Question 1

Who audits the financial statements in an IPO registration statement?

Accepted Answer

The audited financial statements required in an IPO registration statement must be examined by an independent public accountant — specifically, a public accounting firm that is registered with the Public Company Accounting Oversight Board (PCAOB). Rule 2-01(a) of Regulation S-X requires the accountant to be duly registered and in good standing under the laws of its home jurisdiction, and Rule 2-01(b) requires the accountant to be independent of the company it audits. Regulation S-X (17 CFR part 210) governs the form and content of the financial statements filed with the SEC, and Rule 2-01, titled 'Qualifications of accountants,' is designed to ensure that auditors are both qualified and independent of their audit clients 'in fact and in appearance.' Because the company becomes an 'issuer' when it files a Securities Act registration statement, its auditor must also be registered with the PCAOB. The report of the independent registered public accounting firm accompanies the financial statements in the prospectus.

Question 2

What is the PCAOB, and why must the auditor be registered with it?

Accepted Answer

The Public Company Accounting Oversight Board (PCAOB) is the nonprofit board created by the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies. Under Section 102(a) of that Act, it is unlawful for any firm that is not a registered public accounting firm to prepare or issue — or to participate in preparing or issuing — an audit report for an issuer, so an IPO company's auditor must be PCAOB-registered. Section 101 of the Sarbanes-Oxley Act established the PCAOB, and Section 102 makes registration mandatory: a public accounting firm must register with the PCAOB to prepare or issue an audit report for a U.S. public company or broker-dealer, or to play a substantial role in such audits. Firms apply through the PCAOB's Registration, Annual, and Special Reporting (RASR) system and pay a registration fee, and the Board reviews each application. Section 104 provides that the PCAOB inspects registered firms — annually for firms that regularly issue audit reports for more than 100 issuers, and at least once every three years for firms auditing 100 or fewer.

Question 3

Under what standards is the audit conducted?

Accepted Answer

The audit is conducted under the auditing standards of the PCAOB. Section 103 of the Sarbanes-Oxley Act directs the PCAOB to establish auditing and related professional practice standards for registered public accounting firms, and the auditor's report states that the audit was conducted in accordance with the standards of the PCAOB. Section 103 gives the PCAOB authority to set auditing, quality-control, ethics, and independence standards for registered firms that audit issuers. The PCAOB's auditing standards (the 'AS' series) govern how the audit is planned and performed and what the auditor must report. Separately, Rule 2-02(b) of Regulation S-X requires the accountant's report to state the applicable professional standards under which the audit was conducted.

Question 4

What does auditor independence require — the general standard?

Accepted Answer

Rule 2-01(b) of Regulation S-X sets the general independence standard: the SEC will not recognize an accountant as independent if the accountant is not — or if a reasonable investor with knowledge of all relevant facts and circumstances would conclude the accountant is not — capable of exercising objective and impartial judgment on all issues within the accountant's engagement. The SEC applies this standard by asking whether a relationship or service creates a mutual or conflicting interest with the client, places the accountant in the position of auditing its own work, results in the accountant acting as management or an employee of the client, or places the accountant in the position of being an advocate for the client. In determining independence, the Commission considers all relevant circumstances, including relationships beyond those relating to filings. Paragraphs (c)(1) through (c)(8) of the rule then apply the general standard to specific circumstances.

Question 5

What financial, employment, and business relationships impair independence?

Accepted Answer

Rule 2-01(c)(1)-(3) makes an accountant not independent when, at any point during the audit and professional engagement period, it has certain financial relationships (such as a direct or material indirect investment in the audit client), employment relationships (such as a firm professional serving as a director, officer, or employee of the client, or a close family member in a financial-reporting-oversight role), or direct or material indirect business relationships with the audit client or its decision-makers. Rule 2-01(c)(1) addresses financial interests — direct investments in the client, certain loans, bank and brokerage accounts, and beneficial ownership of more than five percent of the client's equity securities. Rule 2-01(c)(2) addresses employment relationships, including a current firm partner or professional employed by, or serving on the board of, the client. Rule 2-01(c)(3) addresses direct or material indirect business relationships with the client or with its officers, directors, or significant-influence owners, other than providing professional services or being a consumer in the ordinary course of business. These restrictions run to 'covered persons in the firm' as defined in Rule 2-01(f)(11).

Question 6

What non-audit services is the auditor prohibited from providing to the company?

Accepted Answer

Rule 2-01(c)(4) of Regulation S-X, which implements Section 10A(g) of the Securities Exchange Act, makes an accountant not independent if it provides specified non-audit services to an audit client. The prohibited services include bookkeeping, financial information systems design and implementation, appraisal or valuation services, actuarial services, internal audit outsourcing, management or human-resources functions, broker-dealer or investment-banking services, legal services, and expert services unrelated to the audit. Several of the prohibitions in Rule 2-01(c)(4)(i)-(v) apply unless it is reasonable to conclude that the results of the service will not be subject to audit procedures during the audit of the client's financial statements. Section 201 of the Sarbanes-Oxley Act added this list of contemporaneously prohibited services to Section 10A(g) of the Exchange Act. Rule 2-01(c)(5) separately makes an accountant not independent if it provides any service or product to an audit client for a contingent fee or a commission.

Question 7

Who selects the auditor and pre-approves its services?

Accepted Answer

Under Section 10A(m) of the Securities Exchange Act, the issuer's audit committee is directly responsible for the appointment, compensation, and oversight of the registered public accounting firm. Rule 2-01(c)(7) and Section 10A(i) make the accountant not independent unless the audit committee pre-approves all audit and permissible non-audit services, either specifically or under detailed pre-approval policies and procedures. Section 10A(m)(3) also requires each member of the audit committee to be independent. Rule 2-01(c)(7) permits a limited de minimis exception to pre-approval for non-audit services that in the aggregate are no more than five percent of the total revenues the audit client pays the accountant in the fiscal year, were not recognized as non-audit services at the time of the engagement, and are promptly brought to the audit committee and approved before the audit is completed.

