This week, the U.S. Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) took significant steps to assist public companies in their efforts to comply with the internal control over financial reporting obligations arising under Section 404 of the Sarbanes-Oxley Act of 2002. The SEC approved the issuance of interpretive guidance to help public companies reduce unnecessary costs by focusing on internal controls that best protect against the risk of a material financial misstatement. The PCAOB approved a new audit standard that eliminates unnecessary procedures and emphasizes the top-down approach to the audit process.

Interpretative Guidance for Public Companies

The interpretive guidance is expected to benefit companies of all sizes (and, in particular, smaller companies) by providing direction to management on its evaluation and audit process. The SEC expects the interpretive guidance, which will become effective thirty (30) days following publication in the Federal Register, to achieve the following objectives:

(i) focus on risk and materiality;

(ii) reduce unnecessary and burdensome costs;

(iii) reduce uncertainty regarding management’s evaluation and provide clarifying assistance on management’s internal control over financial reporting; and

(iv) maintain a flexible and reasonable methodology for issuers with an existing assessment procedure.

Amendments to Existing SEC Rules

The SEC has also approved rule amendments that will allow a company that complies with the new interpretive guidance to be deemed to have complied with the annual evaluation required by Rules 13a-15 and 15d-15 of the U.S. Securities Exchange Act of 1934, as amended. These amendments will also define “material weakness” as a “deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

Revisions to Auditor’s Attestation Report

The SEC also voted to revise the auditor’s attestation report on internal control over financial reporting that is required under Section 404. The SEC’s revisions clarify that the auditor is not evaluating management’s evaluation process; rather, the auditor is opining directly on internal control over financial reporting.

PCAOB’s New Auditing Standard No. 5

The objectives of Auditing Standard No. 5, a principles-based set of standards, are to:

(i) focus the internal control audit on the most important matters;

(ii) eliminate procedures that are unnecessary to achieve the intended benefits;

(iii) make the audit clearly scalable to fit the size and the complexity of any company; and

(iv) simplify the text of the standard.

Once approved by the SEC, Auditing Standard No. 5 will replace the current internal control auditing standard, Auditing Standard No. 2. It will be required for all audits of internal control for fiscal years ending on or after November 15, 2007, although earlier application will be permitted.