[Federal Register: July 18, 2006 (Volume 71, Number 137)]
[Proposed Rules]
[Page 40865-40873]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr18jy06-18]
[[Page 40865]]
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Part IV
Securities and Exchange Commission
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17 CFR Part 240
Concept Release Concerning Management's Reports on Internal Control
Over Financial Reporting; Proposed Rule
[[Page 40866]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-54122; File No. S7-11-06]
RIN 3235-AJ58
Concept Release Concerning Management's Reports on Internal
Control Over Financial Reporting
AGENCY: Securities and Exchange Commission.
ACTION: Advance notice of proposed rulemaking; Concept Release; request
for comment.
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SUMMARY: The Commission is publishing this Concept Release to
understand better the extent and nature of public interest in the
development of additional guidance for management regarding its
evaluation and assessment of internal control over financial reporting
so that any guidance the Commission develops addresses the needs and
concerns of public companies, consistent with the protection of
investors.
DATES: Comments should be submitted on or before September 18, 2006.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-11-06 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.
Paper Comments
Send paper submissions in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-11-06. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/concept.shtml). Comments
also are available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Lillian Brown, Division of Corporation
Finance or Michael Gaynor, Office of Chief Accountant, Securities and
Exchange Commission, 100 F Street, NE., Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Introduction
III. Risk and Control Identification
IV. Management's Evaluation
V. Documentation to Support the Assessment
VI. Solicitation of Additional Comments
I. Background
Section 404(a) of the Sarbanes-Oxley Act of 2002 \1\ directed the
Commission to prescribe rules that require each annual report that a
company, other than a registered investment company, files pursuant to
section 13(a) or 15(d) \2\ of the Securities Exchange Act of 1934 \3\
to contain an internal control report: (1) Stating management's
responsibilities for establishing and maintaining adequate internal
control structure and procedures for financial reporting; and (2)
containing an assessment, as of the end of the company's most recent
fiscal year, of the effectiveness of the company's internal controls
and procedures for financial reporting. On June 5, 2003, the Commission
adopted rules published at 68 FR 36636, June 18, 2003, implementing
section 404 with regard to management's obligations to report on
internal control over financial reporting.
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\1\ 75 U.S.C. 7262.
\2\ 15 U.S.C. 78m(a) or 78o(d).
\3\ 15 U.S.C. 78a et seq.
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Domestic reporting companies that meet the definition of
``accelerated filer'' under the Commission's rules were required to
comply with the internal control reporting provisions for the first
time in connection with their fiscal years ending on or after November
15, 2004. Foreign private issuers that meet the definition of
accelerated filer must comply with those provisions for their first
fiscal year ending on or after July 15, 2006. On September 22, 2005, in
a document published at 70 FR 56825, September 29, 2005, the Commission
postponed the compliance date for domestic and foreign non-accelerated
filers until their first fiscal years ending on or after July 15, 2007.
On May 17, 2006, the Commission announced through a press release
its intent to issue an additional postponement for compliance for non-
accelerated filers. As announced in that press release, the Commission
expects to propose an additional extension of the dates for complying
with our internal control over financial reporting requirements for
companies that are non-accelerated filers, including foreign private
issuers that are non-accelerated filers.
Section 404(b) of Sarbanes-Oxley, as well as the Commission's rules
adopted to implement the requirements of that section of the Act,
require every registered public accounting firm that prepares or issues
a financial statement audit report for a company also to attest to and
report on management's assessment of internal control over financial
reporting, in accordance with standards to be established by the Public
Company Accounting Oversight Board (PCAOB). On June 17, 2004, the
Commission issued an order approving PCAOB Auditing Standard No. 2,
``An Audit of Internal Control over Financial Reporting Performed in
Conjunction with an Audit of the Financial Statements'' (AS No. 2),
published at 69 FR 35083, June 23, 2004, which established the
requirements that apply when an independent auditor is engaged to
provide an attestation and report on management's assessment of the
effectiveness of a company's internal control over financial reporting.
In the release adopting the Commission's rules implementing section
404, we expressed our belief that the methods of conducting assessments
of internal control over financial reporting will, and should, vary
from company to company.\4\ We continue to believe that it is
impractical to prescribe a single methodology that meets the needs of
every company. However, we have received feedback that the limited
nature and extent of detailed management guidance available has
resulted in management's implementation and assessment efforts being
driven largely by AS No. 2. Therefore, we are planning to issue
additional guidance to assist management in its performance of its
assessment of internal control over financial reporting. On May 17,
2006, we announced, among other things, our intent to issue this
Concept Release seeking comment on a variety of issues that might be
the subject of Commission guidance for management. As we noted in that
announcement, in writing any guidance we will be sensitive to the fact
[[Page 40867]]
that many companies already have invested substantial resources to
establish and document programs and procedures to perform their
assessments over the last few years.
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\4\ See SEC Final Rule: Management's Reports on Internal Control
over Financial Reporting and Certification of Disclosure in Exchange
Act Periodic Reports, Release No. 34-47986 (June 5, 2003) [68 FR
36636, June 18, 2003] (hereinafter ``Adopting Release'') at Section
II.B.3.d.
