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COSO Issues Internal Control Guidance for Small Companies

The Committee of Sponsoring Organizations of the Treadway Commission yesterday released an exposure draft on guidance for smaller public companies in complying with the requirement for internal control over financial reporting. COSO referred to the guidance as a supplement to its original document on internal control published in 1992. The supplement focuses on the unique needs of smaller public companies that have struggled with the implementation of the section 404 provisions of the Sarbanes-Oxley Act.

PCAOB Chairman William McDonough has acknowledged that one of the most challenging, but also most promising provisions of the Sarbanes-Oxley Act is the requirement that public companies annually provide investors with an assessment of the quality of their internal controls over financial reporting and that auditors attest to management's assessment under Auditing Standard No. 2. McDonough, in remarks to the National Association of Corporate Directors, observed that these assessments and attestations took corporate responsibilities for internal control over financial reporting to an entirely different level from the original internal control requirements encompassed in the Foreign Corrupt Practices Act of 1977.

When the SEC adopted rules to implement section 404, it advised that management must base its evaluations on the effectiveness of a company's internal controls on a suitable framework and acknowledged the original COSO framework as one that would satisfy that criteria. However, after a cascade of complaints that the framework was not suited to a small business control environment, the SEC encouraged COSO to consider providing guidance on the application of its framework in a manner that would reflect the needs of smaller companies. COSO created a task force to help develop the guidance that was published yesterday.

The new guidance includes 26 fundamental principles associated with the five key components of internal control, which include the control environment, risk assessment, control activities, information and communication, and monitoring. The guidance includes approaches that small companies can take to incorporate the principles and examples of companies that have applied the principles.

The guidance does not change the requirements for effective control over financial reporting, according to PricewaterhouseCoopers partner Miles Everson, who participated in the task force, but more clearly explains how smaller companies can achieve effective internal controls in a more cost-efficient manner. For example, small companies may strengthen their internal controls through their choice of audit committee members, by using accounting software with built-in controls, by leveraging management monitoring and by outsourcing certain activities.

SEC Chief Accountant Donald Nicolaisen said the guidance is an important step in helping smaller businesses apply COSO's internal control framework. Section 404 is too important not to get right, he said, and getting it right requires effective and efficient implementation. He added that the staff will continue to monitor and assess the effects of the internal control reporting rules on smaller public companies.

The SEC's Advisory Committee on Smaller Public Companies has anxiously awaited the release of the COSO guidance as it considers possible recommendations to the SEC with respect to the application of section 404 for smaller public companies, including microcap companies. Janet Dolan, the chair of the Advisory Committee's section 404 subcommittee, said at a meeting earlier this week that the members will look at the COSO report to see if it provides a simple, straight-forward way to determine what constitutes adequate internal controls for management's assertion.

The SEC and the PCAOB each provided an observer to the COSO project. COSO is seeking comments on the exposure draft through December 31 and hopes to issue final guidance in the first quarter of 2006.