any significant
modifications to the disclosure of those policies and practices
proposed by the auditor that management did not make.
    c. Conclusions regarding critical accounting estimates. The basis
for the auditor's conclusions regarding the reasonableness of the
critical accounting estimates.\23\
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    \23\ See AU sec. 342, which discusses the auditor's
responsibilities to obtain and evaluate sufficient appropriate audit
evidence to support significant accounting estimates in an audit of
financial statements.
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    d. Significant unusual transactions. The auditor's understanding of
the business rationale for significant unusual transactions.\24\
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    \24\ See paragraph .66 of AU sec. 316, Consideration of Fraud in
a Financial Statement Audit.
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    e. Financial statement presentation. The results of the auditor's
evaluation of whether the presentation of the financial statements and
the related disclosures are in conformity with the applicable financial
reporting framework, including the auditor's consideration of the form,
arrangement, and content of the financial statements (including the
accompanying notes), encompassing matters such as the terminology used,
the amount of detail given, the classification of items, and the bases
of amounts set forth.\25\
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    \25\ See paragraphs 30-31 of Auditing Standard No. 14, which
describe the auditor's responsibilities related to the evaluation of
whether the financial statements are presented fairly, in all
material respects, in conformity with the applicable financial
reporting framework. Other PCAOB standards, such as AU sec. 334,
Related Parties, and AU sec. 341, The Auditor's Consideration of an
Entity's Ability to Continue as a Going Concern, describe the
auditor's responsibilities related to evaluation of specific
disclosures in financial statements.
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    f. New accounting pronouncements. Situations in which, as a result
of the auditor's procedures, the auditor identified a concern regarding
management's anticipated application of accounting pronouncements that
have been issued but are not yet effective and might have a significant
effect on future financial reporting.
    g. Alternative accounting treatments. All alternative treatments
permissible under the applicable financial reporting framework for
policies and practices related to material items that have been
discussed with management, including the ramifications of the use of
such alternative disclosures and treatments and the treatment preferred
by the auditor.\26\
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    \26\ See also Section 10A(k) of the Exchange Act, 15 U.S.C. 78j-
1(k), and Rule 2-07(a)(2) of Regulation S-X, 17 CFR 210.2-07(a)(2).
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Other Information in Documents Containing Audited Financial Statements
    14. When other information is presented in documents containing
audited financial statements, the auditor should communicate to the
audit committee the auditor's responsibility under PCAOB rules and
standards for such information, any related procedures performed, and
the results of such procedures.\27\
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    \27\ See, e.g., AU sec. 550, Other Information in Documents
Containing Audited Financial Statements. In addition to AU sec. 550,
discussion of the auditor's consideration of other information is
included in AU sec. 558, Required Supplementary Information, and AU
sec. 711, Filings Under Federal Securities Statutes.
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Difficult or Contentious Matters for Which the Auditor Consulted
    15. The auditor should communicate to the audit committee matters
that are difficult or contentious for which the auditor consulted
outside the engagement team and that the auditor reasonably determined
are relevant to the audit committee's oversight of the financial
reporting process.
Management Consultation With Other Accountants
    16. When the auditor is aware that management consulted with other
accountants about significant auditing or accounting matters and the
auditor has identified a concern regarding such matters, the auditor
should communicate to the audit committee his or her views about such
matters that were the subject of such consultation.
Going Concern
    17. The auditor should communicate to the audit committee, when
applicable, the following matters relating to the auditor's evaluation
of the company's ability to continue as a going concern: \28\
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    \28\ See AU sec. 341 for the requirements regarding an auditor's
responsibility to evaluate whether there is substantial doubt about
a company's ability to continue as a going concern for a reasonable
period of time, not to exceed one year beyond the date of the
financial statements being audited. Additionally, AU secs. 341.03a-c
provide the auditor with an overview of the requirements for
evaluating whether there is substantial doubt about the company's
ability to continue as a going concern for a reasonable period of
time.
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    a. If the auditor believes there is substantial doubt about the
company's ability to continue as a going concern for a reasonable
period of time, the conditions and events that the auditor identified
that, when considered in the aggregate, indicate that there is
substantial doubt; \29\
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    \29\ See AU sec. 341.06, which provides examples of such
conditions and events and AU sec. 341.07, which discusses the
auditor's procedures if the auditor believes there is substantial
doubt about the company's ability to continue as a going concern for
a reasonable period of time.
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    b. If the auditor concludes, after consideration of management's
plans, that substantial doubt about the company's ability to continue
as a going concern is alleviated, the basis for the auditor's
conclusion, including elements the auditor identified within
management's plans that are significant to overcoming the adverse
effects of the conditions and events; \30\
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    \30\ See AU sec. 341.08, which discusses the auditor's
responsibilities related to the auditor's evaluation of management's
plans.
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    c. If the auditor concludes, after consideration of management's
plans, that substantial doubt about the company's ability to continue
as a going concern for a reasonable period of time remains: \31\
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    \31\ See AU sec. 341.12, which describes the effects on the
auditor's report. See also AU sec. 341.03c, which discusses the
auditor's evaluation of factors that indicate there is substantial
doubt about the company's ability to continue as a going concern.
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    (1) The effects, if any, on the financial statements and the
adequacy of the related disclosure; \32\ and
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    \32\ See AU sec. 341.10, which discusses the possible effects on
the financial statements and the adequacy of the related disclosure.
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    (2) The effects on the auditor's report.\33\
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    \33\ See AU secs. 341.12-.16, which discuss the auditor's
consideration of the effects on the auditor's report when the
auditor concludes that substantial doubt exists about the company's
ability to continue as a going concern for a reasonable period of
time.
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Uncorrected and Corrected Misstatements
    18. The auditor should provide the audit committee with the
schedule of uncorrected misstatements related to accounts and
disclosures\34\ that the auditor presented to management.\35\ The
auditor should discuss with the audit committee, or determine that
management has adequately discussed with the audit committee, the basis
for the determination that the uncorrected

misstatements were immaterial, including the qualitative factors\36\
considered. The auditor also should communicate that uncorrected
misstatements or matters underlying those uncorrected misstatements
could potentially cause future-period financial statements to be
materially misstated, even if the auditor has concluded that the
uncorrected misstatements are immaterial to the financial statements
under audit.
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    \34\ Footnote 13 to paragraph 20 of Auditing Standard No. 14
indicates that misstatements include omission and presentation of
inaccurate or incomplete disclosures.
    \35\ See Section 13(i) of the Exchange Act, 15 U.S.C. 78m(i),
which states, in part, that financial statements prepared in
accordance with generally accepted accounting principles and filed
with the Securities and Exchange Commission ``shall reflect all
material correcting adjustments that have been identified by a
registered public accounting firm * * *.''
    \36\ Appendix B of Auditing Standard No. 14 discusses the
qualitative factors related to the evaluation of the materiality of
uncorrected misstatements.
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    19. The auditor should communicate to the audit committee those
corrected misstatements, other than those that are clearly trivial,\37\
related to accounts and disclosures that might not have been detected
except through the auditing procedures performed, and discuss with the
audit committee the implications that such corrected misstatements
might have on the company's financial reporting process.
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    \37\ See paragraph 10 of Auditing Standard No. 14, which
requires the auditor to accumulate misstatements identified during
the audit, other than those that are clearly trivial.
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Material Written Communications
    20. The auditor should communicate to the audit committee other
material written communications between the auditor and management.\38\
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    \38\ See also Section 10A(k) of the Exchange Act, 15 U.S.C. 78j-
1(k) and Rule 2-07(a)(3) of Regulation S-X, 17 CFR 210.2-07 (a)(3).
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Departure From the Auditor's Standard Report
    21. The auditor should communicate to the audit committee the
following matters related to the auditor's report:
    a. When the auditor expects to modify the opinion in the auditor's
report, the reasons for the modification, and the wording of the
report; and
    b. When the auditor expects to include explanatory language or an
explanatory paragraph in the auditor's report, the reasons for the
explanatory language or paragraph, and the wording of the explanatory
language or paragraph.
Disagreements With Management
    22. The auditor should communicate to the audit committee any
disagreements with management about matters, whether or not
satisfactorily resolved, that individually or in the aggregate could be
significant to the company's financial statements or the auditor's
report. Disagreements with management do not include differences of
opinion based on incomplete facts or preliminary information that are
later resolved by the auditor obtaining additional relevant facts or
information prior to the issuance of the auditor's report.
Difficulties Encountered in Performing the Audit
    23. The auditor should communicate to the audit committee any
significant difficulties encountered during the audit. Significant
difficulties encountered during the audit include, but are not limited
to:
    a. Significant delays by management, the unavailability of company
personnel, or an unwillingness by management to provide information
needed for the auditor to perform his or her audit procedures;
    b. An unreasonably brief time within which to complete the audit;
    c. Unexpected extensive effort required by the auditor to obtain
sufficient appropriate audit evidence;
    d. Unreasonable management restrictions encountered by the auditor
on the conduct of the audit; and
    e. Management's unwillingness to make or extend its assessment of
the company's ability to continue as a going concern when requested by
the auditor.

    Note:  Difficulties encountered by the auditor during the audit
could represent a scope limitation,\39\ which may result in the
auditor modifying the auditor's opinion or withdrawing from the
engagement.

    \39\ See paragraphs .22-.32 of AU sec. 508, Reports on Audited
Financial Statements, for a discussion of scope limitations.
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Other Matters
    24. The auditor should communicate to the audit committee other
matters arising from the audit that are significant to the oversight of
the company's financial reporting process. This communication includes,
among other matters, complaints or concerns regarding accounting or
auditing matters that have come to the auditor's attention during the
audit and the results of the auditor's procedures regarding such
matters.\40\
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    \40\ AU secs. 316.79-.81 and AU sec. 317.17 include specific
communication requirements relating to fraud or illegal acts,
respectively.
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Form and Documentation of Communications
    25. The auditor should communicate to the audit committee the
matters in this standard, either orally or in writing,\41\ unless
otherwise specified in this standard. The auditor must document the
communications in the work papers, whether such communications took
place orally or in writing.\42\
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    \41\ See paragraphs .07-.11 of AU sec. 532, Restricting the Use
of an Auditor's Report, which apply to certain written reports on
matters coming to the auditor's attention during the course of the
audit.
    \42\ Consistent with the requirements of Auditing Standard No.
3, Audit Documentation, the audit documentation should be in
sufficient detail to enable an experienced auditor, having no
previous connection with the engagement, to understand the
communications made to comply with the provisions of this standard.