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II. Introduction
Based on the cumulative feedback received since the adoption of the
rules implementing section 404, the Commission deems it necessary to
issue additional guidance for management on its assessment of the
effectiveness of internal control over financial reporting. We
currently anticipate that the guidance issued would be in the form of a
rule, which would address the topics that we have outlined in this
Concept Release: Risk and control identification, management's
evaluation, and documentation requirements (each of these topics is
addressed separately throughout the remainder of this document).
Additionally, we anticipate that the rule would be written in such a
manner that if companies followed the rule, they would be deemed to
have complied with Rules 13a-15(c) and 15d-15(c) of the Exchange Act.
Further, we anticipate any modifications to AS No. 2 would be
consistent with the rule.
The Commission is publishing this Concept Release to solicit public
comment on the provision of additional guidance to management of public
companies that are subject to the SEC's rules related to management's
assessment of internal control over financial reporting and, to assist
the Commission so that any guidance it ultimately develops addresses
the needs and concerns of all public companies. We raise a series of
questions throughout this release on assessing risks, identifying
controls, evaluating effectiveness of internal control, and documenting
the basis for the assessment. Through the questions in this Concept
Release, we seek to elicit specific public comment on such matters
including, but not limited to, the extent and nature of public interest
in the development of additional management guidance, whether
additional guidance would be useful for all reporting companies or just
a subset of those companies, the particular subject areas that any
additional guidance should address, and the extent of additional
guidance that would be useful.
Since the Commission adopted rules in June 2003 to implement
section 404 of the Sarbanes-Oxley Act, companies and third parties have
devoted considerable attention to the methods that management may use
to assess the effectiveness of internal control over financial
reporting. To date, many public companies have developed their own
assessment procedures internally. Many also have retained consultants
or purchased commercial software and other products to establish or
improve their assessment procedures. When the Commission first adopted
the internal control over financial reporting requirements, we
emphasized two broad principles: (1) That the scope and process of the
assessment must be based on procedures sufficient both to evaluate its
design and to test its operating effectiveness; \5\ and (2) that the
assessment, including testing, must be supported by reasonable
evidential matter.\6\ We stated that it was important for each company
to use its informed judgment about its own operations, risks, and
processes in documenting and evaluating its controls. We continue to
believe that management must bring its own experience and informed
judgment to bear in designing an assessment process that meets the
needs of its company and that provides reasonable assurance as to
whether the company's internal control over financial reporting is
effective.
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\5\ See Adopting Release at Section II.B.3.d.
\6\ See Adopting Release at Section II.B.3.d.
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While we emphasized the concept of management flexibility in
adopting our rules implementing section 404, our rules do require
management to base its assessment of a company's internal control on a
suitable evaluation framework, in order to facilitate comparability
between the assessment reports. It is important to note that our rules
do not mandate the use of a particular framework, because multiple
frameworks exist and others may be developed in the future. However, in
the release adopting the Section 404 requirements, the Commission
identified the Internal Control--Integrated Framework created and
published by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) as an example of a suitableframework.7 8
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\7\ See COSO, Internal Control-Integrated Framework (1992). In
1994, COSO published an addendum to the Reporting to External
Parties volume of the COSO Report. The addendum discusses the issue
of, and provides a vehicle for, expanding the scope of a public
management report on internal control to address additional controls
pertaining to safeguarding of assets. In 1996, COSO issued a
supplement to its original framework to address the application of
internal control over financial derivative activities.
The COSO framework is the result of an extensive study of
internal control to establish a common definition of internal
control that would serve the needs of companies, independent public
accountants, legislators, and regulatory agencies, and to provide a
broad framework of criteria against which companies could evaluate
and improve their control systems. The COSO framework divides
internal control into three broad objectives: effectiveness and
efficiency of operations, reliability of financial reporting, and
compliance with applicable laws and regulations. Our rules relate
only to reliability of financial reporting. Each of the objectives
in the COSO framework is further broken down into five interrelated
components: control environment, risk assessment, control
activities, information and communication, and monitoring. Under the
COSO framework, management is able to monitor, evaluate, and improve
their control systems through the use of the five components.
\8\ In that release, we also cited the Guidance on Assessing
Control published by the Canadian Institute of Chartered Accountants
and the Turnbull Report published by the Institute of Chartered
Accountants in England & Wales as examples of other suitable
frameworks that issuers could choose in evaluating the effectiveness
of their internal control over financial reporting. We encourage
companies to examine and select a framework that may be useful in
their own circumstances and the further development of alternative
frameworks.
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While the COSO framework provides an integrated framework that
identifies the components and objectives of internal control, it does
not set forth detailed guidance as to the steps that management must
follow in assessing the effectiveness of a company's internal control
over financial reporting. We, therefore, distinguish between the COSO
framework as an internal control framework and other forms of guidance
that illustrate how to conduct an assessment of the effectiveness of
internal control over financial reporting. Any additional management
guidance that we may issue is not intended to replace or modify the
COSO framework or any other suitable framework.
In determining the need for additional guidance to management on
how to conduct its assessment, it is important to consider the steps
that already have been taken by the Commission and others to provide
guidance to companies and audit firms. The Commission held its first
roundtable discussion about implementation of the internal control
reporting provisions on April 13, 2005. The Commission held the 2005
roundtable to seek input to consider the impact of the section 404
reporting requirements in view of the fact that the
[[Page 40868]]
implementation of the requirements resulted in a major change for
management and auditors. A broad range of interested parties, including
representatives of managements and boards of domestic and foreign
public companies, auditors, investors, legal counsel, and board members
of the PCAOB, participated in the discussion. We also invited and
received written submissions from the public regarding section 404 in
advance of the roundtable.
