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SEC Adopts Guidance For Management On Internal Control Over Financial Accounting

SEC Chairman Christopher Cox advised at yesterday's open meeting that there will be no additional postponement of the requirement for smaller public companies to comply with the section 404 internal control requirement since the guidance for management has been adopted in time to affect the 2007 fiscal year financial statements. Smaller companies still have an additional year before they must comply so will be able to "watch and learn" from the larger companies' application of the new guidance, according to Cox. Commissioner Paul Atkins noted that Senators John Kerry (D-MA) and Olympia Snowe (R-ME) had requested an additional extension of time, but the staff concluded, and the commissioners concurred, that companies of all sizes will be able to comply with the new guidance in 2007.

In addition to adopting the interpretive guidance, the commissioners voted to adopt rule amendments to ensure that companies which perform their internal control evaluations in accordance with the guidance will satisfy the annual evaluation required by 1934 Act rules 13a-15 and 15d-15. The SEC also amended its rules to define a material weakness and will seek comments on a definition of a significant deficiency. The SEC also amended Regulation S-X to require a single opinion on the effectiveness of internal control over financial reporting by the auditor in its attestation report.

The interpretive guidance will be a stand-alone document, separate from the rule amendments. The staff determined that the guidance for management was preferable as an interpretive release rather than being codified as a rule. John White, the director of the Division of Corporation Finance, noted that interpretive guidance would be easier to update or modify. He also emphasized that companies are not required to alter their current procedures with respect to management's report on internal controls unless they choose to do so.

White said the release seeking comment on the definition of a significant deficiency was necessary since the guidance that was proposed for management in December only defined material weakness. Commenters requested the additional definition of a significant deficiency.

One of the main modifications to the December proposal is a closer alignment with the PCAOB's Auditing Standard No. 5, which was adopted by the Board today. Deputy Director Zoe-Vonna Palmrose noted that the SEC's guidance and the PCAOB's standard will differ in some respects, not because of contradictions or misalignments, but due to the different responsibilities of auditors and management. The SEC's guidance was also revised to provide greater clarity with respect to entity level controls, self-assessment and ongoing monitoring activities, and to enhance the explanation of the risks associated with fraudulent financial reporting.

Palmrose said the guidance advises that the risk of fraudulent financial reporting will exist in virtually all companies. The risk of management override of internal controls is something every company should consider, especially with respect to the year-end process.

Cox said the goal of the guidance is to ensure that management's assessment of internal control is not driven by the audit process. Palmrose assured that the revised guidance addresses that concern. The comment process was enormously helpful, she added, since commenters emphasized the importance of the SEC and the PCAOB staffs working together on their respective proposals.

White said the staff is hopeful that auditors will begin to implement the procedures in the PCAOB's standard since there will be a delay in its effectiveness due to the requirement that the SEC approve the standard that the Board adopted. Cox added that the industry has a fairly high degree of confidence in what the final standard will look like.

Atkins said he is optimistic that the PCAOB's new standard will finally "close the loop" without having to revise it a third time. In response to his question about the impact of the SEC's guidance on foreign private issuers, Palmrose advised that the staff is drafting an update to its frequently asked questions, some of which specifically addresses foreign private issuers.

Commissioner Roel Campos acknowledged some people's concerns that the guidance focuses too much on efficiency rather than effectiveness, but he believes the staff has worked to find the right balance. Campos said the success of the guidance will depend on the good faith and hard work of auditors and managers. 

Commissioner Annette Nazareth asked why the revised definitions were adopted as rules. Palmrose said the staff concluded that managers should look to the SEC's rules for the definitions rather than the auditing literature. White agreed, noting that CEOs and CFOs must make quarterly certifications that there are no material weaknesses in their internal controls, so it makes sense to have the definitions in the SEC's rules.

Commissioner Kathleen Casey said her greatest concern is with the proper implementation of the rules. The PCAOB must focus its inspections on sound judgment, she said. The SEC must be satisfied that the PCAOB's new standard is adopted in proper form and is implemented correctly, she said. Palmrose noted that as part of the SEC's oversight of the PCAOB, it will be examining the PCAOB's inspection activities and how the standard-setting group trains the inspection team.

The SEC yesterday also adopted final rules for the oversight of credit rating agencies that are nationally recognized statistical rating organizations, and proposed a number of rules to modernize and improve the disclosure requirements and capital raising efforts of smaller public companies. The proposals respond to a number of recommendations submitted to the SEC by the Advisory Committee on Smaller Public Companies in its final report.