(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Annual Report Should Contain Management's Internal Control Discussion

According to the SEC staff, a company's audited financial statements with an accompanying audit report that are contained in or accompany a proxy statement should also be accompanied by management's report on internal control over financial reporting and the auditor's report on management's assessment of those controls. This was the message the staff delivered in an updated answer to frequently-asked questions on issues under Section 404 of the Sarbanes-Oxley Act.

The staff views this position as carrying out the intent of Section 404, which requires that annual reports filed with the SEC be accompanied by a management report assessing the effectiveness of the company's internal controls and a report by the company's auditor reporting on and attesting to management's assessment of the internal controls. Accordingly, the staff intends to recommend amendments to the proxy rules to include such a requirement. In the interim, the staff encourages companies to include both management's report on internal control over financial reporting and the auditor's report on management's assessment of those controls in the annual report to shareholders when audited financial statements are included.

If management states in the report that the internal controls are ineffective, or the auditor's report takes any form other than an unqualified opinion, and these reports are not included in the annual report to shareholders, the company would have to consider whether the annual report to shareholders contained a material omission making the disclosures in the annual report misleading. Separately, the staff also advised that adequate internal controls over the preparation of supplementary information are required and therefore should be in place and assessed regularly by management. However, the issue of whether the supplementary information included in the financial statements should be included in management's assessment of internal control over financial reporting is being considered by the staff as a subject for possible rulemaking. An example of such supplementary information is FASB-required disclosures about oil and gas production.

The staff advised that internal control over the preparation of this supplementary information need not be encompassed in management's assessment of internal control over financial reporting until the Commission issues new rules addressing such requirements. On related issue, the staff noted that SEC rules mandating that management's report include disclosure of any material weakness in the internal controls identified in the course of management's evaluation do not require the use of any specific language in the report. However, the staff would generally expect that, in order for management to provide full disclosure relating to any identified material weakness, management would use the term "material weakness" in their disclosures.

The staff advised that, when a Form 10-K is incorporated into a Securities Act filing, a consent is required relating to the auditor's report on management's assessment of internal control over financial reporting. The staff explained that Rule 436 requires Securities Act filings to include a consent for all accountant reports incorporated into that filing, including a consent for the auditor's report on management's assessment of internal controls along with the auditor's report on the financial statements.