Feedback obtained from the 2005 roundtable indicated that the
internal control reporting requirements had led to increased focus by
management on internal control over financial reporting. However, the
feedback also identified particular implementation areas in need of
further clarification to reduce unnecessary costs and burdens without
jeopardizing the benefits of the new requirements.
In response to this feedback, the Commission and its staff issued
guidance on May 16, 2005.\9\ An overarching message of that guidance
was that it is the responsibility of management, not the auditor, to
determine the appropriate nature and form of internal controls for the
company and to scope their evaluation procedures accordingly.
Additionally, based on feedback received, a number of the
implementation issues arose from an overly conservative application of
the Commission rules and AS No. 2, and the requirements of AS No. 2
itself, as well as questions regarding the appropriate role of the
auditor. Accordingly, much of the guidance in the staff statement
emphasized and clarified existing provisions of the rules and other
Commission guidance relating to the exercise of professional judgment,
the concept of reasonable assurance, and the permitted communications
between management and auditors.
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\9\ Commission Statement on Implementation of Internal Control
Reporting Requirements. Press Release No. 2005-74 (May 16, 2005)
(hereinafter ``May 2005 Commission Guidance''); Division of
Corporation Finance and Office of Chief Accountant: Staff Statement
on Management's Report on Internal Control Over Financial Reporting
(May 16, 2005) (hereinafter ``May 2005 Staff Guidance'') available
at SEC.gov/spotlight/soxcom/.htm.
Also on May 16, 2005, the PCAOB and its staff issued guidance to
auditors on their audits under Auditing Standard No. 2. The PCAOB's
guidance focused on areas in which the efficiency of the audit could
be substantially improved. Topics included the importance of the
integrated audit, the role of risk assessment throughout the
process, the importance of taking a top-down approach, and auditors'
use of the work of others.
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The staff's guidance addressed implementation issues in the
following seven areas:
The purpose of internal control over financial reporting;
The concept of reasonable assurance, the importance of a
top-down, risk-based approach, and scope of testing and assessment;
Evaluating internal control deficiencies;
Disclosures about material weaknesses;
Information technology issues;
Communications with auditors; and
Issues related to small businesses and foreign private
issuers.
Overall, the May 16, 2005 guidance was well-received, and some
commenters have indicated there has been some improvement in the
effectiveness and efficiency of section 404 compliance efforts.
However, some constituents, especially smaller public companies,
continue to request the provision of additional guidance. For example,
in its Final Report to the Commission, issued on April 23, 2006, the
Commission's Advisory Committee on Smaller Public Companies raised a
number of concerns it perceived regarding the ability of smaller
companies to comply cost-effectively with the requirements of section
404. The Advisory Committee identified as an overarching concern the
difference in how smaller and larger public companies operate. The
Advisory Committee focused in particular on three characteristics: (1)
The limited number of personnel in smaller companies constrains the
companies' ability to segregate conflicting duties; (2) top
management's wider span of control and more direct channels of
communication increase the risk of management override; and (3) the
dynamic and evolving nature of smaller companies limits their ability
to maintain well-documented static business processes.\10\
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\10\ Final Report of the Advisory Committee on Smaller Public
Companies to the United States Securities and Exchange Commission
(April 23, 2006) (hereinafter ``Advisory Committee Report'') at 35-
36, available at http://SEC.gov/info/smallbus/acspc.shtml.
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The Advisory Committee suggests these characteristics create unique
differences in how smaller companies achieve effective internal control
over financial reporting that may not be adequately accommodated in AS
No. 2 or other implementation guidance as currently applied in
practice.\11\ In addition, the Advisory Committee noted serious cost
ramifications for smaller public companies stemming from the cost of
frequent documentation change and sustained review and testing for
perceived compliance with section 404.
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\11\ Advisory Committee Report at 37, available at http://SEC.gov/info/smallbus/acspc.shtml
.
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The Advisory Committee's final report set forth several
recommendations for the Commission to consider regarding the
application of the section 404 requirements to smaller public
companies. The Advisory Committee recommended partial or complete
exemptions for specified types of smaller public companies from the
internal control reporting requirements under certain conditions,
unless and until a framework is developed for assessing internal
control over financial reporting that recognizes the characteristics
and needs of those companies. The Advisory Committee also recommended,
among other things, that COSO and the PCAOB provide additional guidance
to help facilitate the design and assessment of internal control over
financial reporting and make processes related to internal control more
cost-effective.\12\ In addition, some commenters on the Advisory
Committee's exposure draft of its report suggested that the Commission
reexamine the appropriate role of outside auditors in connection with
the management assessment required by Section 404.\13\
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\12\ Advisory Committee Report at 52, available at http://SEC.gov/info/smallbus/acspc.shtml
.
\13\ See, e.g., letter from BDO Seidman, LLP (April 3, 2006),
available at http://SEC.gov/info/smallbus/acspc.shtml.
