Is relief coming for smaller public companies?

Much has been said and written lately about the regulatory burdens that are falling on smaller public companies in the wake of reform measures such as the Sarbanes-Oxley Act. Various articles have cited that the Securities and Exchange Commission (SEC), under its new Chairman Christopher Cox, supports steps that the SEC is taking to make accounting rules less burdensome for smaller companies.

One step is the formation of the SEC Advisory Committee on Smaller Public Companies. Created last year by former Chairman William Donaldson to consider the impact of Sarbanes-Oxley and other federal securities laws, the 21-person committee was established to provide the SEC with recommendations designed to assure that the burdens and expenses associated with small-firm compliance with federal securities laws square with the benefits being realized by investors and the public. The committee is comprised of four subcommittees: internal control over financial reporting, corporate disclosure, accounting standards and capital formation.

The SEC's Office of Small Business Policy, which is part of the Division of Corporation Finance, serves as secretariat for the committee and provides staff support, but is prohibited by law from telling the committee what to recommend to the SEC, according to office chief Gerald J. Laporte. Likewise, the SEC will consider recommendations, but can choose whether or not to adopt them.

The committee recently sought public comment on ways to improve the current regulatory system for smaller companies through its "Request for Input on Ways to Improve the Current Regulatory System for Smaller Companies (the questionnaire)." Comprised of 29 open-ended questions, the request's comment period ended August 31.

First Response to Section 404

Although the committee isn't scheduled to present a final report to the SEC until April 2006, on August 10, the committee approved two resolutions containing recommendations aimed at relief for smaller firms, which are summarized in a letter sent to Chairman Cox on August 18.

The first resolution relates to Sarbanes-Oxley Section 404 compliance dates for non-accelerated filing companies. The committee recommended that the SEC further extend compliance dates so that a non-accelerated filer should begin to comply with the management report on internal control for its first fiscal year ending on or after July 15, 2007, instead of July 15, 2006. The committee provided several reasons, including costs, complexity and process improvements.

In its response to the questionnaire, FEI's Small Public Company Task Force supported this recommendation: "The delay in the compliance date of Section 404 will provide more time ... to take advantage of lessons learned--at great cost--by larger companies, particularly since larger companies generally already had more highly developed internal control systems, documentation and testing in place than most smaller companies ..."

Task force Chair Richard D. Brounstein, director of The CFO Network (he also represents microcap and life sciences industry companies on the SEC Advisory Committee), notes that smaller public companies--as well as larger companies with small bottom lines--inherently have a lower scale of materiality. When extrapolating the effect of a control weakness, a small company's reported income can cause such control deficiency findings as to be deemed material weaknesses.

As a result, the FEI comment letter called for guidance to appropriately consider issues of scale impacting materiality for such public companies--and the related Auditing Standard No. 2 (AS2) ramifications.

Accelerated Filing, Definition of 'Smaller Public Company'

In its second resolution, the committee recommended that smaller public companies not be subject to any further acceleration of due dates for annual and quarterly reports. The accelerated filing requirements currently proposed call for annual report deadlines to move over several years from 90 days to 60 days after the close of the fiscal year, and quarterly reports from 45 to 35 days after the prior quarter's close. Current requirements are 75 days for annual reports and 40 days for quarterly reports. (In a related article beginning on page 36, David Copenhafer of Bowne & Co. argues for eliminating Phase II of the 10-K filing deadlines.)

The second resolution also recommended that the SEC look for guidance in defining the term "smaller public company" to the definition of that term adopted by the committee. The committee's definition of a smaller public company is determined by six elements:

* the company's total market capitalization;

* a measurement metric that facilitates scaling of regulation;

* a measurement metric that is self-calibrating;

* a standardized measurement and methodology for computing market capitalization;

* a date for determining total market capitalization; and

* clear and firm transition rules (from small to large and vice versa).

The committee recommended that a company ranking in the bottom 6 percent of total U.S. public market capitalization--as defined by the SEC, when the capitalization of all public companies is combined--would qualify as a smaller public company, and that a company ranking in the bottom 1 percent would qualify as a microcap company.

Specifically, if the committee's current definitions were to be adopted, companies with approximately $750 million or less in market capitalization would be defined as smaller public companies, and those with approximately $100 million-$120 million or less in market capitalization would be defined as microcap companies.