    Note:  If, as part of its communications to the audit committee,
management communicated some or all of the matters identified in
paragraphs 12 or 18 and, as a result, the auditor did not
communicate these matters at the same level of detail as management,
the auditor must include a copy of or a summary of management's
communications provided to the audit committee in the audit
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documentation.

Timing
    26. All audit committee communications required by this standard
should be made in a timely manner and prior to the issuance of the
auditor's report.\43\ The appropriate timing of a particular
communication to the audit committee depends on factors such as the
significance of the matters to be communicated and corrective or
follow-up action needed, unless other timing requirements are specified
by PCAOB rules or standards or the securities laws.
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    \43\ Consistent with Rule 2-07 of Regulation S-X, 17 CFR 210.2-
07, in the case of a registered investment company, audit committee
communication should occur annually, and if the annual communication
is not within 90 days prior to the filing of the auditor's report,
the auditor should provide an update in the 90-day period prior to
the filing of the auditor's report, of any changes to the previously
reported information.

    Note:  An auditor may communicate to only the audit committee
chair if done in order to communicate matters in a timely manner
during the audit. The auditor, however, should communicate such
matters to the audit committee prior to the issuance of the
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auditor's report.

Appendix A--Definitions

    A1. For purposes of this standard, the terms listed below are
defined as follows:
    A2. Audit committee--A committee (or equivalent body)
established by and among the board of directors of a company for the
purpose of overseeing the accounting and financial reporting
processes of the company and audits of the financial statements of
the company; if no such committee exists with respect to the
company, the entire board of directors of the company.
    For audits of nonissuers, if no such committee or board of
directors (or equivalent body) exists with respect to the company,
the person(s) who oversee the accounting and financial reporting
processes of the company and audits of the financial statements of
the company.
    A3. Critical accounting estimate--An accounting estimate where
(a) the nature of

the estimate is material due to the levels of subjectivity and
judgment necessary to account for highly uncertain matters or the
susceptibility of such matters to change and (b) the impact of the
estimate on financial condition or operating performance is
material.
    A4. Critical accounting policies and practices--A company's
accounting policies and practices that are both most important to
the portrayal of the company's financial condition and results, and
require management's most difficult, subjective, or complex
judgments, often as a result of the need to make estimates about the
effects of matters that are inherently uncertain.

Appendix B--Communications With Audit Committees Required by Other
PCAOB Rules and Standards

    This appendix identifies other PCAOB rules and standards related
to the audit that require communication of specific matters between
the auditor and the audit committee.
    a. Auditing Standard No. 4, Reporting on Whether a Previously
Reported Material Weakness Continues to Exist, paragraphs 60, 62,
and 64.
    b. Auditing Standard No. 5, An Audit of Internal Control Over
Financial Reporting That Is Integrated with An Audit of Financial
Statements, paragraphs 78-81, 91, C7, and C14.
    c. Auditing Standard No. 12, Identifying and Assessing Risks of
Material Misstatement, paragraphs 5.f. and 54-57.
    d. PCAOB Rule 3524, Audit Committee Pre-approval of Certain Tax
Services.
    e. PCAOB Rule 3525, Audit Committee Pre-approval of Non-audit
Services Related to Internal Control Over Financial Reporting.
    f. PCAOB Rule 3526, Communication with Audit Committees
Concerning Independence.
    g. AU sec. 316, Consideration of Fraud in a Financial Statement
Audit, paragraphs .79-.81.
    h. AU sec. 317, Illegal Acts by Clients, paragraphs .08, .17,
and .20.
    i. AU sec. 325, Communications About Control Deficiencies in an
Audit of Financial Statements, paragraphs 4-7 and 9.
    j. AU sec. 328, Auditing Fair Value Measurements and
Disclosures, paragraph .50.
    k. AU sec. 333, Management Representations, paragraph .05.
    l. AU sec. 550, Other Information in Documents Containing
Audited Financial Statements, paragraphs .04 and .06.
    m. AU sec. 711, Filings Under Federal Securities Statutes,
paragraph .13.
    n. AU sec. 722, Interim Financial Information, paragraphs
.08-.09, .30-.31, and .33-.36.

Appendix C--Matters Included in the Audit Engagement Letter

    C1. The auditor should include the following matters in the
engagement letter.\44\ The auditor's description of these matters
will vary depending on whether the auditor is engaged in a financial
statement audit or in an audit of internal control over financial
reporting that is integrated with an audit of financial statements
(``integrated audit'').
---------------------------------------------------------------------------

    \44\ Certain matters should not be included in an engagement
letter; for example, under Securities and Exchange Commission,
Section 602.02.f.i. of the Codification of Financial Reporting
Policies, indemnification provisions are not permissible for audits
of issuers.
---------------------------------------------------------------------------

    a. The objective of the audit is:
    a. Integrated audit: The expression of an opinion on both the
effectiveness of internal control over financial reporting and the
financial statements.
    b. Audit of financial statements: The expression of an opinion
on the financial statements.
    b. Auditor's responsibilities:
    a. The auditor is responsible for conducting the audit in
accordance with the standards of the Public Company Accounting
Oversight Board. Those standards require that the auditor:
    a. Integrated audit: Plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free
of material misstatement, whether caused by error or fraud, and
whether effective internal control over financial reporting was
maintained in all material respects. Accordingly, there is some risk
that a material misstatement of the financial statements or a
material weakness in internal control over financial reporting would
remain undetected. Although not absolute assurance, reasonable
assurance is a high level of assurance. Also, an integrated audit is
not designed to detect error or fraud that is immaterial to the
financial statements or deficiencies in internal control over
financial reporting that, individually or in combination, are less
severe than a material weakness. If, for any reason, the auditor is
unable to complete the audit or is unable to form or has not formed
an opinion, he or she may decline to express an opinion or decline
to issue a report as a result of the engagement.
    b. Audit of financial statements: Plan and perform the audit to
obtain reasonable assurance about whether the financial statements
are free of material misstatement, whether caused by error or fraud.
Accordingly, there is some risk that a material misstatement would
remain undetected. Although not absolute assurance, reasonable
assurance is a high level of assurance. Also, a financial statement
audit is not designed to detect error or fraud that is immaterial to
the financial statements. If, for any reason, the auditor is unable
to complete the audit or is unable to form or has not formed an
opinion, he or she may decline to express an opinion or decline to
issue a report as a result of the engagement.
    d. An audit includes:
    c. Integrated audit: In fulfillment of the responsibilities
noted above, the auditor communicates:
     To the audit committee and management: All material
weaknesses in internal control over financial reporting identified
during the audit, in writing.
     To the audit committee: All significant deficiencies
identified during the audit, in writing, and informs the audit
committee when the auditor has informed management of all internal
control deficiencies.
     To management: All internal control deficiencies
identified during the audit and not previously communicated in
writing by the auditor or by others, including internal auditors or
others within the company.
     To the board of directors: Any conclusion that the
audit committee's oversight of the company's external financial
reporting and internal control over financial reporting is
ineffective, in writing.
    d. Audit of financial statements: Obtaining an understanding of
internal control sufficient to plan the audit and to determine the
nature, timing, and extent of audit procedures to be performed.\45\
An audit of financial statements is not designed to provide
assurance on internal control or to identify internal control
deficiencies. However, the auditor is responsible for communicating:
---------------------------------------------------------------------------

    \45\ AU sec. 325, Communications About Control Deficiencies in
an Audit of Financial Statements, provides direction on control
deficiencies identified in an audit of financial statements.
---------------------------------------------------------------------------

    1. To the audit committee and management: All significant
deficiencies and material weaknesses identified during the audit, in
writing.
    2. To the board of directors: If the auditor becomes aware that
the oversight of the company's external financial reporting and
internal control over financial reporting by the audit committee is
ineffective, that conclusion, in writing.
    c. Management's responsibilities:
    f. Management is responsible for the company's financial
statements, including disclosures.
    g. Management is responsible for establishing and maintaining
effective internal control over financial reporting.
    h. Management is responsible for identifying and ensuring that
the company complies with the laws and regulations applicable to its
activities.
    i. Management is responsible for making all financial records
and relevant information available to the auditor.
    j. At the conclusion of the engagement, management will provide
the auditor with a letter that confirms certain representations made
during the audit.
    k. Management is responsible for adjusting the financial
statements to correct material misstatements relating to accounts or
disclosures and for affirming to the auditor in the representation
letter that the effects of any uncorrected misstatements aggregated
by the auditor are immaterial, both individually and in the
aggregate, to the financial statements taken as a whole.
    C2. In connection with a review of interim financial
information, to confirm and document the understanding, the auditor
should either: (a) Document in the audit engagement letter the
nature and objectives of the engagement to review interim financial
information and the responsibilities of management and the auditor
or (b) issue a separate engagement letter that addresses such
matters.\46\

    \46\ Paragraphs .08-.09 of AU sec. 722, Interim Financial
Information, discuss the auditor's responsibilities related to
establishing an understanding with the audit committee in connection
with a review of the company's interim financial information.