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Further, in April 2006, the U.S. Government Accountability Office
issued a Report to the Committee on Small Business and
Entrepreneurship, U.S. Senate, entitled Sarbanes-Oxley Act,
Consideration of Key Principles Needed in Addressing Implementation for
Smaller Public Companies, which recommends that in considering the
concerns of the Advisory Committee, the Commission should assess the
available guidance on management's assessment to determine whether it
is sufficient or whether additional action is needed. The report
indicates that management's implementation and assessment efforts were
largely driven by AS No. 2, as guidance at a similar level of detail
was not available for management's implementation and assessment
process.\14\ Further, the GAO report recommended that the Commission
coordinate with the PCAOB to help ensure that the section 404-related
audit standards and guidance are consistent with any
[[Page 40869]]
additional management guidance issued.\15\
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\14\ United States Government Accountability Office Report to
the Committee on Small Business and Entrepreneurship, U.S. Senate:
Sarbanes-Oxley Act: Consideration of Key Principles Needed in
Addressing Implementation for Smaller Public Companies (April 2006)
(hereinafter ``GAO Report'') at 52-53.
\15\ GAO Report at 58.
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On May 10, 2006, the Commission and PCAOB conducted a second
Roundtable on Internal Control Reporting and Auditing Provisions to
solicit feedback on accelerated filers' second year of compliance with
the section 404 requirements. Although some participants expressed
reservations about changing the processes they have already
implemented, a number of the participants expressed at the roundtable
and in their written comments the view that additional guidance was
needed.\16\
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\16\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 1, 2, 3, and 5; letter
from The Institute of Internal Auditors (IIA) (May 1, 2006); letter
from Institute of Management Accountants (IMA) (May 4, 2006); letter
from Canadian Bankers Association (CBA) (April 28, 2006); letter
from Deloitte & Touche LLP (May 1, 2006); letter from Ernst & Young
LLP (May 1, 2006); letter from KPMG LLP (May 1, 2006); letter from
PricewaterhouseCoopers LLP (May 1, 2006) and letter from Pfizer Inc.
(May 1, 2006).
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COSO plans to publish additional application guidance on its
control framework in the near future.\17\ This guidance is intended to
assist the management of smaller companies in understanding and
applying the COSO framework. It is expected that COSO's new guidance
will outline principles fundamental to the five components of internal
control described in the COSO framework. The guidance will define each
principle and describe the attributes of each, list a variety of
approaches that smaller companies can use to apply the principles, and
include examples of how smaller companies have applied the principles.
As noted in the May 17, 2006 announcement, we anticipate that this
guidance will help organizations of all sizes to better understand and
apply the COSO framework as it relates to internal control over
financial reporting.
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\17\ See letter from Larry Rittenberg, COSO (May 16, 2006) [File
Number 4-511].
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We are issuing this Concept Release to understand better the extent
of public interest in the development of additional guidance for
management regarding its evaluation and assessment of internal control
over financial reporting. As noted in our May 17, 2006 announcement, so
that this guidance might be helpful to all companies, the Commission
currently intends that any future guidance we issue will be scalable
and responsive to individual circumstances. We also are interested in
understanding what additional guidance accelerated filers would find
helpful.\18\
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\18\ We emphasize that the publication of this Concept Release
does not reflect a general dissatisfaction by the Commission with
the assessments accelerated filers have completed to date. Rather,
we are issuing this Concept Release because we are committed to
doing as much as we can to reduce any concerns about the nature and
extent of assessment procedures that management must establish and
maintain, to assist in making the requirements scalable for
companies of all sizes and complexity, and to help companies
evaluate internal control over financial reporting in a practical
and cost-efficient manner.
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1. Would additional guidance to management on how to evaluate the
effectiveness of a company's internal control over financial reporting
be useful? If so, would additional guidance be useful to all reporting
companies subject to the Section 404 requirements or only to a sub-
group of companies? What are the potential limitations to developing
guidance that can be applied by most or all reporting companies subject
to the section 404 requirements?
2. Are there special issues applicable to foreign private issuers
that the Commission should consider in developing guidance to
management on how to evaluate the effectiveness of a company's internal
control over financial reporting? If so, what are these? Are such
considerations applicable to all foreign private issuers or only to a
sub-group of these filers?
3. Should additional guidance be limited to articulation of broad
principles or should it be more detailed?
4. Are there additional topics, beyond what is addressed in this
Concept Release, that the Commission should consider issuing guidance
on? If so, what are those topics?
5. Would additional guidance in the format of a Commission rule be
preferable to interpretive guidance? Why or why not?
6. What types of evaluation approaches have managements of
accelerated filers found most effective and efficient in assessing
internal control over financial reporting? What approaches have not
worked, and why?
7. Are there potential drawbacks to or other concerns about
providing additional guidance that the Commission should consider? If
so, what are they? How might those drawbacks or other concerns best be
mitigated? Would more detailed Commission guidance hamper future
efforts by others in this area?
8. Why have the majority of companies who have completed an
assessment, domestic and foreign, selected the COSO framework rather
than one of the other frameworks available, such as the Turnbull
Report? Is it due to a lack of awareness, knowledge, training, pressure
from auditors, or some other reason? Would companies benefit from the
development of additional frameworks?
