AU 380: The Auditor’s Communication with Those Charged with Governance1

AU-C 260: The Auditor’s Communication with Those Charged with Governance

AU EFFECTIVE DATE AND APPLICABILITY

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

AU-C 260 does not change extant requirements in any significant respect. It does include a requirement to communicate matters related to other information included in documents containing audited financial statements.

AU DEFINITIONS OF TERMS

Management. The person(s) responsible for achieving the objectives of the entity and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management is responsible for the financial statements, including designing, implementing and maintaining effective internal control over financial reporting.

Those charged with governance. The person(s) with responsibility for overseeing the strategic direction of the entity and obligations related to the accountability of the entity. This includes overseeing the financial reporting process. In some cases, those charged with governance are responsible for approving the entity’s financial statements (in other cases management has this responsibility). For entities with a board of directors, this term encompasses the term “board of directors” or “audit committee” used elsewhere in GAAS.

AU-C DEFINITIONS OF TERMS

Management. The person(s) with executive responsibility for the conduct of the entity’s operations. For some entities, management includes some or all of those charged with governance; for example, executive members of a governance board or an owner-manager.

Those charged with governance. The person(s) or organization(s) (for example, a corporate trustee) with responsibility for overseeing the strategic direction of the entity and the obligations related to the accountability of the entity. This includes overseeing the financial reporting process. Those charged with governance may include management personnel; for example, executive members of a governance board or an owner-manager.

OBJECTIVES OF AU SECTION 380

Effective communication between an auditor and his or her client plays in important role in achieving audit objectives. Section 380 is built on the premise that those charged with governance at the entity have a responsibility to oversee the financial reporting progress, and the standard requires the auditor to communicate to those individuals matters significant and relevant to that oversight responsibility.

The principal purposes of this required communications are to:

The standard also provides a framework for the auditor’s communication that includes matters such as the form and timing of the communication.

OBJECTIVES OF AU-C SECTION 260

The objectives of the auditor are to:

(AU-C 260.05)

FUNDAMENTAL REQUIREMENTS

General Responsibility

The auditor must communicate with those charged with governance matters related to the financial statement audit that are, in the auditor’s professional judgment, significant and relevant to the responsibilities of those charged with governance in overseeing the financial reporting process. Certain matters should be communicated in each audit (as described below; however the auditor is not required to perform procedures specifically to identify these matters.

Those Charged with Governance

The auditor should determine “those charged with governance” (see the two sections on “Definitions of Terms”). Governance structures vary by entity; however in most entities, governance is the collective responsibility of a governing body, such as a board of directors, a supervisory board, partners, proprietors, a committee of management, trustees, or equivalent. In some entities, one person, such as the owner-manager, may be the sole person charged with governance of the entity.

When “those charged with governance” are not clearly identifiable, the auditor and the engaging party should agree on the person(s) with whom the auditor will communicate.

In those situations where the entity’s governance structure includes subgroups (e.g., an audit committee), the auditor also should evaluate whether communication with a subgroup is sufficient.

Communication Process

The auditor should communicate with those charged with governance regarding the timing and expected general content of communications. The auditor may also communicate matters such as:

• The purpose of communications. When the purpose is clear, the auditor and those charged with governance are in a better position to have a mutual understanding of relevant issues and the expected actions arising from the communication process.
• The person(s) on the audit team and among those charged with governance who will communicate regarding particular matters.
• The auditor’s expectation that communication will be two way, and that those charged with governance will communicate with the auditor matters they consider relevant to the audit. Such matters might include strategic decisions that may significantly affect the nature, timing, and the extent of audit procedures; the suspicion or the detection of fraud; or concerns about the integrity or competence of senior management.
• The process for taking action and reporting back on matters communicated by the auditor.
• The process for taking action and reporting back on matters communicated by those charged with governance.

The auditor should evaluate whether the two-way communication between the auditor and those charged with governance has been adequate for the purpose of the audit.

