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SEC Updates FAQ on Internal Control Over Financial Reporting

The SEC staff has updated its responses to frequently asked questions about management's report on internal controls. The staff of Division of Corporation Finance and the Office of the Chief Accountant deleted 12 previously referenced questions that are no longer relevant after the issuance of the management guidance on complying with the internal control disclosure mandates of Section 404 of the Sarbanes-Oxley Act. The staff added four new items dealing with foreign private issuers. In the SEC's management guidance release, the SEC noted that there are issues unique to foreign private issuers and instructed the staffs to consider whether these items should be addressed in response to frequently asked questions.

The new advice focuses on how foreign private issuers can comply with the management guidance and addresses unique issues concerning their statutory internal control disclosure duty. The staff advised the management of foreign private issuers to plan and scope their evaluations of the effectiveness of their internal controls based on their primary financial statements, such as home country GAAP or International Financial Reporting Standards. Management's evaluation should consider controls related to the preparation of the U.S. GAAP reconciliation because the reconciliation is a required element of the financial statements.

A foreign private issuer may be confronted with an entity that is accounted for differently in its home country GAAP or IFRS than in the reconciliation to U.S. GAAP. In that instance, the staff advised that the determination of how entities subject to these differences should be included in management's evaluation of the effectiveness of internal controls should be based on how those entities are accounted for in the primary financial statements. Management's evaluation should also consider controls related to the preparation of the U.S. GAAP reconciliation.

The staff expects a foreign private issuer's management report on internal controls to include all consolidated entities, even those consolidated on a proportionate basis. The staff recognizes that there may be circumstances when the foreign private issuer is not authorized to evaluate the internal controls of the consolidated entity and also lacks the access necessary to make that evaluation. In those circumstances, the staff believes that management should evaluate its controls over the recording of the amounts related to the entity recorded in the consolidated financial statements.

Foreign private issuers determining that the entity is within the scope of their assessment should consider the controls over the selection of accounting method for the recognition of the proportionate balances of the entity in the consolidated financial statements, including the proper elimination of inter-company balances and transactions. For example, a foreign private issuer might require that these entities annually provide audited financial statements as one of its controls over the recognition of proportionate balances in the consolidated financial statements.

In these circumstances, the SEC staff said that management's report on internal controls should disclose that they have not evaluated the internal controls of the applicable proportionately consolidated entity. The report should also note that the conclusion regarding the effectiveness of the internal controls does not extend to the internal controls of these entities. The report should disclose any key sub-totals, such as total and net assets, revenues and net income that result from the proportionate consolidation of entities whose internal controls have not been evaluated.

The disclosure should note that the financial statements include the accounts of entities accounted for via proportionate consolidation, but that management has been unable to evaluate the effectiveness of internal controls at those entities due to the fact that the company is neither authorized to evaluate the internal controls nor has the access necessary to do so.

Since home country rules on the preparation of interim financial information vary significantly, and there are no uniform requirements under the Exchange Act for foreign private issuers to file periodic interim financial information, the staff said that the reference to interim financial statements in the definition of material weakness in internal controls is not applicable to foreign private issuers. However, foreign private issuers filing on domestic forms are subject to the same requirements with respect to interim information as domestic issuers.