9. Should the guidance incorporate the May 16, 2005 ``Staff
Statement on Management's Report on Internal Control Over Financial
Reporting''? Should any portions of the May 16, 2005 guidance be
modified or eliminated? Are there additional topics that the guidance
should address that were not addressed by that statement? For example,
are there any topics in the staff's ``Management's Report on Internal
Control Over Financial Reporting and Certification of Disclosure in
Exchange Act Periodic Reports Frequently Asked Questions (revised
October 6, 2004)'' \19\ that should be incorporated into any guidance
the Commission might issue?
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\19\ Available at http://www.sec.gov/info/accountants/controlfaq1004.htm
.
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10. We also seek input on the appropriate role of outside auditors
in connection with the management assessment required by section 404(a)
of Sarbanes-Oxley, and on the manner in which outside auditors provide
the attestation required by section 404(b). Should possible
alternatives to the current approach be considered and if so, what?
Would these alternatives provide investors with similar benefits
without the same level of cost? How would these alternatives work?
III. Risk and Control Identification
While companies have been required to establish and maintain
internal accounting controls since the enactment of the Foreign Corrupt
Practices Act in 1977,\20\ section 404 of the Sarbanes-Oxley Act re-
emphasized the importance of the relationship between effective
internal controls and reliable financial reporting. An integral element
of establishing and maintaining effective internal control over
financial reporting involves identifying risks to reliable financial
reporting and designing appropriate internal controls that address the
risks. The controls that management identifies as addressing risks to
financial reporting include those that operate at a company level and
are pervasive to many individual account balances and disclosures, as
well as those that are specific to certain individual account balances
or disclosures. Echoing the Commission's statement in its May 16, 2005
guidance that management must bring reasoned judgment to the process,
the staff stated
[[Page 40870]]
that management should use its cumulative knowledge, experience, and
judgment (applying both qualitative and quantitative factors) in
identifying these controls and designing the appropriate procedures for
their documentation and testing.
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\20\ Title I of Public Law No. 95-213. The FCPA required the
Commission to adopt rules requiring public companies to make and
keep accurate financial records, and to maintain a system of
internal accounting controls. See Exchange Act section 13(b).
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Feedback that the Commission has received indicates that, in
implementing the requirements of section 404, many companies did not
efficiently and effectively identify risks to reliable financial
reporting and relevant internal control functions, ultimately leading
to the identification, documentation, and testing of an excessive
number of controls.\21\ We are also skeptical of the large number of
internal controls that some companies have identified, documented and
tested. While there were likely numerous contributing factors to these
implementation issues, one cause may have been the overly conservative
application of AS No. 2 by auditors in the initial years.
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\21\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 2 and 3; letter from
Protiviti Inc. (April 28, 2006); letter from Computer Sciences
Corporation (CSC) (April 28, 2006); and letter from IMA (May 4,
2006).
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The Commission also has heard that companies had difficulty in
determining how controls related to the prevention of fraud should be
included in their risk assessment.\22\ However, as noted in the May 16,
2005 staff guidance, while no system of internal control can prevent or
detect every instance of fraud, effective internal control over
financial reporting can help companies deter fraudulent financial
accounting practices or detect them earlier.
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\22\ See letter from QUALCOMM Inc. (April 27, 2006); and letter
from Diane Allen, 3M (Allen) (April 28, 2006).
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As noted above, the Advisory Committee observed that the distinct
characteristics of smaller public companies affect the financial
reporting risks and the controls needed to address them. For example,
the significant risk of management override that arises from wider
spans of control and more direct channels of communication may create
an increased need for entity level controls and board oversight.
Moreover, the difficulty in segregating duties and changing business
processes may impact the implementation of internal controls at these
companies.
We anticipate additional guidance in this area would cover a number
of the implementation issues that have arisen during the first two
years of compliance. Guidance issued in this area would address how
management should determine the overall objectives for internal control
over financial reporting and identify the related risks. In determining
the objectives for internal control over financial reporting, the
guidance would discuss how management might address company-level,
financial statement account and disclosure level considerations, as
well as fraud risks. Additionally, we anticipate that we would provide
additional guidance on how management identifies the controls to
address the recognized risks. This would include guidance on common
issues that exist in identifying controls (e.g. materiality
considerations, multi-location issues, concept of ``key'' controls).
11. What guidance is needed to help management implement a ``top-
down, risk-based'' approach to identifying risks to reliable financial
reporting and the related internal controls?
12. Does the existing guidance, which has been used by management
of accelerated filers, provide sufficient information regarding the
identification of controls that address the risks of material
misstatement? Would additional guidance on identifying controls that
address these risks be helpful?
13. In light of the forthcoming COSO guidance for smaller public
companies, what additional guidance is necessary on risk assessment or
the identification of controls that address the risks?
14. In areas where companies identified significant start-up
efforts in the first year (e.g., documentation of the design of
controls and remediation of deficiencies) will the COSO guidance for
smaller public companies adequately assist companies that have not yet
complied with section 404 to efficiently and effectively conduct a risk
assessment and identify controls that address the risks? Are there
areas that have not yet been addressed or need further emphasis?
