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Proposed Definition of Material Weakness May Not Help Lower Internal Control
Costs
The revised definition of
material weakness proposed by the PCAOB and endorsed by the SEC's proposed
guidance is flawed and unhelpful, according to the American Bar Association
committees on federal securities regulation and accounting. In a letter to the
SEC, the committees said that the terminology employed in the proposed
formulation of the term material weakness is sufficiently ambiguous that it will
continue to result in the overly conservative applications that the proposals
seek to remedy.
The definition of material
weakness is a central feature of the proposed reforms because management's
assessment of the company's internal controls is based on whether any material
weaknesses exist. The objective of an audit of internal control is to obtain
reasonable assurance as to whether material weaknesses exist. The term's
importance is evident from the rule that management is not permitted to conclude
that the company's internal controls are effective if there are one or more
material weaknesses. The Paulson Committee on Capital Markets Regulation
believes that the SEC's revised guidance on materiality is the most important
issue affecting the cost of section 404(b) implementation and must be
considerably strengthened if the Sarbanes-Oxley Act costs are to be
significantly decreased.
The SEC staff has said that it
will apply the PCAOB's definition of material weakness when applying Commission
rules. Currently, Auditing Standard No. 2 defines material weakness as a
significant deficiency, or combination of significant deficiencies, resulting in
more than a remote likelihood that a material misstatement of the financial
statements will not be prevented or detected. Acting on complaints that this
definition was confusing and made it difficult to assess the severity of
deficiencies, the Board revised the definition in proposed Auditing Standard No.
5.
The Board proposes to define a
material weakness as a control deficiency, or combination of control
deficiencies, in which there is a reasonable possibility that a material
misstatement of the company's financial statements will not be prevented or
detected. The Board replaced the standard "more than a remote
likelihood" with "reasonable possibility" based on its belief
that companies and auditors were evaluating the likelihood of a misstatement at
a much lower threshold than the Board intended. In the Board's view, the new
standard should result in the identification of the most important material
weaknesses.
While agreeing that the current
"more than remote likelihood" is too low a probability standard, the
ABA committees said that inserting "reasonable possibility" would not
change the probability standard. Accountants have interpreted the terms remote,
reasonably possible and probable, as used in FASB Standard No. 5, Accounting for
Contingencies, as levels of probability that are contiguous, the committees
noted. The auditors interpret it to mean that, once an event is more probable
than remote, it is reasonably possible. This interpretation of reasonably
possible leads to events being reasonably possible at a probability level of
substantially less than 50%. In fact, the ABA committees said that some
accountants take the position that a reasonable possibility is triggered at a
probability level as low as 25%. The committees believe that such a level of
probability is too low for this purpose. The market does not perceive material
weakness disclosures as meaningful because they sweep in items that are not
important to an investor's evaluation of the effectiveness of the internal
controls or the reliability of the financial statements, in the committees'
view.
The committees noted that FASB
used a different standard in its Interpretation No. 48, Accounting for
Uncertainty in Income Taxes. FASB used a more likely than not standard in Fin
48, which it defined as a likelihood of more than 50%. FASB explained that the
confidence level expressed by "probable" is not consistently
understood and applied by constituents. The committees believe that the
confidence level expressed by "reasonable possibility" will similarly
not be consistently understood and applied. The committees urged the Board to
identify a level of likelihood that is higher than that underlying the
synonymous phrases "more than remote likelihood" and "reasonable
possibility."
The Cleary Gottlieb firm
recommends that the Board adopt a "reasonably likely" standard to
replace "more than a remote likelihood." The firm found it difficult
to see how replacing the term "more than remote likelihood" with its
synonym under SFAS No. 5, "reasonable possibility," will have a
meaningful impact on issuer or auditor behavior. The firm pointed out that the
"reasonably likely" threshold is used by the SEC in connection with
MD&A disclosure and is well understood by both issuers and auditors. Because
it is meaningfully higher than the "more than remote" standard, the
firm reasoned, a "reasonably likely" threshold will have a better
chance of focusing the evaluation and audit on the deficiencies that are of
greatest concern to investors.
James Hamilton
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