Form of Communication

The auditor should communicate in writing significant findings from the audit (see “Matters to be Communicated”). All other communications may be oral or in writing. When matters are to be communicated orally, the auditor should document them.

Timing of Communication

The auditor should communicate with those charged with governance on a sufficiently timely basis to enable those charged with governance to take appropriate action.

Matters to Be Communicated

The auditor should communicate with those charged with governance

The Auditor’s Responsibilities

The auditor should communicate the following:

• The auditor is responsible for forming and expressing an opinion about whether the financial statements are presented fairly.
• The audit does not relieve management or those charged with governance of their responsibilities.

The auditor may communicate other matters such as

• The auditor is responsible for performing the audit in accordance with GAAS.
• An audit is designed to obtain reasonable, not absolute, assurance.
• An audit includes consideration of internal control as a basis for designing audit procedures, but not for expressing an opinion on the effectiveness of internal control over financial reporting.
• The auditor is responsible for communicating significant matters related to the audit that are relevant to the responsibilities of those charged with governance.
• When applicable, the auditor is also responsible for communicating particular matters required by laws or regulations, by agreement with the entity, or by additional requirements applicable to the engagement.

Overview of the Planned Scope and Timing of the Audit

The auditor should communicate an overview of the planned scope and timing of the audit.

To meet that general requirement, the auditor may communicate matters such as the following:

• How the auditor proposes to address the significant risks of material misstatement
• The auditor’s approach to internal control
• The concept of materiality in planning and executing the audit
• Where the entity has an internal audit function, the extent to which the auditor will use the work of internal audit
• The views of those charged with governance about:
  • The appropriate person(s) in the entity’s governance structure with whom to communicate
  • The allocation of responsibilities between those charged with governance and management
  • The entity’s objectives and strategies, and the related business risks that may result in material misstatements
  • Matters those charged with governance consider warrant particular attention during the audit, and any areas where they request additional procedures to be undertaken
  • Significant communications with regulators
  • Other matters those charged with governance believe are relevant to the audit of the financial statements
• The attitudes, awareness, and actions of those charged with governance concerning (1) the entity’s internal control and its importance in the entity and (2) the detection or the possibility of fraud.
• The actions of those charged with governance in response to developments in financial reporting, laws, accounting standards, corporate governance practices, and other related matters.
• The actions of those charged with governance in response to previous communications with the auditor.

Significant Findings

The auditor should communicate the following matters:

• The auditor’s views about qualitative aspects of the entity’s significant accounting practices, including accounting policies, accounting estimates, and financial statement disclosures
• Significant difficulties, if any, encountered during the audit; these may include:
• Significant delays in management providing required information
  • An unnecessarily brief time within which to complete the audit
  • Extensive unexpected effort required to obtain sufficient appropriate audit evidence
  • The unavailability of expected information
  • Restrictions imposed on the auditors by management
  • Management’s unwillingness to provide information about management’s plans for dealing with the adverse effects of the conditions or events that lead the auditor to believe there is substantial doubt about the entity’s ability to continue as a going concern
• Uncorrected misstatements, other than those the auditor believes are trivial, if any
• Disagreements with management, if any
• Other findings or issues, if any, arising from the audit that are significant and relevant to those charged with governance

Unless all of those charged with governance are involved in managing the entity, the auditor also should communicate:

• Material, corrected misstatements that were brought to the attention of management as a result of audit procedures
• Representations the auditor is requesting from management
• Management’s consultations with other accountants
• Significant issues, if any, that were discussed, or the subject of correspondence, with management

Auditor’s Judgments about the Quality of the Entity’s Accounting Principles

The auditor should discuss his or her judgments about the quality, not just the acceptability, of the company’s accounting principles with the audit committees of SEC clients. Such discussion should include management as a participant and should include:

• Matters such as the consistency of application of the entity’s accounting policies and the clarity and completeness of the entity’s financial statements and related disclosures
• Certain items that have a significant impact on the representational faithfulness,2 verifiability,3 neutrality,4 and consistency of the accounting information included in the financial statements, such as:
  • New or changed accounting policies
  • Estimates, judgments, and uncertainties
  • Unusual transactions

INTERPRETATIONS

There are no interpretations for this section.