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Amendments to PCAOB Standards
Auditing Standards
Auditing Standard No. 5, An Audit of Internal Control Over Financial
Reporting That Is Integrated With An Audit of Financial Statements
    Auditing Standard No. 5, An Audit of Internal Control Over
Financial Reporting That is Integrated with An Audit of Financial
Statements, as amended, is amended as follows:
     The following sentence is added at the end of paragraph
80: This communication should be made in a timely manner and prior to
the issuance of the auditor's report on internal control over financial
reporting.
     The following sentence is added after the first sentence
of paragraph 81: The auditor should communicate this information to the
audit committee in a timely manner and prior to the issuance of the
auditor's report on internal control over financial reporting.
Auditing Standard No. 9, Audit Planning
    Auditing Standard No. 9, Audit Planning, is amended as follows:
     Paragraph 6.c. is replaced with: Establish an
understanding of the terms of the audit engagement with the audit
committee in accordance with Auditing Standard No. 16, Communications
with Audit Committees.
     Footnote 4 to paragraph 6 is deleted.
     In footnote 7 to paragraph 9.a., the references to AU sec.
310 and AU sec. 380, Communication with Audit Committees, are replaced
with a reference to Auditing Standard No. 16, Communications with Audit
Committees.
Auditing Standard No. 13, The Auditor's Responses to the Risks of
Material Misstatement
    Auditing Standard No. 13, The Auditor's Responses to the Risks of
Material Misstatement, is amended as follows:
    The note to paragraph 5.d. is deleted.
AU sec. 310, ``Appointment of the Independent Auditor''
    SAS No. 1, ``Codification of Auditing Standards and Procedures''
section 310, ``Appointment of the Independent Auditor'' (AU sec. 310,
``Appointment of the Independent Auditor''), as amended, is superseded.
AU sec. 316, ``Consideration of Fraud in a Financial Statement Audit''
    SAS No. 99, ``Consideration of Fraud in a Financial Statement
Audit'' (AU sec. 316, ``Consideration of Fraud in a Financial Statement
Audit''), as amended, is amended as follows:
    a. The third sentence of paragraph .79 is replaced with: Fraud
involving senior management and fraud (whether caused by senior
management or other employees) that causes a material misstatement of
the financial statements should be reported directly to the audit
committee in a timely manner and prior to the issuance of the auditor's
report.
    b. The second sentence of paragraph .81 is replaced with: Such a
communication may be a part of an overall communication to the audit
committee of business and financial statement risks affecting the
entity and/or in conjunction with the auditor communication about the
qualitative aspects of the entity's accounting policies and practices
(see paragraphs 12-13 of Auditing Standard No.16, Communications with
Audit Committees). The auditor should communicate these matters to the
audit committee in a timely manner and prior to the issuance of the
auditor's report.
    c. Within footnote 10 to paragraph .88, the reference to section
380, Communication With Audit Committees, is replaced with a reference
to Auditing Standard No.16, Communications with Audit Committees.
AU sec. 317, ``Illegal Acts by Clients''
    SAS No. 54, ``Illegal Acts by Clients'' (AU sec. 317, ``Illegal
Acts by Clients''), as amended, is amended as follows:
     The fourth sentence of paragraph .08 is replaced with:
    The auditor should make inquiries of management and the audit
committee1 concerning the client's compliance with laws and regulations
and knowledge of violations or possible violations of laws or
regulations.
     Footnote 1 is added to paragraph .08 after the term
``audit committee'': For this standard, audit committee is defined as a
committee (or equivalent body) established by and among the board of
directors of an entity for the purpose of overseeing the accounting and
financial reporting processes of the entity and audits of the financial
statements of the entity; if no such committee exists with respect to
the entity, the entire board of directors of the entity. For audits of
nonissuers, if no such committee or board of directors (or equivalent
body) exists with respect to the entity, the person(s) who oversee the
accounting and financial reporting processes of the entity and audits
of the financial statements of the entity.
     The first sentence of paragraph .17 is replaced with:
    The auditor should assure himself that the audit committee is
adequately informed as soon as practicable and prior to the issuance of
the auditor's report with respect to illegal acts that come to the
auditor's attention.
     Footnote 1 to paragraph .17 is deleted.
AU sec. 328, ``Auditing Fair Value Measurements and Disclosures''
    SAS No. 101, ``Auditing Fair Value Measurements and Disclosures''
(AU sec. 328, ``Auditing Fair Value Measurements and Disclosures''), as
amended, is amended as follows:
    Paragraph .50 is replaced with:
    Paragraphs 12-13 of Auditing Standard No. 16, Communications with
Audit Committees, require the auditor to communicate to the audit
committee matters related to critical accounting estimates, which may
include fair value measurements.
AU sec. 333, ``Management Representations''
    SAS No. 85, ``Management Representations'' (AU sec. 333,
``Management Representations''), as amended, is amended as follows:
    The following sentence is added as the last sentence of paragraph
.05: The auditor should provide a copy of the representation letter to
the audit committee if management has not already provided the
representation letter to the audit committee.
AU sec. 341, ``The Auditor's Consideration of an Entity's Ability To
Continue as a Going Concern''
    SAS No. 59, ``The Auditor's Consideration of an Entity's Ability to
Continue as a Going Concern'' (AU sec. 341, ``The Auditor's
Consideration of an Entity's Ability to Continue as a Going Concern''),
as amended, is amended as follows:
    Paragraph .17A is added, along with the heading preceding this
paragraph: Communications with Audit Committees.
    Paragraph 17 of Auditing Standard No. 16, Communications with Audit
Committees, describes matters an auditor is required to communicate to
the audit committee related to the auditor's evaluation of a company's
ability to continue as a going concern for a reasonable period of time.
AU sec. 380, ``Communication With Audit Committees''
    SAS No. 61, ``Communication With Audit Committees'' (AU sec. 380,
``Communication With Audit Committees''), as amended, is superseded.

AU sec. 9380, ``Communication With Audit Committees: Auditing
Interpretations of Section 380''
    AU sec. 9380, ``Communication With Audit Committees: Auditing
Interpretations of Section 380,'' is superseded.
AU sec. 532, ``Restricting the Use of an Auditor's Report''
    SAS No. 87, ``Restricting the Use of an Auditor's Report (AU sec.
532, ``Restricting the Use of an Auditor's Report''), as amended, is
amended as follows:
    In the second bullet point of paragraph .07, the reference to
Section 380, Communication With Audit Committees, is replaced with a
reference to Auditing Standard No. 16, Communications with Audit
Committees.
AU sec. 550, ``Other Information in Documents Containing Audited
Financial Statements''
    SAS No. 8, ``Other Information in Documents Containing Audited
Financial Statements'' (AU sec. 550, ``Other Information in Documents
Containing Audited Financial Statements''), as amended, is amended as
follows:
    a. The sixth sentence of paragraph .04 is replaced with: If the
other information is not revised to eliminate the material
inconsistency, he should communicate the material inconsistency to the
audit committee and consider other actions, such as revising his report
to include an explanatory paragraph describing the material
inconsistency, withholding the use of his report in the document, and
withdrawing from the engagement.
    b. The second sentence of paragraph .06 is replaced with: He should
communicate the material misstatement of fact to the client and the
audit committee, in writing, and consider consulting his legal counsel
as to further appropriate action in the circumstances.
AU sec. 711, ``Filings Under Federal Securities Statutes''
    SAS No. 37, ``Filings Under Federal Securities Statutes'' (AU sec.
711, ``Filings Under Federal Securities Statutes''), as amended, is
amended as follows:
    The last sentence of paragraph .13 is replaced with:
    In either case, the accountant should communicate the matter to the
audit committee and also consider withholding his consent to the use of
his report on the audited financial statements in the registration
statement.
AU sec. 722, ``Interim Financial Information''
    SAS No. 100, ``Interim Financial Information'' (AU sec. 722,
``Interim Financial Information''), as amended, is amended as follows:
    The heading preceding paragraph .08, ``Establishing an
Understanding With the Client'' is replaced with the heading,
``Establishing an Understanding with the Audit Committee.''
    Paragraph .08 is replaced with:
    The accountant should establish an understanding of the terms of an
engagement to review interim financial information with the audit
committee or others with equivalent authority and responsibility
(hereafter referred to as the audit committee).6 This understanding
includes the objective of the review of interim financial information,
the responsibilities of the accountant, and the responsibilities of
management. Such an understanding reduces the risk that either the
accountant or the audit committee may misinterpret the needs or
expectations of the other party. The accountant should record this
understanding of the terms of the engagement in an engagement letter
and should provide the engagement letter to the audit committee. The
accountant should have the engagement letter executed by the
appropriate party or parties on behalf of the company. If the
appropriate party or parties are other than the audit committee, or its
chair on behalf of the audit committee, the accountant should determine
that the audit committee has acknowledged and agreed to the terms of
the engagement. If the accountant believes he or she cannot establish
an understanding of the terms of an engagement to review interim
financial information with the audit committee, the accountant should
decline to accept, continue, or perform the engagement.
    Footnote 6 to paragraph .08 is replaced with: See paragraph .16 of
QC sec. 20, System of Quality Control for a CPA Firm's Accounting and
Auditing Practice.
    In the first sentence of paragraph .09, the word ``client'' is
replaced with the words ``audit committee.''
    Paragraph .30 is replaced with:
    If management does not respond appropriately to the accountant's
communication within a reasonable period of time, the accountant should
communicate these matters to the audit committee as soon as practicable
and prior to the registrant filing its periodic report with the SEC.
The communications to the audit committee should be made and documented
in accordance with paragraph 25 of Auditing Standard No. 16,
Communications with Audit Committees.
    f. The following sentence is added at the end of paragraph .33:
    The accountant should communicate significant deficiencies or
material weaknesses of which the accountant has become aware to the
audit committee or those responsible for oversight of the company's
financial reporting in a timely manner and prior to the registrant
filing its periodic report with the SEC.
    g. Paragraph .34 is replaced with:
    When conducting a review of interim financial information, the
accountant also should determine whether any of the matters described
in Auditing Standard No. 16, Communications with Audit Committees, as
they relate to interim financial information, have been identified. If
such matters have been identified, the accountant should communicate
them to the audit committee in a timely manner and prior to the
registrant filing its periodic report with the SEC. For example, the
accountant should communicate a description of the process management
used to develop the critical accounting estimates; a change in a
significant accounting policy affecting the interim financial
information; misstatements that, either individually or in the
aggregate, could have a significant effect on the entity's financial
reporting process; and uncorrected misstatements aggregated by the
accountant that management determined to be immaterial, both
individually and in the aggregate, to the interim financial statements
taken as a whole.23 As part of its communications to the audit
committee, management might communicate some or all of the matters
related to the company's accounting policies, practices, estimates, and
significant unusual transactions described in paragraph 12 of Auditing
Standard No. 16, Communications with the Audit Committees. If
management communicates any of these matters, the accountant does not
need to communicate them at the same level of detail as management, as
long as the accountant (1) participated in management's discussion with
the audit committee, (2) affirmatively confirmed to the audit committee
that management has adequately communicated these matters, and (3) with
respect to critical accounting policies and practices, identified for
the audit committee those accounting policies and practices that the
accountant considers critical. The accountant should communicate any
omitted or inadequately described matters to the audit committee.

