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Beller Defines Scope of Internal Control Over Financial Reporting

During a dialogue with the European Union on Section 404 of the Sarbanes-Oxley Act, Alan Beller, the director of the Division of Corporation Finance, explained that the SEC and the Public Company Accounting Oversight Board focus on internal control over financial reporting, rather than the broader spectrum of internal control. Accurate and improved financial reporting is clearly the focus and theme of the Sarbanes-Oxley Act, he stated, as every provision in the Sarbanes-Oxley Act was designed to improve financial reporting.

Mr. Beller noted the perception that the PCAOB's Auditing Standard No. 2, and outside auditors in general, may have gone too far in many of the internal controls over financial reporting. The perception would be much worse if the spectrum of internal control covered by this requirement went beyond financial reporting, he noted. Auditors have a very important role in getting the numbers right, he said, but they don't have a significant role in getting operational risk management right.

Mr. Beller added that Section 404's exclusive focus on internal control over financial reporting does not mean that the SEC is not interested in internal control that relates to other risks. The Commission believes that other risks are very important. The Foreign Corrupt Practices Act extends to other internal controls in certain respects, and bodies around the world have established best practices to deal with internal control more generally. These include COSO in the United States and the Turnbull Review Group in the United Kingdom , and both of these bodies have gone beyond financial reporting. That makes perfect sense, according to Mr. Beller. The fact that the Sarbanes-Oxley Act does not extend to those areas should not be read as a lack of SEC interest, as the agency is not doing anything other than working within the statutory mandate presented by the Sarbanes-Oxley Act.

Mr. Beller, referring to the first year experiences and second year prospects under the mandate, said that Section 404 has been beneficial. For example, he noted that many well-run companies that went through this experience found and remediated deficiencies in their internal controls as part of that process. Mr. Beller acknowledged that the process costs too much, but emphasized that the efforts of the PCAOB and the Commission since the first round ended have been directed at how to obtain the benefits without the costs. With regard to the first year experience, he said that there was a lack of time to plan, a lack of time to do an integrated audit, and the financial statement audit was well under way by the time the internal control audits started. That should not be repeated, he explained.

The process the SEC observed in the first year did not include the kind of judgment that the staff thought the Commission's rules and Auditing Standard No. 2 permitted. Companies started at the bottom and worked their way up, as opposed to starting at the top and working their way down. Entity level controls should have received at least as much attention as they did, he said, and process level controls probably should have received considerably less attention.

The second year should be better in terms of cost, he suggested, but still not as low as most companies would like it to be. Mr. Beller believes that this exercise may require more than a two-year learning curve. It is likely that the corporate community will continue to perceive that it is being over-audited and that compliance with Section 404 is costing too much, he said. Mr. Beller has previously emphasized that the regulatory review of Section 404 will not rely on the costs of compliance to support calls for modification of its purposes or core requirements. While the costs are important and the SEC has been closely monitoring its implementation, the benefits are also important. He noted that the actual data available at this time falls far short of what would be necessary to look back and seek to reach firm empirical conclusions about costs or benefits that are supported by historical information.

Mr. Beller said it will take some time to get an idea of ongoing costs because costs in the first year or two of compliance are likely to be greater than those in subsequent years. There are significant benefits of Section 404 that are critical to the health of the capital markets but are hard to measure, such as improved investor confidence. In his view, mandated internal control disclosure has the long-term potential to have the most important impact on financial reporting of all of the provisions of the Sarbanes-Oxley Act.