SEC Proposes Management Guidance, One Auditor Report for 404
December 13, 2006
At its open commission meeting on Dec. 13, 2006, the five commissioners of the U.S. Securities and Exchange Commission (SEC) unamimously approved the release of proposed interpretive guidance and proposed rulemaking in response to calls to reduce the cost (improve the efficiency) and increase the benefit (improve the effectiveness) of management’s assessment and reporting of internal control over financial reporting (ICFR) under Sarbanes-Oxley Section 404, and the related auditor’s report. UPDATE: On December 20, the SEC posted the proposed management guidance here. The comment deadline ends Feb. 26, 2007.
SUMMARY OF SEC’S SECTION 404 RELATED PROPOSALS:
The three components of Section 404 reporting proposed on December 13 include:
o Proposed interpretive guidance for management. Use of the proposed interpretive guidance would be optional, such that, companies that have already effectively implemented internal control reporting under Section 404 can continue their current implementation if they wish, although they may wish to apply the interpretive guidance to increase efficiency.
o Proposed amendments to Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934 to make clear that an evaluation of internal control over financial reporting conducted in accordance with the proposed interpretive guidance would satisfy the SEC’s requirement that companies conduct an annual evaluation of internal control over financial reporting.
- A proposed rule change to SEC Regulation S-X, relating to the auditors’ requirements under Section 404(b) of the Sarbanes-Oxley Act. Specifically, the SEC will propose that instead of the two auditors’ opinions on internal control currently required (one a direct report on a client’s internal control, the other the auditor’s assessment of management’s report on internal control), under the proposal the auditor would only express one opinion – a direct opinion – on the effectiveness of internal control over financial reporting. This was described during the SEC meeting as “subsuming” the separate auditor’s opinion on management’s assessment.
GUIDANCE WILL BE SCALABLE, ALLOW JUDGMENT
In response to a question from SEC Chairman Christopher Cox as to whether to proposed guidance was scalable (i.e. to companies of different sizes) and whether it would address concerns about the level of documentation, SEC Deputy Chief Accountant Zoe Vonna Palmrose responded, “Yes, it is scalable,” and that the proposal “focuses on where management has to get, not how it has to get there.”
Regarding documentation, Palmrose said the proposal, will require “reasonable support” in terms of documentation and evidence, recognizing individual facts and circumstances, but that it “does not create any artificial documentation requirements.” Additionally, she said that companies with ongoing monitoring may not have to engage in as much documentation, but smaller companies may need to document management’s daily interaction which is considered part of monitoring through such things as memos.
SEC Chief Accountant Conrad Hewitt said, “We took the many recommendations of the excellent report of the SEC Advisory Committee on Smaller Public Companies,” including a top-down approach, and recognizing the involvement of top management of companies that are less complex. He added the SEC looked at the documentation requirements “to make sure the documentation requirements for small companies could be done very easily without extensive flowcharting.”
Palmorse added the SEC staff, “spent a good deal of time and effort on how to delineate small public companies,” and that the parameters recommended by the SEC Advisory Committee on Smaller Public Companies (e.g., defining “small companies”) have been included in the proposal.
Chairman Cox also asked if companies that are “well down the learning curve” would be required to completely revamp their evaluation process to conform to the interpretive guidance, or if the SEC staff was sensitive to the fact that some companies already had established their implementation of 404.
John White, director of the Division of Corporation Finance at the SEC, said: “The short answer is yes; companies that have developed effective procedures over the last three years can continue to follow them. If they’ve got effective procedures, they’re in good shape,” he said, and added, “they may well find this guidance helps them be efficient, but they’re required [by SEC rules only to be] effective. “
“Smaller companies will look particularly to this [proposed guidance],” said White. “The guidance is available to larger companies if they wish to use it.”
Update: In a press release issued late on December 13, the SEC indicated the comment period for the proposed guidance relating to Section 404 will be 60 days after publication in the Federal Register. [During the discussion at the open commission meeting, the SEC indicated it is trying to establish overlapping comment periods with the Public Company Accounting Oversight Board’s (PCAOB) related anticipated proposed rulemaking, discussed below, so that people could consider the two sets of proposals in tandem.]
COORDINATION WITH PCAOB’S ANTICIPATED PROPOSALS
SEC Chairman Cox, the other SEC commissioners and staff noted the importance of coordinating the SEC’s proposed interpretive guidance and proposed rule amendments with the PCAOB’s related anticipated proposals scheduled to be considered at the PCAOB’s open board meeting on December 19, including potentially proposing a new internal control audit standard that would replace Auditing Standard No. 2 (AS2) as previously announced by PCAOB.
FEI PRESIDENT AND CEO COLLEEN CUNNINGHAM COMMENTS
In a statement issued today, FEI President and CEO Colleen Cunningham made the following comment in response to the SEC’s action today on Sarbanes0-Oxley Section 404:
“The increased emphasis on corporate internal controls brought about by Sarbanes-Oxley has been very positive. Yet it has been well documented that the cost and effort required to comply has been far more than anticipated or what can be considered reasonable. We welcome the new SEC proposed guidance approved today and look forward to revisions to AS2 from the PCAOB. It is important the SEC and PCAOB work in concert, and address both management and auditor roles, and taken together hopefully these steps will move us toward a more risk-based approach to Section 404.”
PRESS RELEASES ISSUED ON ACTIONS TAKEN AT SEC'S DEC. 13 MEETING
Following are links to press releases issued by the SEC summarizing actions taken at the December 13 open commission meeting:
Updated Dec. 21, 2006 by Edith Orenstein eorenstein@FinancialExecutives.org, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion, unless specifically noted above.