    h. Footnote 23 to paragraph .34 is replaced with:
    The schedule of uncorrected misstatements related to accounts and
disclosures provided to the audit committee should be the same schedule
that was included in or attached to the management representation
letter that is described in paragraph .24(k) of this section.
    i. The last two sentences of paragraph .35 are replaced with:
    Therefore, any communication the accountant may make about the
entity's accounting policies, practices, estimates, and significant
unusual transactions as applied to its interim financial reporting,
generally would be limited to the effect of significant events,
transactions, and changes in accounting estimates that the accountant
considered when conducting the review of interim financial information.
Further, interim review procedures do not provide assurance that the
accountant will become aware of all matters that might affect the
accountant's judgments about the qualitative aspects of the entity's
accounting policies and practices that would be identified as a result
of an audit.
    j. Paragraph .36 is replaced with:
    If the accountant has identified matters to be communicated to the
audit committee, the accountant should communicate such matters to the
audit committee, or at least its chair, in a timely manner and prior to
the registrant filing its periodic report with the SEC. The
communications to the audit committee should be made and documented in
accordance with paragraph 25 of Auditing Standard No. 16,
Communications with Audit Committees.
Transitional Amendments to AU sec. 380, Communication With Audit
Committees
AU sec. 380, Communication With Audit Committees
    SAS No. 61, ``Communication With Audit Committees'' (AU sec. 380,
``Communication With Audit Committees''), as amended, is amended as
follows:
    The last sentence of paragraph .01 is replaced with:
    The communications required by this section are applicable to the
audits of (i) issuers and (ii) brokers and dealers, as those terms are
defined in the Sarbanes-Oxley Act of 2002, as amended.\2\
    Footnote 2 to paragraph .01 is replaced with:
    See Sections 2(a)(7), 110(3), and 110(4) of the Sarbanes-Oxley Act
of 2002.

II. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules

    In its filing with the Commission, the Board included statements
concerning the purpose of, and basis for, the proposed rules and
discussed any comments it received on the proposed rules. The text of
these statements may be examined at the places specified in Item IV
below. The Board has prepared summaries, set forth in sections A, B,
and C below, of the most significant aspects of such statements. The
Board is also requesting that the Commission approve the proposed
rules, pursuant to Section 103(a)(3)(C) of the Sarbanes-Oxley Act, for
application to audits of emerging growth companies (``EGCs''), as that
term is defined in Section 3(a)(80) of the Securities Exchange Act of
1934 (``Exchange Act''). The Board's request is set forth in section D.

A. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules

(a) Purpose
    Section 103(a) of the Sarbanes-Oxley Act directs the Board, by
rule, to establish, among other things, ``auditing and related
attestation standards * * * to be used by registered public accounting
firms in the preparation and issuance of audit reports, as required by
th[e] [Sarbanes-Oxley] Act or the rules of the Commission, or as may be
necessary or appropriate in the public interest or for the protection
of investors.'' The Board adopted Auditing Standard No. 16,
Communications with Audit Committees (the ``standard''), and related
amendments to improve the audit by enhancing communications between
auditors and audit committees.
    As discussed more fully in Exhibit 3, the Board adopted Auditing
Standard No. 16 because it believes that the standard is in the public
interest because the standard establishes requirements that enhance the
relevance, timeliness, and quality of the communications between the
auditor and the audit committee. The enhanced relevance, timeliness,
and quality of communications should facilitate audit committees'
financial reporting oversight, fostering improved financial reporting,
thereby benefitting investors.
    With the passage of the Sarbanes-Oxley Act and the establishment of
the PCAOB, Congress acknowledged that auditors play an important role
in protecting the interests of investors by preparing and issuing
informative, accurate, and independent audit reports.\47\ The audit
committee \48\ also plays an important role in protecting the interests
of investors by assisting the board of directors in fulfilling its
responsibility to a company's shareholders and others to oversee the
integrity of a company's accounting and financial reporting processes
and audits. The audit committee, among other things, serves as the
board of director's principal interface with the company's auditors and
facilitates communications between the company's board of directors,
its management, and its independent auditors on significant accounting
issues and policies. The roles of auditors and audit committees are
critical to the efficiency and integrity of the capital markets.
---------------------------------------------------------------------------

    \47\ See Section 101(a) of the Sarbanes-Oxley Act, 15 U.S.C.
7211(a); Senate Report No. 107-206, at 5-6 (July 3, 2002).
    \48\ The term ``audit committee,'' as defined in Auditing
Standard No. 16, is a committee (or equivalent body) established by
and among the board of directors of a company for the purpose of
overseeing the accounting and financial reporting processes of the
company and audits of the financial statements of the company; if no
such committee exists with respect to a company, the entire board of
directors of the company. For audits of nonissuers, if no such
committee or board of directors (or equivalent body) exists with
respect to the company, the person(s) who oversee the accounting and
financial reporting processes of the company and audits of the
financial statements of the company.
---------------------------------------------------------------------------

    Both the auditor and the audit committee benefit from a meaningful
exchange of information regarding significant risks of material
misstatement in the financial statements and other matters that may
affect the integrity of the company's financial reports. Communications
between the auditor and the audit committee allow the audit committee
to be well-informed about accounting and disclosure matters, including
the auditor's evaluation of matters that are significant to the
financial statements, and to be better able to carry out its oversight
role. Communications with the audit committee provide auditors with a
forum separate from management to discuss matters about the audit and
the company's financial reporting process.
    Auditing Standard No. 16 is aligned with the requirements of the
Sarbanes-Oxley Act. For many public companies, the Sarbanes-Oxley Act
served to strengthen and expand the role of the audit committee in the
financial reporting process. For example, the Sarbanes-Oxley Act
requires that audit committee members of listed companies be
independent and that audit committees be responsible for the
appointment, compensation, and oversight of the work of the external
auditor for the purpose of preparing or

issuing an audit report or related work.\49\ These requirements place
the audit committee at the center of the relationship between
management of a public company and its auditor.
---------------------------------------------------------------------------

    \49\ See Section 301 of the Sarbanes-Oxley Act and Section
10A(m)(2) of the Exchange Act, 15 U.S.C. 78j-1(m)(2).
---------------------------------------------------------------------------

    Auditing Standard No. 16 is intended to improve the audit \50\ by
fostering constructive dialogue between the auditor and the audit
committee about significant audit and financial statement matters. The
standard requires the auditor to communicate certain matters regarding
the audit and the financial statements to the audit committee, which
should assist the audit committee in fulfilling its oversight
responsibilities regarding the financial reporting process. Effective
two-way communication between the auditor and the audit committee on
such relevant matters also will benefit the auditor in performing an
effective audit.
---------------------------------------------------------------------------

    \50\ For purposes of this release and standard, an audit is
either an audit of internal control over financial reporting that is
integrated with an audit of financial statements or an audit of
financial statements only.
---------------------------------------------------------------------------

    Auditing Standard No. 16 encourages effective two-way communication
between the auditor and the audit committee throughout the audit to
assist both parties in understanding matters relevant to the audit.
Communications that are tailored to the circumstances and informative,
rather than ``boiler-plate'' or standardized, will enable the auditor
and the audit committee to engage in a dialogue that is more likely to
benefit both the audit committee, in conducting its oversight
responsibilities, and the auditor, in conducting an effective audit.
Effective communication between the auditor and the audit committee may
involve many forms of communication, such as presentations, charts,
written reports, or robust discussions.
    AU sec. 380, which became effective in January 1989, indicated that
audit committee communications are incidental to the audit and are not
required to occur prior to the issuance of the auditor's report. In
contrast, Auditing Standard No. 16 recognizes the importance of the
auditor's communications with the audit committee in today's business
and regulatory environment; therefore, Auditing Standard No. 16
requires the auditor to communicate the audit strategy and results of
the audit to the audit committee in a timely manner and prior to the
issuance of the auditor's report to provide an opportunity for the
audit committee and the auditor to take appropriate action to address
the matters communicated.
    Timely communications with the audit committee help the auditor
improve the audit by, among other things (i) informing the audit
committee, which has responsibility for the oversight of financial
reporting, about significant matters related to the audit and the
financial statements, (ii) enabling the auditor to obtain the audit
committee's insights and information about transactions and events,
(iii) enabling the auditor to learn about complaints regarding
accounting or auditing matters, and (iv) assisting the auditor in
gaining a better understanding of the company and its control
environment.
    Auditing Standard No. 16 generally links the new communication
requirements to the results of related audit performance requirements
in other PCAOB standards, or the conduct of the audit. The standard
does not otherwise impose new performance requirements, other than
communications. Because other PCAOB standards already require the
auditor to perform procedures underlying the communications required in
Auditing Standard No. 16, and the standard primarily requires
communication of the results of the auditor's procedures, the Board
does not anticipate a significant increase in cost as a result of the
implementation of the standard.
    Some of the matters to be communicated under Auditing Standard No.
16 relate specifically to matters involving management's preparation of
the company's financial statements. In many companies, management might
communicate these matters or take the lead on communicating these
matters to the audit committee. The PCAOB does not have the authority
to require management to communicate to the audit committee.
Additionally, certain communications by the auditor are mandated by
federal securities laws and Commission rules.\51\ Therefore, Auditing
Standard No. 16 establishes required communications by the auditor to
the audit committee but, at the same time, clearly recognizes and
acknowledges that management might communicate to the audit committee
certain matters related to the company's financial statements. In such
circumstances, the auditor does not need to communicate those matters
at the same level of detail as management, as long as certain
conditions are met, as specified in the standard.
---------------------------------------------------------------------------

