SEC Proposes Guidance to Ease Burdens of Sarbanes-Oxley Section 404

December 13, 2006

At its meeting on December 13, the Securities and Exchange Commission voted to propose rule changes and interpretive guidance relating to reporting on internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002. The text of the proposal is not yet available.

The proposals are part of a coordinated effort by the SEC and the PCAOB to improve the implementation of Section 404, which the SEC describes as being too burdensome. On December 19, the PCAOB plans to propose an amendment of Auditing Standard No. 2, which governs the obligations of a registered public accounting firm when it reports on internal control. The SEC and PCAOB proposals are intended as companion initiatives and will have coordinated comment periods. They are intended to be effective in time to affect annual reports of calendar-year companies for 2007, but not for 2006.

Today’s proposals seek to clarify the obligations of management in connection with internal control reporting, and to distinguish them from those of the external auditors. At the meeting, the commissioners and staff participants recognized that management’s approach to assessing its controls has been driven by the documentation and testing requirements applicable to external auditors under AS No. 2, and that this has contributed to the excessive burdens of complying with Section 404.

The proposals have three parts:

  • Simplified auditors’ report. Auditors’ reports on internal control now express two opinions: whether internal control is effective and whether management’s assessment of internal control is fairly stated. The proposal would amend the SEC’s rules to eliminate the second opinion. Next week, the PCAOB will propose amending AS No. 2 to the same effect.

  • Guidance for management. The SEC is proposing interpretive guidance, not in the form of a rule, on how management should evaluate the effectiveness of internal control. The guidance was described at today’s meeting as being “principles-based,” and as providing flexibility to exercise judgment and develop an assessment process tailored to a company’s circumstances, in view of the overall goal of achieving reliable financial reporting.

  • Safe harbor. The SEC’s rules require management to evaluate internal control annually. The proposal would amend those rules to provide that the requirement is met if a company performs the evaluation in accordance with the interpretive guidance.

The participants at the meeting provided only general descriptions of the proposed management guidance, which is also summarized in the press release issued after the meeting. As described, the guidance is designed to reduce excessive management testing and documentation by:

  • Requiring identification only of controls that relate to areas that are both material and pose a risk to reliable financial reporting.

  • Focusing testing of controls on areas that pose the greatest risk to reliable financial reporting.

  • Providing a framework, outside the accounting literature, for making judgments about the materiality of control deficiencies. This framework will apparently address questions that have been troublesome under AS No. 2 such as whether a restatement implies the existence of a material weakness.

  • Clarifying the nature and extent of documentation management must maintain to document the assessment.

The guidance will be generally applicable to all companies, although the SEC expects it will be particularly helpful to smaller companies. The SEC confirmed in remarks at the meeting that none of its proposals specifically addresses the situation of foreign private issuers. Although the guidance is described as being principles-based, the SEC staff made clear that it will also be quite detailed. The balance between those approaches may determine how useful the guidance will prove to be in reducing the complexity and cost of Section 404 reporting.

The comment period will be 60 days from publication of the proposed interpretive guidance and rule amendments in the Federal Register.

The SEC’s press release describing the proposal can be viewed at the following link:

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