SEC discounts concerns about AS5

Strategic Finance, Sept, 2007 by Stephen Barlas

When the SEC finally blessed the Public Company Accounting Oversight Board's (PCAOB) Auditing Standard No. 5 (AS5), "An Audit of Internal Control over Financial Reporting that Is Integrated with an Audit of Financial Statements," on July 25, it split the difference on the last remaining issue: how to define the term "significant deficiency." The SEC had sent out a notice in late June, asking for comments on that, and business groups had asked the agency to modify the PCAOB's definition--which the SEC declined to do on July 25. The Sarbanes-Oxley Act requires a company to report a significant deficiency to its outside auditor and the audit committee, but not the shareholders, as is the case with a "material weakness." The SEC has made it clear that its management guidance on Section 404 would use whatever definition of "significant deficiency" becomes final in AS5.

The auditing industry and financial executives pushed--unsuccessfully, it seems--for the SEC to tweak the definition that the PCAOB had settled on last May in the version of AS5 approved at that time, which defined a "significant deficiency" as "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 a registrant's financial reporting."

Richard D. Brounstein, chairman, Small Public Company Task Force, Financial Executives International, wanted the SEC to add a "likelihood" standard to the May definition, and he endorsed a PricewaterhouseCoopers LLP suggestion that the SEC add a "reasonable possibility" qualification as the PCAOB had included when it first proposed its version of AS5 in December 2006. Vincent Coleman, a PricewaterhouseCoopers LLP official, had wanted a "reasonableness" component because it "would enhance management's ability to identify those deficiencies that should be communicated to the audit committee and the auditor and align the definition of significant deficiency with the definition of material weakness without detracting from management's opportunity to exercise appropriate judgment or establishing 'bright lines.'"

But on July 25, the SEC refused to return the definition to where it was last December, saying, "It is not necessary for the definition of significant deficiency to explicitly include a likelihood component (that is, reasonable possibility) and that focusing on matters that are important enough to merit attention will allow for sufficient and appropriate judgment for management to determine the deficiencies that should be reported to the auditor and the audit committee."

Some business groups also wanted the SEC to eliminate the requirement to report on significant deficiencies. Michael J. Ryan, Jr., senior vice president and executive director, U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, says the requirement "has given rise to another set of required procedures and conclusions on significant deficiencies, in addition to the inquiries that are required for material weaknesses. This results in unnecessary duplication and confusion." The SEC didn't take that suggestion, either.

Convergence Proposal Elicits Views along Wide Spectrum

The SEC issued a concept release on July 25 asking for opinions on whether U.S. companies should be able to prepare their financial statements using International Financial Reporting Standards (IFRS) as published by the International Accounting Standards Board (IASB). This came a month after the SEC proposed allowing foreign issuers to use IFRS, thereby axing the current requirement that they reconcile their financial statements with U.S. generally accepted accounting principles (GAAP)--which are, essentially, FASB standards. But already the earlier proposal to allow foreign companies to use IFRS has generated opposition for reasons that may have even more resonance when applied to the potential use of IFRS by American companies.

Lawrence Cunningham, a law professor at George Washington University, says the proposal ignores the fact that the Sarbanes-Oxley Act requires the Financial Accounting Standards Board (FASB) to be funded from public fees while the IASB depends on funding from a small number of private donors. "These differences pose for the two bodies different incentives during standard-setting processes that raise convergence issues," Cunningham says. William Craven, an accountant, suggests IFRS are fungible and cites a recent story in The Economist that cited the continuing propensity of certain European countries to be selective and imaginative in how they apply any IFRS. "It appears that IFRS are becoming more of a suggestion than a standard," Craven states. On the other hand, Greg Taylor, CFO, Fairfax Financial Holdings in Toronto, says a "no reconciliation" dictate would "help to level the playing field between U.S. and non-U.S. issuers and would eliminate the incentive that foreign private issuers currently have to avoid the U.S. capital markets and move to jurisdictions with less costly compliance and disclosure requirements.