    \51\ See e.g., Section 10A(k) of the Exchange Act, 15 U.S.C.
78j-1(k); SEC Rule 2-07 of Regulation S-X (``SEC Rule 2-07''), 17
CFR 210.2-07; and Rule 10A-3 under the Exchange Act, 17 CFR 240.10A-
3.
---------------------------------------------------------------------------

    Auditing Standard No. 16 is scalable for audits of companies of
various sizes and complexities. A company's size and complexity might
affect the risks of misstatements, the audit strategy, and other
significant matters that warrant the attention of the audit committee.
Based on the specific company's circumstances, the standard requires
communications only to the extent that the matters are relevant to the
audit of the financial statements of the company or of internal control
over financial reporting. For example, an auditor of a smaller, less
complex company with fewer difficult auditing or financial reporting
issues may have fewer matters to communicate than the auditor of a
larger, more complex company.
    The proposed rules also amend the Board's interim standards
including superseding interim standards AU sec. 380, Communication With
Audit Committees, and AU sec. 310, Appointment of the Independent
Auditor (``AU sec. 310'').
(b) Statutory Basis
    The statutory basis for the proposed rules is Title I of the
Sarbanes-Oxley Act.

B. Board's Statement on Burden on Competition

    Not applicable.

C. Board's Statement on Comments on the Proposed Rules Change Received
From Members, Participants or Others

    The Board released the proposed rules for public comment in PCAOB
Release No. 2010-001 (March 29, 2010). The Board received 35 comment
letters. On September 21, 2010, the Board held a roundtable to obtain
insight from additional stakeholders, including investors, audit
committee members, auditors, and preparers. The Board reopened the
public comment period on the original proposed rules to allow for
interested parties to provide additional comments on the topics
discussed at the roundtable. The Board received nine additional comment
letters during this extended comment period.
    The Board considered the comments received relating to its initial
proposed rules and at the roundtable and made changes to the initial
proposed rules. As a result, the Board again sought public comment on
the proposed rules on December 20, 2011. The Board received 39 written
comment letters relating to its reproposal of the proposed rules.
    The Board has carefully considered all comments received. The
Board's response to the comments it received

and the changes made to the rules in response to the comments received
are discussed below.
Overview of Auditing Standard No. 16
    Auditing Standard No. 16 provides a definition of audit committee,
retains or enhances existing communication requirements, incorporates
certain SEC auditor communication requirements to audit committees, and
adds new communication requirements that are generally linked to
performance requirements in other PCAOB standards.
    For audits of issuers, Auditing Standard No. 16 incorporates the
Sarbanes-Oxley Act's definition of audit committee as a committee (or
equivalent body) established by and among the board of directors of a
company for the purpose of overseeing the accounting and financial
reporting processes of the company and audits of the financial
statements of the company; if no such committee exists with respect to
the company, then the audit committee is the entire board of directors
of the company. For audits of nonissuers, the definition of audit
committee contained in Auditing Standard No. 16 provides that if no
audit committee or board of directors (or equivalent body) exists with
respect to the company, then the audit committee is the person(s) who
oversee the accounting and financial reporting processes of the company
and audits of the financial statements of the company.
    AU sec. 310 requires the auditor to establish an understanding with
the client regarding the services to be performed. Auditing Standard
No. 16 requires the auditor to establish the understanding of the terms
of the audit engagement with the audit committee. This requirement
aligns the auditing standard with the provision of the Sarbanes-Oxley
Act that requires the audit committee of listed companies to be
responsible for the appointment of the external auditor.\52\
---------------------------------------------------------------------------

    \52\ See Section 301 of the Sarbanes-Oxley Act, and Sections
10A(m)(2) of the Exchange Act, 15 U.S.C. 78j-1(m)(2).
---------------------------------------------------------------------------

    Additionally, Auditing Standard No. 16 requires the auditor to
record the terms of the engagement in an engagement letter and to have
the engagement letter executed by the appropriate party or parties on
behalf of the company and determine that the audit committee has
acknowledged and agreed to the terms. These requirements are an
expansion of the requirement in AU sec. 310 for the auditor to document
the understanding in the working papers, preferably through a written
communication with the client.
    Auditing Standard No. 16 retains many of the communication
requirements in AU sec. 380 and also incorporates the SEC communication
requirements.\53\ The standard improves the current communication
requirements of AU sec. 380 by requiring the communications with the
audit committee to occur before the issuance of the audit report.
Additionally, the standard enhances certain existing auditor
communication requirements by requiring the auditor to communicate:
---------------------------------------------------------------------------

    \53\ See Section 10A(k) of the Exchange Act, 15 U.S.C. 78j-1(k)
and SEC Rule 2-07(a)(1)-(3).
---------------------------------------------------------------------------

    d. Certain matters regarding the company's accounting policies,
practices, and estimates;
    e. The auditor's evaluation of the quality of the company's
financial reporting;
    f. Information related to significant unusual transactions,
including the business rationale for such transactions; and
    g. The auditor's views regarding significant accounting or auditing
matters when the auditor is aware that management consulted with other
accountants about such matters and the auditor has identified a concern
regarding these matters.
    Auditing Standard No. 16 expands the inquiries of the audit
committee required by Auditing Standard No. 12, Identifying and
Assessing Risks of Material Misstatement, which requires the auditor to
inquire of the audit committee regarding the matters important to the
identification and assessment of risks of material misstatement and
fraud risks. The additional inquiries in Auditing Standard No. 16
address whether the audit committee is aware of matters relevant to the
audit, including, but not limited to, violations or possible violations
of laws or regulations.
    Additionally, Auditing Standard No. 16 adds new communication
requirements that provide the audit committee with additional
information about significant aspects of the audit. These
communications are generally linked to the results of the audit
procedures or the conduct of the audit. Under Auditing Standard No. 16
the auditor would be required to communicate:
    h. An overview of the overall audit strategy, including timing of
the audit, significant risks the auditor identified, and significant
changes to the planned audit strategy or identified risks;
    i. Information about the nature and extent of specialized skill or
knowledge needed in the audit, the extent of the planned use of
internal auditors, company personnel or other third parties, and other
independent public accounting firms, or other persons not employed by
the auditor that are involved in the audit;
    j. The basis for the auditor's determination that he or she can
serve as principal auditor, if significant parts of the audit will be
performed by other auditors;
    k. Situations in which the auditor identified a concern regarding
management's anticipated application of accounting pronouncements that
have been issued but are not yet effective and might have a significant
effect on future financial reporting;
    l. Difficult or contentious matters for which the auditor consulted
outside the engagement team;
    m. The auditor's evaluation of going concern;
    n. Departure from the auditor's standard report; and
    o. Other matters arising from the audit that are significant to the
oversight of the company's financial reporting process, including
complaints or concerns regarding accounting or auditing matters that
have come to the auditor's attention during the audit.

In addition to the communication requirements included in Auditing
Standard No. 16, other PCAOB standards and rules that require the
auditor to communicate specific matters to the audit committee are
referenced in Appendix B to Auditing Standard No. 16.
    While the standard establishes certain requirements regarding
auditor communications to the audit committee, Auditing Standard No. 16
does not preclude the auditor from providing additional information to
the audit committee. Nor does the standard preclude the auditor from
responding to audit committee requests for additional information from
the auditor.
Definition of Audit Committee (Paragraph A-2 of Auditing Standard No.
16)
    Auditing Standard No. 16 defines an audit committee as a committee
(or equivalent body) established by and among the board of directors of
a company for the purpose of overseeing the accounting and financial
reporting processes of the company and audits of the financial
statements of the company; if no such committee exists with respect to
the company, the entire board of directors of the company. This
definition largely incorporates the

definition of ``audit committee'' from the Sarbanes-Oxley Act.\54\ The
parenthetical phrase ``or equivalent body'' after the term
``committee'' clarifies that entities with bodies performing a function
similar to that of an audit committee would fit within this category.
---------------------------------------------------------------------------

    \54\ Section 2(a)(3) of the Sarbanes-Oxley Act, 15 U.S.C. Sec.
7201.
---------------------------------------------------------------------------

    The standard modifies the Sarbanes-Oxley Act's version of the
definition of an audit committee as it relates to audits of nonissuers.
Specifically, for audits of nonissuers, Auditing Standard No. 16 states
that, if no such committee or board of directors (or equivalent body)
exists with respect to the company, the audit committee would be
considered the person(s) who oversee the accounting and financial
reporting processes of the company and audits of the financial
statements of the company. This modification was made to recognize that
some nonissuers, including brokers and dealers, may have governance
structures that do not include boards of directors or audit committees.
In those cases, the auditor would identify those persons at the
nonissuer company who oversee the company's accounting and financial
reporting processes and audits. This modification is meant to indicate
that senior persons in an oversight role in such circumstances would be
the recipients of the auditor communications.
    Using the definition of ``audit committee,'' the auditor would
identify the bodies or persons that oversee the company's accounting,
auditing, and financial reporting processes to find the appropriate
recipient of the communications under the standard.\55\ For issuers,
the definition is the same as the definition included in the Sarbanes-
Oxley Act.\56\ For nonissuers, the definition contains three categories
of bodies or persons. The first two categories (audit committee and the
entire board of directors of the company) are the same as those
included in the definition of audit committee for an issuer. The third
category covers situations in which the company does not have an audit
committee, board of directors, or equivalent body, such as certain non-
public brokers and dealers. The parenthetical phrase ``or equivalent
body'' after the term ``board of directors'' clarifies that entities
with bodies performing a function similar to that of a corporate board
of directors would fit within this category.
---------------------------------------------------------------------------