15. What guidance is needed about the role of entity-level controls
in evaluating and assessing the effectiveness of internal control over
financial reporting? What specific entity-level control issues should
be addressed (e.g., GAAP expertise, the role of the audit committee,
using entity-level controls rather than low-level account and
transactional controls)? Should these issues be addressed differently
for larger companies and smaller companies?
16. Should guidance be given about the appropriateness of and
extent to which quantitative and qualitative factors, such as
likelihood of an error, should be used when assessing risks and
identifying controls for the entity? If so, what factors should be
addressed in the guidance? If so, how should that guidance reflect the
special characteristics and needs of smaller public companies?
17. Should the Commission provide management with guidance about
fraud controls? If so, what type of guidance? Is there existing private
sector guidance that companies have found useful in this area? For
example, have companies found the 2002 guidance issued by the AICPA
Fraud Task Force entitled ``Management Antifraud Programs and
Controls'' \23\ useful in assessing these risks and controls?
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\23\ Management Antifraud Programs and Controls: Guidance to
Help Prevent and Deter Fraud, commissioned by the Fraud Task Force
of the American Institute of Certified Public Accounting's Auditing
Standards Board (2002), available at http://www.aicpa.org/download/members/div/auditstd/AU-00316.PDF
.
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18. Should guidance be issued to help companies with multiple
locations or business units to understand how those affect their risk
assessment and control identification activities? How are companies
currently determining which locations or units to test?
IV. Management's Evaluation
As noted, the Commission's and the staff's May 16, 2005 guidance
emphasized that management's assessment should be based on the
particular risks of individual companies, and recommended a top-down,
risk-based approach to determine the accounts and related processes
that management should consider in its assessment. Therefore,
management's judgments about the significance and complexity of the
risk areas it has identified should form the basis not only for
determining what controls to evaluate, but also for determining the
nature, timing, and extent of its evaluation procedures. A risk-based
evaluation can allow management to assess whether the company's
internal control over financial reporting is effective at a
``reasonable assurance'' level.\24\
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\24\ See Rules 13a-15(f) and 15d-15(f) of the Exchange Act.
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One of the reasons cited most frequently by accelerated filers for
the higher than anticipated costs in their first year of compliance
with the section 404 requirements is that too much work was done to
test and document low-risk areas.\25\ The Commission continues to hear
that management has difficulty applying a top-down, risk-based
[[Page 40871]]
approach in their individual assessments and some believe that
compliance costs are, and may continue to be, higher than
necessary.\26\
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\25\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 2 and 3; letter from
Watson Wyatt Worldwide (March 31, 2006); letter from QUALCOMM Inc.
(April 27, 2006); and letter from Association for Financial
Professionals (May 1, 2006).
\26\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 1 and 2; letter from
Pfizer Inc. (May 1, 2006); letter from Sotheby's Holdings, Inc. (May
1, 2006); and letter from U.S. Chamber of Commerce (May 3, 2006).
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The Commission's rules require that management's assessment be ``as
of'' the company's fiscal year end, but the rules do not preclude
management from obtaining evidence to support its assessment through
cumulative knowledge it acquires throughout the year and in prior
years. In fact, management's daily interactions with its internal
controls may provide it with an enhanced ability to make informed
judgments regarding the areas that present the greatest risk to the
reliability of the financial statements, as well as how to evaluate the
relevant controls. We have heard anecdotal evidence that, in some
cases, management may have unnecessarily tested controls using separate
evaluation-type testing in connection with its annual assessment,
rather than relying on its ongoing monitoring activities, which may
include, for example, cumulative knowledge and experiences from its
daily interactions with controls.
In addition to testing, another key part of management's assessment
process is the evaluation of control deficiencies it discovers in the
process of its evaluation. Paramount to evaluating the significance of
an individual control deficiency, or combination of control
deficiencies, is to have a comprehensive understanding of the nature of
the deficiency, its cause, the relevant financial statement assertion
the control was designed to support, its effect on the broader control
environment, and whether effective compensating controls exist.\27\
Management must exercise judgment in a reasonable manner in the
evaluation of deficiencies in internal control, considering both
quantitative and qualitative factors.\28\
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\27\ See May 2005 Staff Guidance at B.
\28\ Id.
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As noted above, the Advisory Committee observed that the distinct
characteristics of smaller public companies affect the assessment of
financial reporting risks and the controls implemented to address them.
These characteristics may also affect how those companies evaluate
their internal control.
Another area where the Commission continues to hear that companies
are having difficulty in completing their assessment of internal
control over financial reporting involves the impact of information
technology (IT) processes. For example, some commenters have expressed
concerns over the extent to which IT processes should be included in
the scope of their assessment.\29\ As the staff's May 16, 2005 staff
guidance indicates, Section 404 is not a one-size-fits-all approach to
assessing controls, and for that reason, while we believe that controls
not related to internal control over financial reporting should not be
included in the assessment, providing a list of the exact general IT
controls that should be included in an assessment may not be practical.
Given that fact, we would like to explore whether there are specific
areas related to IT where additional guidance could be provided.
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\29\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 2 and 3; letter from
IIA (May 1, 2006); letter from CSC (April 28, 2006); letter from
Allen (April 28, 2006); letter from WPS Resources Corp. (May 5,
2006); and letter from R.G. Scott & Associates, LLC (April 8, 2006).
