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Commenters Differ on Regulatory Approach to Smaller Public Companies

The Council of Institutional Investors believes that Sarbanes-Oxley Act section 404 should remain in place for all public companies, both large and small. The Ohio Public Employees Retirement Systems believes that PCAOB Auditing Standard No. 2 is the appropriate auditing standard for both large and small public companies. SOX compliance is equivalent to the Good Housekeeping Seal of Approval, according to OPERS, and a company should not consider listing in the U.S. without it. CII and OPERS submitted their comments to the Advisory Committee on Smaller Public Companies in response to a series of questions on the appropriate level of regulatory relief for small companies.

Any company seeking to raise capital in the U.S. from the investing public must be held to the highest possible standards for accounting integrity, disclosure and transparency, according to CII. CII, which represents over 130 public, corporate and union pension funds, cautioned the Committee about any considerations that would water down SOX compliance for small companies. In the organization's view, it would be irrational to lower investor protection encompassed in key regulatory reforms such as section 404 in the very market in which the largest number of internal control failures occur. CII said that special guidance in the area of the section 404 review and reliance on the work of others is one constructive way to assist smaller public companies in reducing the costs that disproportionately burden smaller companies. CII also noted that shareholders are not complaining about the costs of compliance with section 404.

OPERS, citing the Treadway Commission's Committee of Sponsoring Organizations, noted that most of the companies involved in financial statement fraud cases between 1987-1997 were small companies with under $100 million in total assets. CEOs and CFOs were involved in 83% of these fraud cases, while 25% did not have an audit committee or had one that met only once a year. OPERS said that smaller public companies should not be permitted to conduct their section 404 assessments less than once a year given that they restate their financial statements at twice the rate of the largest companies. OPERS also noted that less frequent testing would be a violation of section 404. OPERS said it would support a total exemption from the section 404 requirements only for smaller companies that remain private.

Financial Executives International is hoping that the Advisory Committee will recommend some relief and that the SEC and the PCAOB will act to better balance the cost-benefit equation of complying with section 404. FEI believes that AS2's "principal evidence" and walkthrough requirements make it difficult for auditors to fully effect the efficiencies outlined in the SEC's and the PCAOB's May 16 guidance. The costs of section 404 are in a gross imbalance to the benefits, in FEI's view, largely because it has been driven by auditors. Their liability concerns have led to overkill, according to FEI, both in documentation and in testing of low-risk accounts.

FEI called for further guidance from the SEC and/or the PCAOB, including a safe harbor for the installation of new or upgraded information technology systems. This concern was not addressed by the May 16 guidance or the April 13 roundtable, according to FEI. Commenters had raised concerns about the installation of IT systems in the section 404 environment. FEI also urged the PCAOB to remove from AS2 the term "more than remote" from the definition of material weakness. A standard of "reasonably possible" would be more appropriate, in FEI's view. FEI also suggested the removal of the word "could" in relation to whether something could cause a material weakness. The use of the word is driving unintended results, according to FEI.

FEI also recommended that the PCAOB rescind the requirement that a lack of documentation alone be deemed a control weakness. At a minimum, FEI said the PCAOB should reiterate that the form and extent of documentation will vary depending on the size, nature and complexity of the company.