Impact on Standard-Setting and Auditor Relationships

George J. Batavick, Financial Accounting Standards Board (FASB) member and official observer to the committee, says that if such a definition is adopted, future accounting standards could then provide the same standard implementation deadlines for both private companies and public microcap ones. For example, if a given standard's implementation date is Dec. 15, 2005, the implementation date for private and microcap companies would occur anywhere from six months to a year later, depending on complexity and/or the nature of each standard. Whatever the SEC does adopt, Batavick says, will be communicated to FASB, as it impacts its standard-setting.

(As an observer, Batavick cannot vote on the full committee's recommendations, but he is part of its accounting standards subcommittee. He participates in the full committee meetings and provides views on the issues being discussed, and also offers briefings during regularly scheduled meetings of FASB's Small Business Advisory Committee, User Advisory Council and Financial Accounting Standards Advisory Council.)

When asked about other significant concerns expressed by small public companies, Batavick points to the strained relationship between preparers and external auditors. At smaller companies, accountants wear many hats, and may have neither the time or expertise to adopt new standards or account for new transactions.

Thus, he says that the accounting subcommittee is trying to address the independence issues around the preparer-auditor relationship. Specifically, the subcommittee is debating how to word recommendations for the Public Company Accounting Oversight Board (PCAOB) to consider leniency in two areas: 1) external auditor assistance in implementing new standards; and 2) external auditor review of the accounting treatment for new transactions.

Next Steps

Daniel L. Goelzer, a PCAOB member who serves as the board's official observer to the committee, notes that the PCAOB has heard similar concerns. He says that "questions about the auditor's ability to give accounting advice to clients without eroding independence arise constantly, particularly at the forums we have held around the country during the past year to discuss the special problems of smaller accounting firms and their clients."

Goelzer also says that, as a result, the board has emphasized--both in a policy statement issued on May 16 and in speeches and informal discussions--that, within broad limits, auditors may provide audit clients with advice on the application of generally accepted accounting principles (GAAP) and may assist clients in determining the proper accounting for novel transactions.

"If the committee believes that additional steps to make sure that the parameters in this area are clear, we would certainly give careful consideration to its recommendations," Goelzer adds.

Since the committee isn't scheduled to submit its final report to the SEC until April 21, 2006, the full impact of its work will not be felt until then. However, Herbert S. Wander, the committee co-chair from Katten Muchin Rosenman LLP in Chicago, hopes to beat the April deadline for all recommendations.

"We met with the [SEC] commissioners, who have been very receptive to [receiving] the recommendations and making their own assessment," he notes. As with the case of the two resolutions already delivered, Wander says that as issues become urgent, the committee will submit recommendations rather than waiting until the deadline.

With the fact-finding portion of the Advisory Committee's work scheduled to close in September, the committee was scheduled to meet on September 20 to discuss subcommittee recommendations and sort through and prioritize those that will likely be the final ones. The work will then shift into the writing phase, during which time report drafts are expected to go back and forth among committee members; final adoption is scheduled as early as next March 21. In the meantime, smaller public companies are encouraged to monitor developments. At press time, there were hints that the SEC would adopt the resolution for relief on Section 404.

By early September, the SEC had received 250 different responses to the questionnaire. Both Laporte and Wander said they were pleased with the quality of responses, which indicate that people are clearly taking these issues seriously.

Wander says that the prevalence of thoughtful comments generally affirms that most Sarbanes-Oxley requirements are feasible and were probably necessary to calm public concerns. But, with regard to Section 404, the comments clearly expressed the belief that something needs to be done. "When you step back, [you see] business managers and directors spending time on checklists ... but who is minding the store?" Wander notes. "Governance is a means, not an end, to achieve the goal of doing well for shareholders [in an] honest [manner]."

Goelzer agrees that internal control auditing is not a "one-size-fits-all" exercise that can be reduced to checklists. "Clearly, there are significant costs associated with assessing, strengthening and auditing controls, especially in the first year. There are, however, also substantial benefits. The trick, particularly in smaller companies, is to make sure that the process is thoughtful and risk-focused, so that the benefits exceed the costs."

Cheryl de Mesa Graziano, CPA ([e-mail]), is Director of Research at Financial Executives Research Foundation (FERF).

RELATED ARTICLE: takeaways

* The SEC has formed an Advisory Committee on Smaller Public Companies to review the regulatory burdens these organizations face.

* The committee is reviewing a series of responses to an informational questionnaire sent during a comment period that recently ended.

* In its first two recommendations, the committee has asked the SEC to extend compliance deadlines or not to accelerate others.

* Concerns have been expressed that smaller companies are using "checklists" and not going through a comprehensive compliance process.