    \55\ The Board's proposed definition is not intended to conflict
with or affect any requirements, or the application of any
requirements, under federal law, state law, foreign law, or an
entity's governing documents regarding the establishment, approval,
or ratification of board of directors or audit committees, or the
delegation of responsibilities of such a committee or board.
    \56\ Section 2(a)(3) of the Sarbanes-Oxley Act, 15 U.S.C. Sec.
7201.
---------------------------------------------------------------------------

    The reproposed standard required the auditor to communicate to
those persons designated to oversee the financial reporting processes
of the company in situations in which a nonissuer does not have an
audit committee, board of directors, or equivalent body. Some
commenters indicated that, for certain nonissuers, the person
designated to oversee the accounting and financial reporting processes
of the company could be the chief financial officer, in which case the
communication would be made to the person preparing the financial
statements. Therefore, commenters suggested that the auditor should
make relevant communications to the chief executive officer, or
equivalent officer of the company.
    Some commenters suggested that the standard should clarify to whom
the auditor should communicate when the company is a subsidiary of
another entity. Auditing Standard No. 16 does not require communication
outside the governance structure of the audited entity because the
standard designates the appropriate party to receive the auditor
communications within the audited entity. If directed by the audit
client, or if the auditor otherwise deems it appropriate, the auditor
could also communicate to a parent company audit committee or
equivalent body.
Objectives (Paragraph 3 of Auditing Standard No. 16)
    Auditing Standard No. 16 states that the objectives of the auditor
are to (a) communicate to the audit committee the responsibilities of
the auditor in relation to the audit and establish an understanding of
the terms of the audit engagement with the audit committee; (b) obtain
information from the audit committee relevant to the audit; (c)
communicate to the audit committee an overview of the overall audit
strategy and timing of the audit; and (d) provide the audit committee
with timely observations arising from the audit that are significant to
the financial reporting process. The objectives of the standard are
intended to highlight the overall context for the requirements in the
standard.
Significant Issues Discussed with Management in Connection With the
Auditor's Appointment or Retention (Paragraph 4 of Auditing Standard
No. 16)
    Auditing Standard No. 16 requires the auditor to discuss with the
audit committee any significant issues that the auditor discussed with
management in connection with the appointment or retention of the
auditor, including significant discussions regarding the application of
accounting principles and auditing standards. This requirement was
retained from AU sec. 380.\57\
---------------------------------------------------------------------------

    \57\ AU sec. 380.15.
---------------------------------------------------------------------------

    This requirement is included in the standard because the audit
committee might ask management for its views concerning the appointment
or retention of the auditor. Management's views might be influenced by
the interaction between the auditor and management and the auditor's
evaluations and conclusions regarding the application of accounting
principles or auditing standards.
    Some commenters suggested that these discussions should include a
robust fee discussion or a discussion about the results of the
auditor's considerations during the client acceptance and continuance
process, such as the auditor's views of the entity's accounting and
financial reporting practices or management's integrity. The standard
was not revised to include such additional matters because the
requirement in the standard specifically addresses the auditor's
discussions with management related to accounting and auditing matters
in connection with the appointment or retention of the auditor.
However, Auditing Standard No. 16 requires the auditor to communicate
any matters arising from the audit to the audit committee that the
auditor believes are significant to the audit committee's oversight of
the company's financial reporting process.\58\
---------------------------------------------------------------------------

    \58\ Paragraph 24 of Auditing Standard No. 16.
---------------------------------------------------------------------------

Establish an Understanding of the Terms of the Audit (Paragraphs 5-7 of
Auditing Standard No. 16)
    Auditing Standard No. 16 includes a specific requirement for the
auditor to establish an understanding of the terms of the audit
engagement with the audit committee. Having a mutually clear
understanding of the terms of the engagement, including the objectives
of the audit, the responsibilities of the auditor, and the
responsibilities of management in connection with the audit, should
benefit both the auditor and the audit committee.

    The requirement in Auditing Standard No. 16 is similar to the
requirement in AU sec. 310, Appointment of the Independent Auditor
(``AU sec 310''), which requires the auditor to establish an
understanding with the client regarding the services to be performed.
However, Auditing Standard No. 16 more specifically requires that the
understanding be with the audit committee due to the audit committee's
financial reporting and audit oversight role, rather than with the
``client,'' which could be understood to mean others besides the audit
committee in certain circumstances.
    Auditing Standard No. 16 also requires the auditor to record the
understanding of the terms of the audit engagement in an engagement
letter. Appendix C of Auditing Standard No. 16 describes matters that
should be included in an engagement letter, including the objective of
the audit and the responsibilities of the auditor and management. This
is an expansion of the requirement in AU sec. 310, which requires the
auditor to document the understanding of the engagement in the working
papers, preferably through a written communication with the client.
    Some commenters indicated that the engagement letter should
describe the responsibilities of the audit committee related to the
audit. The Board considered this suggestion and did not change the
standard to include the responsibilities of the audit committee, as
those responsibilities are governed by the rules of other
organizations, such as the Commission and the national securities
exchanges.\59\ However, the standard does not prohibit the auditor from
including other matters in the engagement letter, as agreed upon by the
auditor and the audit committee, so long as those matters are not in
violation of other standards or rules, for example, independence
requirements.
---------------------------------------------------------------------------

    \59\ See, e.g., New York Stock Exchange, Listed Company Manual
at Section 303A.07, Audit Committee Additional Requirements.
---------------------------------------------------------------------------

    Auditing Standard No. 16 requires the auditor to provide the
engagement letter to the audit committee annually. Additionally, the
auditor should have the engagement letter executed by the appropriate
party or parties on behalf of the company.\60\ The standard also states
that if the appropriate party or parties are other than the audit
committee, or its chair on behalf of the audit committee, the auditor
also should determine that the audit committee has acknowledged and
agreed to the terms of the engagement. This acknowledgment may be
obtained in a variety of ways, such as obtaining the audit committee
members' signatures, or its chair's signature on behalf of the audit
committee, or obtaining another form of acknowledgement and agreement
by the audit committee regarding the terms of the audit engagement.
Obtaining this acknowledgement reduces the risk that either the auditor
or the audit committee might misinterpret the needs or expectations of
the other party. An acknowledgement by the audit committee, the
signatures of the audit committee members, or the signature of its
chair on behalf of the audit committee on the engagement letter is not
intended to conflict with or affect any requirements, or the
application of any requirements, under federal law, state law, foreign
law, applicable exchange requirements, or the company's governing
documents, regarding the authority or lack of authority of the audit
committee to enter into any contract or agreement with the auditor.
---------------------------------------------------------------------------

    \60\ Absent evidence to the contrary, the auditor may rely on
the company's identification of the appropriate party or parties to
execute the engagement letter.
---------------------------------------------------------------------------

    Several commenters suggested that the standard should specify that
the engagement letter should be executed by management in addition to
the audit committee or by management alone, along with a representation
that it has the authority to do so on behalf of the audit committee.
The Board considered these comments and decided that, absent evidence
to the contrary, the auditor may rely on the company's identification
of the appropriate party or parties to execute the engagement letter.
Therefore, the standard does not specify the party that should execute
the engagement letter on behalf of the company.
    Some commenters suggested that the standard should indicate that
the audit committee's acknowledgement can be either written or oral.
Other commenters suggested that the audit committee's acknowledgement
should be written, either evidenced by a signature on the engagement
letter or in the audit committee's minutes, to avoid the potential for
subsequent misunderstandings of whether the audit committee's
acknowledgement has been obtained.
    The Board considered these comments and determined that the audit
committee's acknowledgement may be provided in writing, such as a
signed engagement letter or through the minutes of the audit committee
meeting, or orally. The primary focus of this requirement is that the
auditor receives acknowledgment and agreement from the audit committee
rather than the method the audit committee uses to provide that
acknowledgement; therefore, a change to the standard was not warranted.
The reproposed standard did not specify the form of acknowledgment and,
therefore, the standard was not revised. However, the auditor could
request that the audit committee acknowledge the terms of the audit
engagement in writing. If the audit committee's acknowledgement is
received orally, in accordance with paragraph 25 of Auditing Standard
No. 16, the auditor is required to document the acknowledgement in the
auditor's work papers.
Obtaining Information Relevant to the Audit (Paragraph 8 of Auditing
Standard No. 16)
    Auditing Standard No. 16 includes a requirement for the auditor to
inquire of the audit committee about whether it is aware of matters
relevant to the audit, including, but not limited to, violations or
possible violations of laws or regulations. This inquiry contributes to
a two-way dialogue between the auditor and the audit committee
concerning matters relevant to the audit. This inquiry would complement
the requirement for the auditor to make inquiries of the audit
committee (or its chair) about risks of material misstatement,
including inquiries related to fraud risks, in accordance with Auditing
Standard No. 12, Identifying and Assessing Risks of Material
Misstatement.\61\ This requirement is included in the standard because,
in addition to the inquiries required as part of the risk assessment
procedures, audit committees may be aware of other matters relevant to
the auditor in performing audit procedures.
---------------------------------------------------------------------------

    \61\ See paragraph 5.f. and 54-57 of Auditing Standard No. 12.
---------------------------------------------------------------------------

    Auditing Standard No. 16 does not include the reference to
``complaints or concerns received by the audit committee regarding
financial reporting matters'' previously included in the reproposed
standard. This change is not intended to signal a change in the scope
of this communication between the audit committee and the auditor.
Rather, the Board notes that such inquiry by the auditor of the audit
committee is already included in paragraph 56.b(3) of Auditing Standard
No. 12, which requires the auditor to inquire of the audit committee
about tips or complaints regarding the company's financial
reporting.\62\ Since the inquiry

in the reproposed standard was similar to the inquiries in Auditing
Standard No. 12, Auditing Standard No. 16 was revised to remove the
inquiry regarding complaints or concerns.
---------------------------------------------------------------------------