PROFESSIONAL ISSUES TASK FORCE PRACTICE ALERTS

99-1 Guidance for Independence Discussions with Audit Committees

Independence Standard 1, Independence Discussions with Audit Committees (the Standard),5 requires annual written and oral communications between the auditor and the audit committee (or board of directors if there is no audit committee) of a public company client regarding relationships that, in the auditor’s professional judgment, may reasonably be thought to bear on the independence. The standard also requires written confirmation that the auditor is independent of the company within the meaning of the Securities Acts administered by the SEC.

This practice alert is designed to address implementation issues relative to the Standard and is designed to assist firms in:

• Reviewing and improving policies and procedures for identifying and communicating with audit committees those matters that may affect the auditor’s independence, which should in turn assist audit committees/board of directors in fulfilling certain of their corporate governance responsibilities
• Helping auditors to fulfill their responsibilities to serve the public interest and strengthen the public’s confidence in audited financial information

Although the guidance in the alert focuses on communications between the auditor and the audit committee/board of directors, the auditor is also encouraged to have similar communications with senior management.

The alert provides the following guidance:

• Firms should have policies and procedures for independence communications with audit committees. The alert provides examples of relationships that may impact the auditor’s independence, along with relevant safeguards. The alert also suggests that the auditor not conclude that a relationship need not be disclosed because independence is not impaired, especially when information about the relationship may help the audit committee understand auditor independence for this entity’s specific circumstances.
• The auditor should consider engaging the audit committee chair in discussions concerning the chair’s views on relationships that may reasonably be thought to bear on independence and what should be disclosed. The alert provides a sample letter to the audit committee chair that could be used to initiate these discussions.
• Auditors should periodically discuss new or revised independence standards, emerging independence issues, and common threats to auditor objectivity to help audit committees expand their knowledge of independence matters. The alert provides a summary of common threats to auditor objectivity and related safeguards that mitigate these threats.
• The ISB Standard requires written communications that summarize relationships that may reasonably be thought to bear on independence and confirm that, in the auditor’s professional judgment, the auditor is independent of the company within the meaning of the Securities Acts.

The alert also emphasizes that disclosure of relationships that may reasonably be thought to bear on independence should not be construed to imply that the auditor’s independence has been impaired, but rather as a tool to foster discussion between the auditor and the audit committee regarding the nature of the relationship.

The auditor should meet with the audit committee to discuss all applicable actual and proposed relationships between the company and the auditor. The ISB intentionally left timing flexible as long as the communication is done annually.

The alert provides a sample letter relating to annual independence discussions with audit committees and confirmation that the auditor is independent of the company within the meaning of the Securities Acts.

Finally, the alert also provides guidance on initial public offerings, the initial year of application, prospective clients, and failure to comply with the standard. The alert was updated in 2000 to provide guidance on ISB Interpretation 00-1 that relates to the applicability of ISB Statement 1 to secondary auditors.

00-2 Guidance for Communication with Audit Committees Regarding Alternative Treatments of Financial Information within Generally Accepted Accounting Principles (Revised)

In 1999, the Auditing Standards Board issued SAS 90, which requires that the independent auditor of an SEC client discuss with a client’s audit committee the quality, not just acceptability, of the entity’s accounting principles. (See “Auditor’s Judgments About the Quality of the Entity’s Accounting Principles” under “Fundamental Requirements.”) In addition, the Sarbanes–Oxley Act requires that auditors report to, and be overseen by, the entity’s audit committee.

