U.S. Regulator Proposes Expanded Role for Auditors in Detecting Companies’ Legal Violations

The Public Company Accounting Oversight Board (PCAOB) is advocating for auditors to play a more proactive role in identifying potential fraud at client companies. In a recent proposal, the PCAOB aims to require auditors to pinpoint areas of noncompliance that could materially impact the financial statements of the companies they audit.

Currently, auditors of public companies are obligated to identify laws that they believe have a direct and material effect on their clients’ financial statements, as well as detect illegal acts that meet these criteria. However, there is no requirement for auditors to actively seek out noncompliance by clients that may have an indirect effect on financials. Auditors are also expected to communicate any illegal acts to the company’s audit committee before issuing their annual audit report.

The proposed changes would introduce a more active role for auditors in these situations. Under the proposal, auditors would need to perform procedures during their initial risk assessment to identify laws and regulations in which noncompliance could reasonably have a material effect on financial statements, regardless of whether the effects are direct or indirect. This could involve asking company executives about any correspondence they have had with regulators regarding suspected or actual instances of fraud.

Auditors would be required to have knowledge of all relevant laws and regulations pertaining to a company’s operations, although not necessarily every law to which they are subject. For example, auditors of a chemical company would need to be familiar with environmental laws. Existing audit standards already mandate that auditors have a basic understanding of their clients’ regulatory environments.

The current standard allows auditors to have limited responsibilities concerning noncompliance with certain laws and regulations unless they happen to stumble upon relevant information, according to PCAOB Chair Erica Williams. The proposed standard clarifies that auditors are expected to proactively remain vigilant for all noncompliance that may have a material impact on financial statements, aligning with investor expectations.

Additionally, the proposal requires auditors to assess whether they need external experts, such as lawyers or engineers, to evaluate information once they become aware of a client’s violation or potential violation of the law. Currently, auditors only need to consult with specialists if company executives fail to demonstrate that the company did not engage in illegal acts.

The proposal also enhances requirements for how auditors convey their findings to others. Auditors would need to notify the company’s audit committee once they become aware of potential noncompliance and provide an update after evaluating the information.

Two board members, Duane DesParte and Christina Ho, opposed the proposal, expressing concerns about the potential costs and expanded duties placed on auditors. Ho stated that the proposed requirements lack full transparency regarding the extensive new responsibilities imposed on auditors. DesParte voiced apprehension about how the proposal and other items on the PCAOB’s standard-setting agenda could fundamentally alter the role of auditors without a comprehensive understanding of the overall cost-benefit implications.

The current rule on illegal acts has remained largely unchanged since its adoption by the PCAOB in 2003, shortly after the board’s establishment. The standard was initially based on a rule from the American Institute of Certified Public Accountants, which has undergone few major revisions since 1988. Various changes in U.S. laws and auditing standards, including the Sarbanes-Oxley Act of 2002, have occurred over the past 35 years, emphasizing the importance of whistleblower programs and reporting on the adequacy of internal controls over financial reporting.

This recent proposal follows another initiative by the PCAOB aimed at preventing fraud. In December, the watchdog proposed stricter requirements for audit firms to obtain and verify external evidence regarding their clients, such as from customers and lenders.

The public has until August 7 to provide feedback on the proposal.

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