S.E.C. looks to cut costs of meeting audit rules and new guidance for smaller public companies

July 12, 2006 from The New York Times - "The Securities and Exchange Commission, scrambling to find ways to cut the costs of complying with the Sarbanes-Oxley Act without gutting the act, said yesterday that it expected to propose a rule aimed at curbing costs.

The commission published a "concept release," setting forth numerous questions regarding both how the carrying out of the law had proceeded and what should be done now. It asked for comments on those questions over the next two months.

At issue is Section 404 of the law, which requires public companies to assess the adequacy of their internal financial controls and to have that assessment reviewed by external auditors. That provision of the law was based on a law passed in 1991 requiring banks to certify their internal controls and was expected to add little in the way of costs.

But there have been widespread complaints that the cost has been excessive. An S.E.C. advisory committee recommended that smaller companies, which have not yet been required to comply with the section of the law, be exempt. A bill introduced in Congress proposed going further and exempting the vast majority of companies.

"Our goal is to develop practical guidance for companies to help improve the reliability of financial reporting and to make Section 404 implementation more efficient and cost effective for investors," said the commission's chairman, Christopher Cox.

The commission gave little firm indication of what a new rule would say, but in numerous sections it indicated impatience and concern that the process had proved so costly and expensive. It noted that some companies had complained of excessive documentation being required by auditors and added, "We have anecdotally heard that this documentation, in many cases, substantially exceeded that normally produced by financial institutions," even though the Sarbanes-Oxley Act and the 1991 law were similarly worded.

The commission indicated that it suspected that audit firms had done too much work, saying it was "skeptical of the large number of internal controls that some companies have identified, documented and tested." It said it thought one cause of problems might have been an "overly conservative" interpretation of the rules by auditors.

The commission pointed to a document issued yesterday by a group of accounting organizations, known as the Council of Sponsoring Organizations, aimed at providing a simplified framework for smaller companies to assess their financial controls.

"What we are saying is no company is exempted from good internal controls,'' said David Richards, the president of the Institute of Internal Auditors, one organization in the group. "It does not matter what your size is."

He said the document was aimed in part at helping companies identify a relatively small number of controls that needed to be carefully checked because of their importance to accurate financial reporting.

Despite widespread complaints about cost, Section 404 does appear to have had some benefits. In the first year, about one of six companies reported material weaknesses in their controls, while that figure was down to about one in 15 during the second year.

A report by Grant Thornton, an accounting firm, noted that about 10 percent of banks had such problems, even though they had been complying with the 1991 law, which did not require external auditors to monitor the assessment. It said that indicated that auditor review was critical to assuring adequate controls.

The S.E.C. said earlier this year that it was beginning to consider how to modify the carrying out of Section 404. Yesterday's announcement may have been most significant in that it indicated that the commission thought a new rule, rather than increased guidance, would probably be necessary.

Also significant, however, was the renewed endorsement of Section 404 itself.

"Quality financial reporting is a critical cornerstone to our capital markets, and investors are entitled to rely upon it,'' said John W. White, director of the commission's Division of Corporation Finance, in announcing the new action. "Section 404 has a key role to play in enhancing the reliability of public companies' financial statements."

180 View - Every problem is an opportunity for someone. Y2K was a huge opportunity for ERP software developers such as SAP and Oracle. Sarbanes-Oxley has been a huge opportunity for auditors. It seems that some have been overzealous in their work as they rack up their fees. It seems to us that fees would go down dramatically if the auditors applied more common sense. If the absence of a control does not cause material risk, why document and test it? As well, there may be a myriad of controls that contribute to a particular business process. However if one of the controls is sufficient, why bother documenting and testing all the secondary controls?

The article makes reference to the Council of Sponsoring Organizations (COSO) providing a simplified framework for smaller companies to assess their financial controls. The American Institute of Certified Public Accountants (AICPA) and the Institute of Management Accountants have both affirmed support for new guidance for smaller public companies released during a webcast on July 11 by COSO. Click here for the webcast.