SEC and PCAOB Announce Plans for Improving Implementation of Section 404 Internal Control Reporting Requirements

May 23, 2006

 The Securities and Exchange Commission ("SEC") and the Public Company Accounting Oversight Board ("PCAOB") issued separate press releases on May 17, 2006, announcing their plans to improve the implementation of the Section 404 internal control reporting requirements of the Sarbanes-Oxley Act of 2002. The SEC’s press release noted that, among other things, it plans to issue a “concept release” for public comment in order to solicit views on the Section 404 management assessment process and ways to improve this process. For its part, the PCAOB noted in its press release that it “plans to consider amendments” to Auditing Standard No. 2, the standard governing the auditor’s internal control audit. Although neither the SEC nor the PCAOB provided a timetable for the issuance of the “concept release” or the proposed amendments to Auditing Standard No. 2, companies should be aware that an opportunity to comment on these two important subjects will be forthcoming.

The SEC’s release announcing the proposed steps can be found at: http://www.sec.gov/news/press/2006/2006-75.htm. The PCAOB’s announcement can be found at: http://www.pcaob.com/News_and_Events/News/2006/05-17.aspx

SEC’s Next Steps on Section 404

Based on comments it has received in the past year, the SEC’s plan for improving the Section 404 process includes the following steps: 

  • Concept Release On Section 404 Application: The SEC plans to issue for public comment a concept release that will address the management assessment process and the role of outside auditors in management’s assessment process. The SEC also noted that the guidance it issues in the wake of the concept release will address the manner in which management can perform top-down, risk-based assessments of internal control over financial reporting. According to the release, any guidance that is ultimately issued also will take into account the fact that companies have already made substantial investments to their internal control programs and procedures.

  • Application of Section 404 to Smaller Public Companies: The SEC stated in the release that it plans to consider forthcoming guidance from the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) on the application of Section 404 to smaller public companies and will consider, in light of COSO’s guidance, whether additional guidance from the SEC on the application of the Section 404 requirements to smaller public companies is warranted. For now, the SEC declined to accept the recommendation from its own advisory committee that smaller public companies be exempted from the Section 404 requirements.

  • Review Of PCAOB Inspections: As part of its oversight responsibility for the PCAOB, the SEC stated in its release that it plans to review the PCAOB’s 2006 inspection process for registered public accounting firms. In particular, the SEC noted this review will include an inquiry into whether the PCAOB inspections have been effective in encouraging audit firms to implement principles characterized as “cost-saving efficiencies” that the PCAOB outlined in prior guidance issued in 2005. 

  • Extension Of Compliance Deadline For Non-Accelerated Filers: The SEC said that it expects to issue a “short postponement” of the effective date for the Section 404 rules for non-accelerated filers. The exact date of the postponement is not specified in the release. As it currently stands, non-accelerated filers (including foreign private issuers that qualify as non-accelerated filers) do not have to comply with the Section 404 rules until such company files its first annual report for fiscal years ending on or after July 15, 2007. The SEC release made no mention of an extension of the deadline for foreign private issuers meeting the accelerated filer definition, which currently must comply with the Section 404 rules for annual reports filed for fiscal years ending on or after July 15, 2006. 

PCAOB’s Plan

The PCAOB stated in its release that it anticipates instituting a four-point plan designed to improve implementation of Section 404 of the Sarbanes-Oxley Act and Auditing Standard No. 2. The provisions of the four-point plan are:

  • Amend Auditing Standard No. 2: The PCAOB will propose amendments to Auditing Standard No. 2 that it says will be designed to ensure that auditors focus on areas that pose the highest risk of fraud or material error during integrated audits. The PCAOB indicated that the amendments will clarify the auditor’s role, if any, with respect to the evaluation of a company’s assessment of its internal control effectiveness. The SEC stated in its release that it plans to work with the PCAOB in reviewing and approving amendments to Auditing Standard No. 2. Among the other additional areas within Auditing Standard No. 2 that are “being considered” for amendment by the PCAOB include: 

    • Clarifying the definitions of “significant deficiency” and “material weakness” in internal control;

    • Reconsidering the “strong indicators of material weakness” identified in Auditing Standard No. 2 to allow for more judgment in making material weakness assessments;

    • Guiding auditors to increase their use of the work of others;

    • Clarifying materiality and scope decisions; and

    • Emphasizing the integration of the audit of internal control with the audit of the financial statements.

  • Reinforce Auditor Efficiency through PCAOB Inspections: The PCAOB stated that it plans to focus its 2006 inspections of registered public accounting firms on the firms’ efficiency in conducting internal audits.

  • Guidance and Education for Auditors of Smaller Companies: The PCAOB plans to develop implementation guidance for the auditors of smaller public companies and explore ways to ensure that those auditors have access to obtain effective training on auditing internal control over financial reporting.

  • Continue PCAOB Forums on Auditing in the Small Business: The PCAOB plans to hold eight forums in 2006 for the auditors, directors, and financial officers of smaller public companies to provide general education about PCAOB issues and also to gather “real-time” reactions to the internal control implementation changes.


Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
John F. Olson (202-955-8522, jolson@gibsondunn.com),
Ronald O. Mueller (202-955-8671, rmueller@gibsondunn.com),
Brian J. Lane (202-887-3646, blane@gibsondunn.com),
Amy L. Goodman (202-955-8653, agoodman@gibsondunn.com) or
Michael J. Scanlon (202-887-3668, mscanlon@gibsondunn.com)
in the firm’s Washington, D.C. office.

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.