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Comment Period Closes on Proposed Definition of Significant Deficiency

The Society of Corporate Secretaries & Governance Professionals has asked the SEC to clarify that management may bring matters to the audit committee that are not considered significant deficiencies but that management has concluded should be brought to the committee's attention for other reasons. The SEC's proposed definition of a significant deficiency suggests that any matters reported to the audit committee and the external auditors cannot be identified as insignificant. That is an undesirable result, in the Society's view. The Society urged the SEC to revise the definition to permit management, in its discretion, to report a deficiency to the audit committee and the external auditors which it has identified as insignificant. The Society also recommends that the SEC not include a likelihood component in its definition of a significant deficiency. The comment period on the SEC's proposal closed July 18.

BDO Seidman, LLP said the definition should be consistent with the definition included in the PCAOB's Auditing Standard No. 5, which does not include a likelihood component. PricewaterhouseCoopers, however, said the addition of the likelihood component, "reasonable possibility," would improve management's ability to identify the deficiencies that should be reported to the audit committee and the auditor. PwC agreed that the SEC's rules and the PCAOB's standards should be aligned, and urged that any revisions to the final definition be reflected in both.

Financial Executives International's small public company task force outlined a number of improvements it would like to see adopted. FEI reiterated a previously stated view that the definition of material weakness in the SEC's final rule and AS5 should be modified to delete the reference to interim reporting. This view is relevant to the current proposal since significant deficiencies may aggregate to material weaknesses, FEI explained.

FEI supports the addition of a likelihood component in the definition, and suggested the term "reasonable possibility," which is used in the PCAOB's standard, or the more effective terms "reasonable likelihood" or "reasonable assurance," as suggested by the National Venture Capital Association. Conforming changes should be made to the SEC's and the PCAOB's definitions of material weakness, FEI added.

FEI raised concerns about the potential spillover effect of AS5's definition of significant deficiency on management. AS5 directs auditors to consider whether there are any deficiencies, or combinations of deficiencies, that have been identified during the audit as significant deficiencies. FEI is concerned that the term "consider" may be taken to mean "test for" and asked the SEC to make clear that auditors are not required to perform procedures beyond those conducted in accordance with the material weakness threshold for scoping the audit work.

FEI also urged the SEC and the PCAOB to do all they can to encourage communication between auditors and clients. Small companies in particular rely on their auditors for advice. Companies must not be subject to a game of "gotcha" in which the one who identifies a significant deficiency first determines whether it is treated as a material deficiency in itself, FEI explained.

The Institute of Internal Auditors supports the proposed definition of significant deficiency without amendment. The New York State Society of Certified Public Accountants asked for more guidance on the proper classification of a significant deficiency. Without the guidance, the concept of "less severe than a material weakness" could be subject to debate, according to NYSSCPA, which could lead to unnecessary compliance costs.

PepsiCo's senior vice president and controller does not believe the definition should include a likelihood component and believes the proposed definition will be easily understood by management and auditors. PepsiCo supports the adoption of the same definition as the PCAOB's standard.

Jacquelyn Lumb