From: Cleary Gottlieb [clearygottlieb@cgsh.com]
Sent:
Wednesday, December 13, 2006 11:23 PM
To: Cleary
Gottlieb
Subject: SEC Proposes Guidance to Ease Burdens of
Sarbanes-Oxley Section 404
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:
http://www.sec.gov/news/press/2006/2006-206.htm.
Please feel free to contact any of your regular
contacts at the firm or any of our partners and counsel listed under Corporate
Governance or under Securities and Capital Markets in the "Our Practice" section
of our website (http://www.clearygottlieb.com) if you have any questions.
CLEARY GOTTLIEB STEEN & HAMILTON LLP
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