It's been almost three years since the original implementation date for U.S. public companies to adopt the provisions over internal control assessments of Sarbanes-Oxley Section 404 (SOx404), and the SEC is now finalizing guidance for management for the first time. While the guidance is useful to all U.S. public filers, it is particularly important for those smaller "non-accelerated" filers who are now required to provide management's assessment of the effectiveness of their company's internal control over financial reporting this year (for years ending after December 31, 2007). Likewise, the PCAOB is finalizing a revision of the standard for the audit of internal control over financial reporting.
Taken together, these actions by the SEC and PCOAB are the result of a reexamination of the best approaches to complying with the requirements of SOx404. Drawing from the experiences of the initial adopters and a series of recommendations from all interested parties, the latest approach is meant to provide meaningful assessments of the effectiveness of internal control over financial reporting in the most efficient manner.
Certainly the initial implementation by larger companies beginning in 2004 proved to be a burden in both time and money, and many have argued that the efforts greatly outweighed the benefits. Recently, three separate reports (from the U.S. Chamber of Commerce, the Committee on Capital Markets Regulation, and Mayor Bloomberg/Senator Schumer and collectively known as the "Capital Markets" reports) recommended changes in Sarbanes-Oxley, with an emphasis on Section 404, in part to improve the competitiveness of U.S. capital markets. The new guidance is responsive to all concerns, including the Capital Markets reports.
We at Eisner LLP have been working with public companies relating to SOx404 over the last few years. While some of those companies are large multinationals, many are moderate to small. While each company has their own unique considerations, it is certainly true that smaller companies are typically more challenged in meeting their accounting and internal control resource needs. It is more difficult for the smaller public companies to attract and retain sufficient technical staff to meet the combined demands of U.S. public company reporting, thus being able to institute effective internal control over financial reporting and prepare an assessment under SOx 404. The Capital Markets report authors generally believe that SOx 404 contributes to concerns over the competitiveness of the U.S. public capital markets, as it leads public companies, new and old, to avoid U.S. market listing.
While acknowledging the positives of the statute's objectives to strengthen financial reporting, each Capital Markets report provides mostly consistent suggestions for improved implementation, including;
Clearer definitions of what constitutes a "material weakness" in internal control,
Applying a "top-down, risk-based" approach in performing the assessment,
Greater allowance to the use of management and auditor judgment,
Removing the requirement that auditors examine management's assessment, such that there is only an audit of internal control effectiveness,
Permit greater reliance by the auditors on the work of "others" used in management's assessments,
Consider separate requirements for smaller companies or provide exemption, and
Exempt foreign companies that comply with SEC approved foreign regulatory schemes.
Mostly all of these recommendations have been included by the SEC and PCAOB, although there is no intention to exempt or otherwise ultimately provide separate rules for smaller or foreign companies. It's clear that, if implemented correctly, the SEC and PCAOB believe these measures would balance the needs to lessen the burden, without jeopardizing any shareholder rights. So it could be deduced that since the Capital Markets reports recommendations on SOx 404 have been substantially included, the new guidance should be taken as support for U.S. public capital market competitiveness. And while there are likely a number of factors impacting the market competitiveness, the financial reporting transparency and good corporate governance standards of SOx 404 should reduce financial restatements, which would reduce the cost of capital and increase liquidity in the U.S. markets.
Neil Goldenberg is Partner-in-Charge of Eisner's Internal Audit and Risk Management Services Group.