This Practice Alert is intended to assist auditors in identifying relevant matters to discuss with an entity’s audit committee the quality of accounting principles used in the preparation of entity’s financial statements. To meet the objectives of SAS 90, the Alert recommends that:

• Communications should be tailored to and understandable by all members of the audit committee.
• Audit committee members are advised of independence issues on a timely basis.

Topics that management and the auditor should consider discussing with the audit committee would include, but not be limited to

The practice alert also provides guidance if the auditor or the audit committee wants to address the degree of aggressiveness or conservatism of the accounting principles applied in the financial statements.

TECHNIQUES FOR APPLICATION

Qualitative Aspects of Accounting Practices

Auditors should seek to have an open and constructive communication with those charged with governance about the qualitative aspects of the entity’s significant accounting practices. This communication may include comment on the acceptability of significant accounting practices.

When making this communication, the auditor should explain why he or she consider the practice not to be appropriate. When necessary, the auditor should request changes. If requested changes are not made, the auditor should inform those charged with governance that the auditor will consider the effect of this on the financial statements of the current and future years, and on the auditor’s report.

Matters that may be communicated include the following:

Accounting Policies

• The appropriateness of the accounting policies to the particular circumstances of the entity, considering the need to balance the cost of providing information with the likely benefit to users of the entity’s financial statements. Where acceptable alternative accounting policies exist, the communication may include identification of the financial statement items that are affected by the choice of significant policies as well as information on accounting policies used by similar entities.
• The initial selection of, and changes in, significant accounting policies, including the application of new accounting pronouncements. The communication may include the effect of the timing and method of adoption of a change in accounting policy on the current and future earnings of the entity; and the timing of a change in accounting policies in relation to expected new accounting pronouncements.
• The effect of significant accounting policies in controversial or emerging areas (or those unique to an industry, particularly when there is a lack of authoritative guidance or consensus).
• The effect of the timing of transactions in relation to the period in which they are recorded.

Accounting Estimates

For items for which estimates are significant, issues discussed in SAS No. 57, Auditing Accounting Estimates, and SAS No. 101, Auditing Fair Value Measurements and Disclosures include, for example:

• Management’s identification of accounting estimates
• Management’s process for making accounting estimates
• Risks of material misstatement
• Indicators of possible management bias

Financial Statement Disclosures

• The issues involved, and related judgments made, in formulating particularly sensitive financial statement disclosures (for example, disclosures related to revenue recognition, going concern, subsequent events, and contingency issues)
• The overall neutrality, consistency, and clarity of the disclosures in the financial statements

Related Matters

• The potential effect on the financial statements of significant risks and exposures, and uncertainties, such as pending litigation, that are disclosed in the financial statements.
• The extent to which the financial statements are affected by unusual transactions, including nonrecurring amounts recognized during the period, and the extent to which such transactions are separately disclosed in the financial statements.
• The factors affecting asset and liability carrying values, including the entity’s bases for determining useful lives assigned to tangible and intangible assets. The communication may explain how factors affecting carrying values were selected and how alternative selections would have affected the financial statements.
• The selective correction of misstatements, for example, correcting misstatements with the effect of increasing reported earning, but not those that have the effect of decreasing reported earnings.

1 Section 204, Auditor Reports to Audit Committees, and the related SEC implementing rule 33-8138, “Strengthening the Commission’s Requirements Regarding Auditor Independence,” require that the auditor communicate:

The SEC’s Financial Reporting Release 60, Cautionary Advice Regarding Disclosure about Critical Accounting Policies, defines “critical accounting policies” as those policies that are both most important to the company in portraying the company’s financial position and results, and that require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about highly uncertain matters.

2 Representational faithfulness means that the amounts and disclosures in the company’s financial statements represent what really happened. It includes the concept of substance over form.

3 Verifiability means that accountants using the same measurement method would obtain similar results.

4 Neutrality means that information in financial statements cannot be selected to favor one set of financial statement users over another.

5 The Independence Standards Board, which adopted this statement, was dissolved on July 31, 2001. However, ISB 1 will continue in effect.