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Based on the cumulative feedback received, we believe that guidance
on management's evaluation process and revisions to AS No. 2 may help
reduce or eliminate the excessive testing of internal controls by
improving the focus on risk and better use of entity-level controls. We
anticipate that the guidance would cover topics such as the overall
objective of evaluation procedures; methods or approaches available to
management to gather evidence to support its assessment (i.e. on-going
monitoring, benchmarking, and updating prior evaluations); and factors
that management should consider in determining the nature, timing and
extent of its evaluation procedures. This guidance would address
whether and how entity-level controls may adequately address risk at
the financial statement and disclosure level and considerations as to
the extent information technology general controls are included in the
scope of management's assessment. Further, we anticipate the guidance
would cover considerations of management in determining the severity of
an identified control deficiency.
19. What type of guidance would help explain how entity-level
controls can reduce or eliminate the need for testing at the individual
account or transaction level? If applicable, please provide specific
examples of types of entity-level controls that have been useful in
reducing testing elsewhere.
20. Would guidance on how management's assessment can be based on
evidence other than that derived from separate evaluation-type testing
of controls, such as on-going monitoring activities, be useful? What
are some of the sources of evidence that companies find most useful in
ongoing monitoring of control effectiveness? Would guidance be useful
about how management's daily interaction with controls can be used to
support its assessment?
21. What considerations are appropriate to ensure that the guidance
is responsive to the special characteristics of entity-level controls
and management at smaller public companies? What type of guidance would
be useful to small public companies with regard to those areas?
22. In situations where management determines that separate
evaluation-type testing is necessary, what type of additional guidance
to assist management in varying the nature and extent of the evaluation
procedures supporting its assessment would be helpful? Would guidance
be useful on how risk, materiality, attributes of the controls
themselves, and other factors play a role in the judgments about when
to use separate evaluations versus relying on ongoing monitoring
activities?
23. Would guidance be useful on the timing of management testing of
controls and the need to update evidence and conclusions from prior
testing to the assessment ``as of'' date?
24. What type of guidance would be appropriate regarding the
evaluation of identified internal control deficiencies? Are there
particular issues in evaluating deficient controls that have only an
indirect relationship to a specific financial statement account or
disclosure? If so, what are some of the key considerations currently
being used when evaluating the control deficiency?
25. Would guidance be helpful regarding the definitions of the
terms ``material weakness'' and ``significant deficiency''? If so,
please explain any issues that should be addressed in the guidance.
26. Would guidance be useful on factors that management should
consider in determining whether management could conclude that no
material weakness in internal control over financial reporting exists
despite the discovery of a need to correct a financial statement error
as part of the financial statement close process? If so, please
explain.
27. Would guidance be useful in addressing the circumstances under
which a restatement of previously reported financial information would
not lead to the conclusion that a material weakness exists in the
[[Page 40872]]
company's internal control over financial reporting?
28. How have companies been able to use technology to gain
efficiency in evaluating the effectiveness of internal controls (e.g.,
by automating the effectiveness testing of automated controls or
through benchmarking strategies)?
29. Is guidance needed to help companies determine which IT general
controls should be tested? How are companies determining which IT
general controls could impact IT application controls directly related
to the preparation of financial statements?
30. Has management generally been utilizing proprietary IT
frameworks as a guide in conducting the IT portion of their
assessments? If so, which frameworks? Which components of those
frameworks have been particularly useful? Which components of those
frameworks go beyond the objectives of reliable financial reporting?
V. Documentation to Support the Assessment
Developing and maintaining an appropriate amount of evidential
matter is an inherent element of effective internal control.\30 \This
evidential matter should provide reasonable support for the assessment
of whether controls are designed to prevent or detect material
misstatements or omissions; for the conclusion that tests to assess the
effectiveness of internal control were appropriately planned and
performed; and for the conclusion that the results of such tests were
appropriately considered in management's conclusion about
effectiveness.\31\ Further, public accounting firms that attest to, and
report on, management's assessment of the effectiveness of the
company's internal control over financial reporting may review
evidential matter supporting management's assessment.\32\
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\30\ Section 13(b)(2)(A) of the Exchange Act requires companies
to ``make and keep books, records, and accounts, which in reasonable
detail, accurately and fairly reflect the transactions and
dispositions of the assets of the issuer.'' We have previously
stated, as a matter of policy, that under section 13(b)(2) ``every
public company needs to establish and maintain records of sufficient
accuracy to meet adequately four interrelated objectives:
appropriate reflection of corporate transactions and the disposition
of assets; effective administration of other facets of the issuer's
internal control system; preparation of its financial statements in
accordance with generally accepted accounting principles; and proper
auditing.'' Statement of Policy Regarding the Foreign Corrupt
Practices Act of 1977, Release No. 34-17500 (January 29, 1981) [46
FR 11544].
\31\ Instruction 1 to Item 308 of Regulations S-K and S-B,
Instruction 1 to Item 15 of Form 20-F and Instruction 1 to
paragraphs (b), (c), (d), and (e) of General Instruction B.6 to Form
40-F provide that ``the Registrant must maintain evidential matter,
including documentation, to provide reasonable support for
management's assessment of the effectiveness of the registrant's
internal control over financial reporting.''
