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Summary
The U.S. Securities and Exchange Commission (SEC) has, as expected, made compliance with the Sarbanes-Oxley Act (SOX) less onerous than it had been. This is good news for “accelerated filers” (companies with marketable securities totaling more than $75 million) since it will likely reduce their annual auditing costs. The only unfortunate consequence we can see is that companies that need to improve their financial processes to make them more controllable and defect-free will now have less incentive to do so. For many corporations, SOX compliance work exposed numerous instances in which poor systems and processes created not only compliance issues but also errors, delays and higher-than-necessary costs in finance department processes.

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Although it has been a foregone conclusion for months, on May 23rd the SEC adopted new rules that relax the standards that public companies must meet to comply with SOX Section 404. The most significant change was the shift away from avoiding any mistakes to a focus only on finding and fixing internal controls that pose “a reasonable possibility” of causing errors on their financial statements. In concert with this, the next day the Public Company Accounting Oversight Board (PCAOB) tossed out its Auditing Standard Number 2 (AS2) – a checklist approach that became a pettifogger’s delight – and replaced it with the new AS5, a shorter, more principles-based approach to handling the 404 audit. Under AS5, the PCAOB redefines a “material weakness” as a control deficiency or combination of control deficiencies that create a “reasonable possibility” that material errors in a company's financial statements will not be prevented or detected on a timely basis.

The shift to a “reasonable possibility” from the previous “more than a remote likelihood” is significant. Under the old wording auditors had the rationale for being, and substantial incentives to be, exhaustive in examining corporate controls, since the threshold of an auditing error was set very low. Not only would checking everything and anything in minute detail demonstrate due diligence if an error did occur, it also produced higher audit fees.

The redefinition also paves the way for SEC Chairman Cox’s decision to subject “non-accelerated filers” (companies with marketable securities of $75 million or less) to section 404 after numerous extensions of the deadline to do so. The requirement goes into effect at the end of the year, pending enactment of AS5 this summer, which we think is likely. Some are still trying to delay the application of the rule to the smaller companies, so the date still is not definite.

Assessment
The basic idea behind Section 404 enforcement is the “COSO Framework,” based on total quality management (TQM), a popular concept at the time COSO was formulated. For finance departments as well as manufacturing plants, quality doesn’t cost, it pays. By continuously designing out defects from processes and monitoring key output metrics, companies can improve quality and decrease costs. Regardless of how auditors implement and enforce Section 404, companies can reap the benefit from improving the quality of their accounting and finance processes.