    \62\ Auditing Standard No. 12 also includes inquiries regarding
the audit committee's views about fraud risks, its knowledge of
fraud, and the audit committee's response to tips or complaints
regarding the company's financial reporting, and how the audit
committee exercises oversight of the company's assessment of fraud
risks. See paragraphs 56.b(1)-(4) of Auditing Standard No. 12.
---------------------------------------------------------------------------

    Auditing Standard No. 16 does not provide specific timing for these
inquiries to be made. Depending on the circumstances of the audit, it
may be appropriate for the auditor to conduct such inquiries of the
audit committee at the outset of the audit and/or at other various
stages of the audit. For example, the auditor may want to conduct these
inquiries early in the audit to consider any information received from
the audit committee in designing the nature, timing, and extent of
audit procedures. In other circumstances, as the audit progresses, an
auditor may want to inquire of the audit committee as to whether any
additional matters or concerns relevant to the audit have come to the
attention of the audit committee not previously discussed with the
auditor.
    The reproposed standard required the auditor to inquire of the
audit committee about ``whether it is aware of matters that might be
relevant to the audit.'' One commenter raised concerns about this
provision of the reproposed standard as being ``too broad and
overreaching,'' which could obscure information that is truly relevant
to the audit. Other commenters suggested that the inquiries of the
audit committee should be expanded to include other matters, such as
the audit committee's awareness of significant changes in company
conditions or activities.
    After considering the comments received on the scope of the
information to be communicated under this provision, the term ``might
be'' was excluded from this paragraph of the standard. The deletion of
the term ``might be'' is appropriate to avoid an overly broad
interpretation of the standard to require discussion of matters that
may not be directly connected to the audit.
    Although the Board did not revise the requirement to list all the
matters of which the auditor could inquire in this provision, the
requirement in the standard is not meant to be limited only to matters
that are related to violations or possible violations of laws. The
Board did not consider it practical to revise the requirement in an
attempt to list all the matters of which the auditor could inquire in
this provision. Such matters can and should vary from audit to audit.
Rather, the inclusion of such matters was meant to serve only as an
example of a matter that the auditor should discuss with the audit
committee.
    The same commenter who objected to the breadth of the inquiry also
raised concerns related to the audit committee providing information to
the auditor about violations or possible violations of laws or
regulations and complaints or concerns received regarding financial
reporting matters contained in the reproposed standard. The commenter
indicated that the audit committee's communication of such information
could cause the information to lose its confidentiality status with
potential significant harmful consequences to the company, such as
reducing the candor and chilling communications between management,
employees, and the audit committee. The commenter also indicated that
if the audit committee discloses information covered by privileged
attorney-client communications or attorney work product to the auditor
as part of this communication, the company may face a risk that a court
may later deem the company to have waived the protection of such
privilege or work product doctrine.
    The Board did not change the requirement to exclude inquiries
regarding violations or possible violations of laws or regulations that
are relevant to the audit. Limiting the scope of information that the
audit committee might provide to the auditor could severely affect the
auditor's ability to conduct an effective audit.
    The purpose of this requirement is to enable the auditor to have
the information necessary to conduct the audit to support the auditor's
opinion on the company's financial statements. Due to the audit
committee's oversight responsibilities, it is appropriate for the
auditor to ask the audit committee for information relevant to the
audit, including matters related to violations or possible violations
of laws or regulations. Without such inquiry, the auditor may not have
information that could influence the performance of the audit.
    The same commenter also indicated that if the audit committee
provides information relevant to the audit, the audit committee's role
would change fundamentally from overseeing the accounting and financial
reporting process of the company and audits of financial statements to
becoming the original source of information for the auditor and
guarantor of the accuracy and completeness of the financial statements,
a role that historically has been that of management. It is possible,
that in some situations, the communication from the audit committee is
the first instance in which a matter is brought to the attention of the
auditor. For example, in some situations the audit committee may have
unique insight into management's performance. By providing the
opportunity for the audit committee to discuss information with the
auditor, the standard enables the auditor to obtain the audit
committee's perspective on matters which may be different from
management's perspective.
Overall Audit Strategy, Timing of the Audit, and Significant Risks
(Paragraphs 9-11 of Auditing Standard No. 16)
    Auditing Standard No. 16 includes a requirement for the auditor to
communicate to the audit committee an overview of the overall audit
strategy, including the timing of the audit, and to discuss with the
audit committee the significant risks \63\ identified during the
auditor's risk assessment procedures. Under this requirement, the
auditor communicates to the audit committee the results of audit
procedures performed in accordance with other PCAOB standards, such as
Auditing Standard No. 9, Audit Planning, which requires the auditor to
establish an overall audit strategy that sets the scope, timing, and
direction of the audit and guides the development of the audit plan. As
part of the auditor's risk assessment process, the auditor is required
to identify and assess the risk of material misstatement, including
significant risks.\64\
---------------------------------------------------------------------------

    \63\ See paragraph A5 of Auditing Standard No. 12, which defines
significant risk as a risk of material misstatement that requires
special audit consideration.
    \64\ See paragraphs 59, 70, and 71 of the Auditing Standard No.
12.
---------------------------------------------------------------------------

    The timing of communications related to the audit strategy may vary
from audit to audit based on the facts and circumstances. However,
early communication of these matters might enable the audit committee
to understand the auditor's views regarding risk and thereby provide an
opportunity for the audit committee to communicate insights regarding
additional risks that the auditor did not identify and allow the
auditor to more effectively incorporate the additional risks into the
audit strategy.
    Some commenters indicated that the requirement for the auditor to
communicate the audit strategy might result in the audit committee
second guessing the auditor's strategy and the scope of the audit.
These commenters suggested that the standard should

emphasize that the auditor should not disclose details about the audit
strategy that would allow management or the audit committee to take
steps that could reduce the effectiveness of the audit strategy.
Another commenter suggested the standard should require the auditor to
provide specific details about the type and timing of procedures.
Auditing Standard No. 16 includes a note, which indicates that the
overview of the audit strategy is intended to provide information about
the audit, but not specific details that would compromise the
effectiveness of the audit procedures. Communicating certain details
might reduce the effectiveness of those audit procedures. The Board
considers that the language in Auditing Standard No. 16 strikes the
appropriate balance; therefore, the standard was not revised.
    Some commenters suggested that significant risks should be
communicated throughout the audit rather than communicating just those
significant risks identified during the auditor's risk assessment
procedures. It is not the intent of the standard for the auditor to
communicate only the significant risks that are identified during the
auditor's risk assessment procedures. Paragraph 11 of Auditing Standard
No. 16 requires the auditor to communicate significant changes to the
planned audit strategy or the significant risks initially identified
and the reasons for such changes.
    A commenter suggested that the communication of risks be expanded
to include business risks and the auditor's views of the company's
internal controls, in addition to the significant risks of material
misstatement to the financial statements. As part of obtaining an
understanding of the company and its environment, Auditing Standard No.
12 requires the auditor to obtain an understanding of the company's
objectives, strategies, and related business risks that could
reasonably be expected to result in risks of material misstatement.\65\
Under Auditing Standard No. 16, the auditor is required to communicate
significant risks to the audit committee. If the auditor determines
that a business risk results in a significant risk of material
misstatement, the auditor should communicate the significant risk to
the audit committee. Additionally, under Auditing Standard No. 5, An
Audit of Internal Control Over Financial Reporting That Is Integrated
with An Audit of Financial Statements, and AU sec. 325, Communications
About Control Deficiencies in an Audit of Financial Statements, the
auditor is required to communicate to the audit committee material
weaknesses and significant deficiencies in internal control over
financial reporting identified during the audit.\66\ Therefore, the
standard was not revised.
---------------------------------------------------------------------------

    \65\ See paragraph 14 of Auditing Standard No. 12.
    \66\ See paragraphs 78 and 80 of Auditing Standard No. 5 and
paragraph 4 of AU sec. 325.
---------------------------------------------------------------------------

    Auditing Standard No. 16 also requires communications regarding
others involved in the audit, such as persons with specialized skill or
knowledge, internal audit, and other firms or persons performing audit
procedures. Communications of others involved in the audit might be
important for an audit committee to understand as part of the audit
committee's oversight of the financial reporting process.
Specialized Skill or Knowledge (Paragraph 10.a. of Auditing Standard
No. 16)
    Auditing Standard No. 16 includes a requirement for the auditor to
communicate to the audit committee the nature and extent of specialized
skill or knowledge needed to perform the planned audit procedures or
evaluate the audit results related to significant risks. This
requirement is designed for the auditor to communicate the
determination the auditor is required to make as part of developing the
audit strategy in Auditing Standard No. 9.\67\ Many audit firms have
employees with specialized skill or knowledge that the engagement team
can utilize. However, other firms might not have such in-house
expertise. The focus of this requirement is on the communication about
the need for specialized skill or knowledge, regardless of whether the
specialist is from within the firm or outside the firm.
---------------------------------------------------------------------------

    \67\ See paragraph 16 of Auditing Standard No. 9 for the
requirement for the auditor to determine whether specialized skill
or knowledge is needed to perform appropriate risk assessments, plan
or perform audit procedures, or evaluate audit results.
---------------------------------------------------------------------------