\32\ AS No. 2 sets forth the criteria auditors should use when
evaluating whether management's documentation provides reasonable
support for its assessment of internal control over financial
reporting. See ]] 42-46 of PCAOB Auditing Standard No. 2, An Audit
of Internal Control over Financial Reporting Performed in
Conjunction with an Audit of Financial Statements.
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Feedback that the Commission received in connection with its 2005
Roundtable and other feedback on the first year of compliance indicates
that, in implementing the requirements of section 404 for the first
time, many companies approached risk and control identification more
formally than they may have historically and, consequently, companies
may have incurred significant documentation costs.\33\ This
documentation consisted of, among other things, detailed process maps
describing controls over initiating, recording, processing and
reconciling account balances, classes of transactions, and disclosures
included in the financial statements. Many companies also have
indicated that in their initial implementation of section 404, too many
controls were identified, which resulted in excessive
documentation.\34\ Frequently, this excessive documentation was blamed,
at least in part, on the auditors and their application of AS No. 2.
Further, we have anecdotally heard that this documentation, in many
cases, substantially exceeded that normally produced by financial
institutions under the Federal Deposit Insurance Corporation
Improvement Act of 1991,\35\ notwithstanding substantially similar
statutory language to that found in section 404.
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\33\ See transcript of Roundtable on Implementation of Internal
Control Reporting Provisions, April 13, 2005; letter from Mortgage
Bankers Association (February 25, 2005); letter from Paula Jourde
(March 4, 2005); letter from White Mountains Insurance Group (March
29, 2005); and letter from Intel Corporation (March 31, 2005).
\34\ See transcript of Roundtable on Internal Control Reporting
and Auditing Provisions, May 10, 2006, Panels 1 and 2; letter from
IIA (May 1, 2006); letter from America's Community Bankers (May 1,
2006); letter from Stephan Stephanov (March 27, 2006); and letter
from Institute of Chartered Accountants in England and Wales (March
28, 2006).
\35\ 12 U.S.C. 1831m. Section 112 of the Federal Deposit
Insurance Corporation Improvement Act of 1991 added section 36,
``Independent Annual Audits of Insured Depository Institutions,'' to
the Federal Deposit Insurance Act. Section 36 required the Federal
Deposit Insurance Corporation, in consultation with appropriate
federal banking agencies, to promulgate regulations requiring each
insured depository institution with at least $150 million in total
assets, as of the beginning of its fiscal year, to have an annual
independent audit of its financial statements performed in
accordance with generally accepted auditing standards, and to
provide a management report and an independent public accountant's
attestation concerning both the effectiveness of the institution's
internal control structure and procedures for financial reporting
and its compliance with designated safety and soundness laws.
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In its report, the Advisory Committee suggested that smaller public
companies have unique characteristics and needs for flexibility that
make the documentation elements of section 404 particularly burdensome
for those companies. In its opinion, the section 404 internal control
reporting requirements as currently applied in practice might impose a
lack of flexibility on smaller public companies that would put them at
a competitive disadvantage. We have also heard that excessive
documentation demands might impose extra or particularly burdensome
costs on smaller public companies.
The Commission anticipates that management would benefit from
additional guidance on the appropriate and required levels of
documentation to support their assertion on the effectiveness of
internal control over financial reporting. Topics addressed might
include clarifying the overall objectives of the documentation,
including factors that might influence documentation requirements and
other common documentation concerns (e.g. updating of previously
created documentation or how to address controls for which operation
does not result in documented evidence). We also anticipate that
guidance might be helpful in addressing the flexibility and cost
containment needs of smaller public companies in particular.
31. Were the levels of documentation performed by management in the
initial years of completing the assessment beyond what was needed to
identify controls for testing? If so, why (e.g., business reasons,
auditor required, or unsure about ``key'' controls)? Would specific
guidance help companies avoid this issue in the future? If so, what
factors should be considered?
32. What guidance is needed about the form, nature, and extent of
documentation that management must maintain as evidence for its
assessment of risks to financial reporting and control identification?
Are there certain factors to consider in making judgments about the
nature and extent of documentation (e.g., entity factors, process, or
account complexity factors)? If so, what are they?
33. What guidance is needed about the extent of documentation that
management must maintain about its evaluation procedures that support
its
[[Page 40873]]
annual assessment of internal control over financial reporting?
34. Is guidance needed about documentation for information
technology controls? If so, is guidance needed for both documentation
of the controls and documentation of the testing for the assessment?
35. How might guidance be helpful in addressing the flexibility and
cost containment needs of smaller public companies? What guidance is
appropriate for smaller public companies with regard to documentation?
VI. Solicitation of Additional Comments
In addition to the areas for comment identified above, we are
interested in any other issues that commenters may wish to address
relating to companies' compliance with the SEC's rules related to
management's assessment of internal control over financial reporting.
For example, we are interested in whether commenters believe that there
are additional topics not addressed in this Concept Release for which
guidance would be useful. We also invite commenters to provide to us
descriptions of, or actual process plans, that they have utilized or
created for portions or all of management's assessment. Please be as
specific as possible in your discussion and analysis of any additional
issues. Where possible, please provide empirical data or observations
to support or illustrate your comments.
By the Commission.
Dated: July 11, 2006.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. E6-11226 Filed 7-17-06; 8:45 am]
BILLING CODE 8010-01-P