Speech by SEC Staff:
Opening Remarks at the SEC Open Meeting
Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission
July 25, 2007
Thank you John. Chairman Cox and Members of the Commission:
The increased focus on companies' internal controls over financial reporting under Section 404 of the Sarbanes Oxley Act and the Commission's rules has led to improved investor confidence in our financial markets. This improved confidence is a result of improved public disclosures related to ICFR. Also, the increased focus on internal controls has helped many companies to establish and maintain more effective internal controls. However, as you know, these benefits have come with costs that were significantly greater than expected. Of particular concern have been indications of audit and compliance costs for smaller companies. Concerns with Section 404 of course are not new. Efforts by the Commission and the PCAOB have been underway for some time to meet the challenge of providing new guidance and revising the prior requirements to better balance the implementation costs with the benefits.
The proposed auditing standard you are considering today to replace Auditing Standard No. 2 is intended to address the specific concerns of smaller public companies by enabling and encouraging auditors to effectively tailor and scale their audits according to the relevant facts and circumstances of each company.
If adopted, the new standard will become effective for audits of fiscal years ended on or after November 15, 2007. However, it is important to note that early adoption of the new standard would be permitted. In fact, the staff would encourage early adoption by auditors so that issuers and investors can begin to benefit from the improvements that have been made relative to effectiveness and efficiency in the conduct of internal control audits.
Although Zoe-Vonna Palmrose will discuss the comment letters in more detail, I want to highlight one additional matter. Some commenters expressed concern that there was not sufficient incentive for auditors to modify their methods of performing the audit of internal control. Therefore, they were concerned that the benefits afforded by AS 5 would not be fully implemented and realized. These commenters noted that it was important for the PCAOB to adjust its inspection program to align it with the many changes in the auditing standard and to respect the auditors' use of professional judgment in conducting the audit. This has been an area both the Commission and the PCAOB recognize and continue to focus on.
For example, the inspection process was an area specifically identified in the Commission's and the PCAOB's 2006 announcement of actions following the Commission's second roundtable on Section 404 implementation. The PCAOB has incorporated procedures to evaluate the efficiency and effectiveness of ICFR audits in their inspection process. Further, as directed by the Commission, the staff is examining whether the PCAOB inspection program has been designed to be effective in encouraging changes in the conduct of integrated audits to improve both efficiency and effectiveness of attestations on ICFR.
The staff recognizes that, even with adoption of the new standard, the hard work is not over. Appropriate implementation will be just as important as having an improved auditing standard in place. If approved, we will work closely with the PCAOB, management, auditors, and others to monitor the implementation of the new standard. I believe that it is also important for audit committees to be involved with the implementation to enable the success of Auditing Standard No. 5.
The successful implementation of Auditing Standard No. 5 will depend upon several participants in the financial reporting process. For example, the PCAOB has indicated that it will re-train its inspection team and adjust its inspection program. External auditing firms will need to re-train their staffs and change their audit programs for a more integrated audit. The management of each company can challenge its own evaluations of internal controls based upon our interpretive guidance. Just as important, audit committees should play a more active role with particular attention paid to their management guidance implementation and the scope of the external auditor's year-end audits on an integrated basis in accordance with Auditing Standard No. 5. If the above are implemented properly, costs should become more in line with benefits for the investors, particularly for smaller, including micro-cap, companies.
Lastly, the staff believes that it is appropriate for the Commission to include a definition of the term "significant deficiency" in Commission rules. The staff recommends that you adopt the definition which the Commission published for additional public comment in June. As you know, the definition of significant deficiency is used in the context of evaluating the minimum required communications under both Sections 302 and 404 of SOX. That is, "a significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant's financial reporting."
We received 22 comment letters on the proposed definition and the majority of commenters expressed their support for it. In addition, commenters noted that a consistent definition of significant deficiency in the Commission's rules and in the PCAOB's standards was important. The staff believes the definition appropriately emphasizes the communication requirements between management, the audit committee and independent auditors on those matters that are important enough to merit attention. And, the definition will allow management to use its judgment to determine the deficiencies that should be reported to the audit committee and the independent auditor.
At this point, I would like to reiterate the Chairman's thanks to all of the staff who worked tirelessly on our efforts to improve the implementation of Section 404. During this process we have worked closely with the PCAOB, and I would like to add my thanks to the Board and the staff of the PCAOB. We would also like to thank the Commissioners and their staff for all of the hours that they have worked together with us on this topic over the past months, providing their insight and guidance.
Now I'd like to turn it over to my deputy, Zoe-Vonna Palmrose, to discuss the comment letters on AS 5.