SEC advisers seek small cap exemption

Internal Auditor, June, 2006 by T. McCollum

A U.S. SECURITIES AND Exchange Commission (SEC) panel recently recommended fully or partially exempting smaller publicly listed companies from provisions of Section 404 of the Sarbanes-Oxley Act. The recommendations of the SEC's Small Business Advisory Committee on Smaller Public Companies cover companies with market capitalizations of less than US $787 million--representing more than three-fourths of U.S. publicly listed companies, but only 6 percent of the total U.S. equity market.

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In its final report, the committee advises the SEC to exempt micro-cap companies with less than US $125 million in annual revenue and small-cap companies with less than US $10 million in product revenue from Section 404. To qualify for the exemption, such companies would need to have corporate governance controls in place that adhere to audit committee standards in Rule 10A-3 of the U.S. Securities Exchange Act of 1934, as well as adopt a code of ethics for all board directors, officers, and employees.

The committee also proposes exempting small- and micro-cap companies with less than US $250 million in annual revenue from the Section 404 provision requiring an external auditor to sign off on a company's financial statements, citing its "disproportionate cost" for smaller firms. According to a 2005 American Electronics Association study, first-year Section 404 compliance costs as a percentage of revenue were 2.55 percent for companies with annual sales of less than US $100 million versus 0.27 percent for firms with more than US $500 million in sales. Alternatively, the advisory committee recommends that the SEC base the external auditor requirement on a "cost-effective standard" that provides for an external audit of the design and implementation of internal controls.

In addition, the report calls for the SEC to confirm and clarify the application of Section 404's internal control requirements to small- and mid-cap companies, including the need to maintain an effective system of internal controls over financial reporting, disclose modifications to internal controls, and have management report known material weaknesses in internal controls.

Appearing before the U.S. Senate Banking Committee in April, SEC Chairman Christopher Cox suggested that rather than exempting smaller companies from Section 404, an internal control framework tailored to the unique needs of smaller companies could ease the compliance burden for such firms. Such guidance is expected later this year from The Committee of Sponsoring Organizations of the Treadway Commission based on its Internal Control-Integrated Framework guidance.

The Small Business Advisory Committee's report is available on the SEC's Web site, www.sec.gov.