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Beller Reviews Impact of Internal Control Reports

The first year that companies and their auditors are applying the internal control rules adopted under Section 404 of the Sarbanes-Oxley Act is presenting challenges to them, as well as to investors and regulators, according to Alan Beller, the director of the SEC's Division of Corporation Finance. In remarks at a seminar on Section 404 in New York City, he urged companies to take advantage of the new rules to improve their controls and make sure that their disclosure truly informs investors about the status of those controls. For their part, investors should demand the information they need about the internal controls and any possible material weaknesses and carefully analyze it.

Investors should analyze information about internal controls in order to evaluate the implications of any material weaknesses on the reliability of financial reporting and the financial statements, Beller explained, and also to consider what remedial steps companies are taking. The disclosure of a material weakness in internal controls is a serious matter, he said, but the disclosure should be the starting point rather than the ending point for analysis. Understanding the company's remediation plans and their implications is particularly important in the first year of reporting under Section 404, Beller added.

Once the first round of internal control reports is in, Beller said the SEC and the PCAOB will evaluate the processes that have been followed and what has been filed to see what has worked and where improvements can sensibly be made. In undertaking this review, the regulators will ensure that the rules encourage companies to genuinely improve their controls and processes to provide more reliable financial statements. Mere check-the-box compliance exercises will not be sufficient, he warned.

Under the Section 404 rules, a company that identifies a material weakness in its internal controls over financial reporting must conclude that the controls are ineffective. In those cases, the SEC will be looking to see if the company provided informative disclosure about the material weaknesses and their consequences, as well as plans to remediate them. Investors have a right to expect not only strong internal controls, Beller said, but also good disclosure about issues regarding those controls.

Beller also noted that Auditing Standard No. 2 was carefully constructed by the PCAOB and carefully considered by the SEC. The regulators will make sure that the standard allows for the application of professional judgment by auditors, as well as providing for an appropriate scope for that professional judgment, he said.

Beller emphasized that the regulatory review will not use the costs of complying with Section 404 to support calls for modification of its purposes or core requirements. While the costs are important, the benefits are also important. The SEC has been closely monitoring the Section 404 implementation, but the data that is available at this time falls far short of what would be necessary to look back and reach firm empirical conclusions about costs or benefits that are supported by historical information, Beller advised.

Although the costs are increasing, Beller said it will take some time to get an idea of ongoing costs since they are likely to be greater in the first year or two of compliance than in subsequent years. He also indicated that there are significant benefits of Section 404 that, while critical to the health of the capital markets, are hard to measure, such as improved investor confidence. In Beller's view, mandated internal control disclosure has the long-term potential to have the greatest impact on financial reporting of all of the provisions of the Sarbanes-Oxley Act.

Beller also reminded investors that material weaknesses in internal controls do not necessarily equate to deficient financial statements or audit reports. Companies with material weaknesses can also have financial statements and unqualified financial statement audit reports that meet SEC requirements when the auditors do substantive work that effectively overcomes those material weaknesses.

Beller asked investors to remember that the internal control provisions under Section 404 are disclosure provisions. Companies that complete their assessments and find material weaknesses and disclose them, and whose auditors complete the internal control audit and include the required report on internal controls, will be compliant with the reporting requirements of Section 404.