Question 8

How often must the audit partners rotate off the engagement?

Accepted Answer

Rule 2-01(c)(6) of Regulation S-X makes the accountant not independent if the lead audit partner or the Engagement Quality Reviewer serves for more than five consecutive years, or if certain other audit partners serve for more than seven consecutive years. Section 203 of the Sarbanes-Oxley Act requires this rotation of the lead and concurring audit partners. After serving the maximum five-year period as lead partner or Engagement Quality Reviewer, the partner must stay off that audit client for a five-consecutive-year 'time-out' period; other audit partners who reach seven consecutive years must stay off for two years. A small-firm exemption applies to accounting firms with fewer than five issuer audit clients and fewer than ten partners, provided the PCAOB reviews the relevant engagements at least once every three years.

Question 9

Is there a cooling-off period before firm personnel can join the company?

Accepted Answer

Yes. Rule 2-01(c)(2)(iii)(B) makes the accountant not independent if a former partner or professional employee takes a financial-reporting-oversight role at the issuer, unless that person was not a member of the audit engagement team during the one-year period preceding the start of audit procedures for the fiscal period that includes the date of hiring. Section 206 of the Sarbanes-Oxley Act established this one-year cooling-off period. A 'financial reporting oversight role' under Rule 2-01(f)(3)(ii) includes positions such as director, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, and treasurer. The one-year look-back applies to former audit-engagement-team members who move into these roles at the audit client.

Question 10

What must the auditor communicate to the audit committee?

Accepted Answer

Rule 2-07 of Regulation S-X requires the registered public accounting firm to report to the issuer's audit committee, before its audit report is filed with the SEC, all critical accounting policies and practices to be used, all alternative accounting treatments within GAAP that have been discussed with management (including the ramifications of their use and the treatment the firm prefers), and other material written communications between the firm and management. Rule 2-07 works together with Section 10A(k) of the Securities Exchange Act, which requires the auditor to report such matters to the audit committee. 'Other material written communications' can include a management letter or a schedule of unadjusted differences. These required communications are separate from, and in addition to, the auditor's report on the financial statements.

Question 11

What is the auditor's report, and what is an unqualified opinion?

Accepted Answer

The auditor's report is the firm's written report on whether the financial statements are fairly presented. In an unqualified — or 'clean' — opinion under PCAOB Auditing Standard AS 3101, the auditor states that the financial statements present fairly, in all material respects, the company's financial position, results of operations, and cash flows in conformity with the applicable financial reporting framework (such as U.S. GAAP). AS 3101 governs the auditor's report when the auditor expresses an unqualified opinion. The report is titled 'Report of Independent Registered Public Accounting Firm,' states that the audit was conducted in accordance with the standards of the PCAOB, and states that the firm is required to be independent of the company. Separately, Rule 2-02 of Regulation S-X requires the accountant's report to be dated, signed manually, to indicate the city and state where issued, and to state the applicable professional standards and the accountant's opinion. When the auditor takes exception, Rule 2-02(d) and PCAOB standard AS 3105 address qualified, adverse, and disclaimer conclusions. The audited statements and the accompanying report are included in the IPO registration statement (see 'S-1 Filing').

Question 12

What are critical audit matters (CAMs)?

Accepted Answer

A critical audit matter (CAM) is any matter arising from the audit that was communicated or required to be communicated to the audit committee and that both relates to accounts or disclosures material to the financial statements and involved especially challenging, subjective, or complex auditor judgment. AS 3101 requires the auditor to communicate any CAMs in the auditor's report. Under AS 3101, for each critical audit matter the auditor identifies the matter, describes the principal considerations that led it to determine the matter was a CAM, describes how the matter was addressed in the audit, and refers to the relevant financial-statement accounts or disclosures. Communication of CAMs is not required for audits of emerging growth companies, brokers and dealers, investment companies other than business development companies, and certain benefit plans — so many first-time IPO issuers, which qualify as emerging growth companies, do not present CAMs in their initial auditor's reports.

Report element	What it states	Authority
Title	A title that includes the word 'Independent' — the report is titled 'Report of Independent Registered Public Accounting Firm'	PCAOB AS 3101 · source
Addressee	The report is addressed to the company's shareholders and board of directors (or equivalents)	PCAOB AS 3101 · source
Opinion on the financial statements	States that the financial statements present fairly, in all material respects, the company's financial position, results of operations, and cash flows in conformity with the applicable financial reporting framework	PCAOB AS 3101; 17 CFR 210.2-02(c) · source
Basis for opinion	States that the financial statements are management's responsibility and the auditor's responsibility is to express an opinion, that the audit was conducted in accordance with the standards of the PCAOB, and that the firm is required to be independent of the company	PCAOB AS 3101; 17 CFR 210.2-02(b) · source
Critical audit matters	Communicates any critical audit matters (or states that there are none), except for issuers exempt from CAM communication such as emerging growth companies	PCAOB AS 3101 · source
Signature	The manual signature of the audit firm	PCAOB AS 3101; 17 CFR 210.2-02(a)(2) · source
Auditor tenure	A statement of the year the auditor began serving consecutively as the company's auditor	PCAOB AS 3101 · source
City and State	The city and state (or city and country, for a non-U.S. firm) where the report was issued	PCAOB AS 3101; 17 CFR 210.2-02(a)(3) · source
Date	The date of the auditor's report	PCAOB AS 3101; 17 CFR 210.2-02(a)(1) · source

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