Internal Audit (Paragraphs 10.b. and 10.c. of Auditing Standard No. 16)
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee the extent to which the auditor plans to use the work
of the company's internal auditors in an audit of financial statements,
including when internal audit provides direct assistance to the
auditor. In addition, Auditing Standard No. 16 requires the auditor to
communicate the extent to which the auditor plans to use the work of
internal auditors, company personnel (in addition to internal
auditors), and third parties working under the direction of management
or the audit committee when performing an audit of internal control
over financial reporting.
    Auditing Standard No. 9 requires the auditor to establish an
overall audit strategy that sets the scope, timing, and direction of
the audit and guides the development of the audit plan, including the
nature, timing, and extent of resources necessary to perform the
engagement.\68\ Other standards, including AU sec. 322, The Auditor's
Consideration of the Internal Audit Function in an Audit of Financial
Statements, and Auditing Standard No. 5, provide additional
requirements and impose limits on the use of internal audit staff. The
requirement in Auditing Standard No. 16 is to communicate to the audit
committee the extent to which the auditor plans to use the work of the
company's internal auditors and others as determined in the audit plan.
---------------------------------------------------------------------------

    \68\ See paragraphs 8-9 of Auditing Standard No. 9.
---------------------------------------------------------------------------

Other Firms or Persons Performing Audit Procedures (Paragraph 10.d. of
Auditing Standard No. 16)
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee the names, locations, and planned responsibilities of
other independent public accounting firms or other persons, who are not
employed by the auditor, that perform audit procedures in the current
period audit. The standard includes a note stating the term ``other
independent public accounting firms'' includes firms that perform audit
procedures in the current period audit regardless of whether they
otherwise have any relationship with the auditor.
    In planning and performing the audit, the auditor determines
whether to use other auditors or other persons to perform audit
procedures at individual client locations, business units, or to
perform work related to specific audit areas or procedures. Those other
auditors might be affiliated firms, non-affiliated firms, or other
persons not employed by the auditor.
    The note to Auditing Standard No. 16 was revised from the
reproposed standard to clarify that the communication regarding other
independent public accounting firms is not based on the type of
relationship the auditor otherwise has with the other firms. Rather,
the requirement for the auditor to communicate the names, locations,
and planned responsibilities of other independent public accounting
firms and other persons is to provide information to the audit
committee regarding the parties involved in the

audit. This requirement also might facilitate a discussion of how the
work of other parties would affect the audit.
    The reproposed standard also required the auditor to communicate to
the audit committee the ``planned roles'' of others involved in the
audit and the ``scope of audit procedures.'' One commenter suggested
that the requirement to communicate the ``scope of audit procedures''
should be clarified in the standard. Another commenter suggested that
the communication should be expanded to be more robust when other
participants are used to audit foreign components of a company.
Auditing Standard No. 10, Supervision of the Audit Engagement, requires
the auditor to inform engagement team members of their responsibilities
\69\ and AU sec. 543, Part of Audit Performed by Other Independent
Auditors, discusses situations in which the auditor uses the work and
reports of other independent auditors who have audited financial
statements of one or more subsidiaries, divisions, branches, components
or investments included in the financial statements.\70\ To align with
these requirements, the standard was revised to require the auditor to
communicate only the ``planned responsibilities'' of other participants
involved in the audit, the requirements to communicate the ``planned
roles'' of others involved in the audit and the ``scope of audit
procedures'' were removed from the standard, and the standard was not
expanded to include other considerations.
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    \69\ See paragraph 5.a. of Auditing Standard No. 10.
    \70\ See AU sec. 543.01.
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    Many commenters suggested that the standard provide a threshold for
determining when to make communications regarding others involved in
the audit, such as when another auditor performs procedures related to
a percentage of the company's total assets or addresses significant
risks. Others suggested that the communication include only non-
affiliated accounting firms. The standard was not revised because audit
committees have oversight of the entire audit engagement, which
includes work performed by other auditors. The audit committee should
be aware of all the participants in the audit. This communication
regarding other participants in the audit would enable the audit
committee to inquire or otherwise determine, for example, whether the
other participants are registered with the Board and are subject to
PCAOB inspections and whether they have disciplinary history with the
Board or other regulators.
    This communication requirement is intended to be scalable. For
example, the amount of detail the auditor generally would communicate
to the audit committee regarding the participation of other auditors
would be greater for participants that perform a significant portion of
the audit or that perform procedures related to significant risks.
Principal Auditor (Paragraph 10.e. of Auditing Standard No. 16)
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee the basis for the auditor's determination that the
auditor can serve as principal auditor, if significant parts of the
audit are to be performed by other auditors. This communication
requirement is based on the auditor's determination that the auditor
can serve as the principal auditor in accordance with AU sec. 543. This
communication would enable the audit committee to evaluate the extent
of work performed by the principal auditor in relation to work
performed by other auditors.
    The reproposed standard included a note to describe situations
where such communications would be required. The Board determined that
this note was not necessary because AU sec. 543, governs the
determination of whether the auditor can serve as the principal
auditor.
Accounting Policies and Practices, Estimates, and Significant Unusual
Transactions (Paragraph 12 of Auditing Standard No. 16)
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee certain matters related to the company's accounting
policies and practices, estimates, and significant unusual
transactions. However, the standard recognizes that management also
might make communications to the audit committee regarding these
matters and that the auditor might not need to communicate the
information at the same level of detail as management as long as the
auditor meets certain criteria specified in the standard. In such
circumstances, the auditor should communicate any omitted or
inadequately described matters to the audit committee.
Accounting Policies and Practices (Paragraphs 12.a. and 12.b. of
Auditing Standard No. 16)
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee certain information regarding the company's significant
accounting policies and practices and also critical accounting policies
and practices.
    The standard uses the terms ``significant accounting policies and
practices'' and ``critical accounting policies and practices.'' The
Financial Accounting Standards Board's (``FASB'') Accounting Standards
Codification (``ASC'') and the International Accounting Standards
Board, require that companies disclose a description of all significant
accounting policies as an integral part of the financial
statements.\71\ For example, the FASB ASC recognizes that an entity's
description of its significant accounting policies is an integral part
of the financial statements.\72\ Additionally, the term ``significant
accounting policies and practices'' is consistent with the term used in
AU sec. 380 and understood in practice and, therefore, has not been
separately defined.
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    \71\ See FASB ASC, Topic 235, Notes to Financial Statements,
section 235-10-50. As part of this disclosure, the entity is
required to disclose accounting policies and to describe the
accounting principles followed by the entity and the methods of
applying those principles that materially affect the determination
of financial position, cash flows, or results of operations.
Additionally, see paragraph 117 of International Accounting Standard
1, Presentation of Financial Statements, which requires the entity
to disclose the summary of significant accounting policies,
including the measurement basis used in preparing the financial
statements and other accounting policies that are relevant to
understanding the financial statements.
    \72\ See FASB ASC paragraphs 235-10-50-1 through 235-10-50-6.
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    The definition of ``critical accounting policies and practices'' in
Auditing Standard No. 16 is based on the SEC's description of the term
``critical accounting policies and practices'' as a company's
accounting policies and practices that are both most important to the
portrayal of the company's financial condition and results and require
management's most difficult, subjective, or complex judgments, often as
a result of the need to make estimates about the effects of matters
that are inherently uncertain.\73\ The selection of significant
accounting policies and practices involves a broader range of
transactions and events over time, while the selection of critical
accounting policies and practices is tailored to specific events in the
current year. Therefore, critical accounting policies and practices
might be viewed as a subset of significant accounting policies and
practices.
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    \73\ See SEC, Strengthening the Commission's Requirements
Regarding Auditor Independence, Securities Act Release No. 8183
(Jan. 28, 2003).
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Significant Accounting Policies and Practices (Paragraph 12.a. of
Auditing Standard No. 16)
    Auditing Standard No. 16 generally retains the requirements from AU
sec.

380 related to communication of the company's significant accounting
policies and practices, including:
    1. Management's initial selection of, or changes in, significant
accounting policies or the application of such policies in the current
period; and
    2. The effect on financial statements or disclosures of significant
accounting policies in (i) controversial areas or (ii) areas for which
there is a lack of authoritative guidance or consensus, or diversity in
practice.
    Auditing Standard No. 16 requires the auditor to communicate to the
audit committee certain matters related to significant accounting
policies and practices, whereas, AU sec. 380 required the auditor only
to determine that the audit committee was ``informed.'' This change in
wording is intended to indicate that the auditor should make these
communications, rather than determine that the audit committee was
informed, as required in AU sec. 380. However, the note to paragraph 12
of Auditing Standard No. 16 acknowledges that such communications may
be made by management, and if the auditor meets certain conditions,
these communications need not be duplicated by the auditor.
    Some commenters suggested that it was unclear whether the
communication of the initial selection of, or changes in, significant
accounting policies or the application of such policies in the current
period would require communication annually if there is no change.
Another commenter indicated that the auditor may not be in a position
to provide information on areas for which there is diversity in
practice because the auditor may not be knowledgeable of accounting
practices used by other entities.
    Auditing Standard No. 16 was not revised in response to these
comments. The standard indicates that the auditor should communicate to
the audit committee the initial selection in the current period of
significant accounting policies. The standard also indicates that the
auditor should communicate to the audit committee changes in those
policies or changes in the application of those policies in the current
period if they differ from those policies that management previously
utilized or how they were previously applied.
    Additionally, the auditor's responsibility to communicate the
effect of significant accounting policies includes (i) controversial
areas or (ii) areas for which there is lack of authoritative guidance
or consensus, or diversity in practice. The auditor should be aware of
diversity in practice related to significant accounting policies and
practices used by the company because Auditing Standard No. 12 requires
the auditor to evaluate whether the company's selection of and
application of accounting principles are appropriate for its business
and consistent with the applicable financial reporting framework and
accounting principles used in the relevant industry.\74\ Based on this
evaluation, the auditor should be in a position to make such
communication.
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    \74\ Paragraph 12 of Auditing Standard No. 12.
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Critical Accounting Policies and Practices (Paragraph 12.b. of Auditing
Standard No. 16)
    Auditing Standard No. 16 incorporates the Exchange Act requirement
for the auditor to communicate to the audit committee all critical
accounting policies and practices to be used.\75\ Auditing Standard No.