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SEC Approves New Guidance for Compliance with Section 404 of Sarbanes-Oxley

June 6, 2007

On May 23, 2007 the Securities and Exchange Commission approved interpretive guidance to help public companies strengthen their internal control over financial reporting while reducing unnecessary costs. 

Although the SEC has not yet released the text of the new guidance, it issued a press release stating that the new guidance will enhance compliance under Section 404 of the Sarbanes-Oxley Act by focusing company management on the internal controls that best protect against the risk of a material financial misstatement. 

SEC Chairman Christopher Cox stated that with the new guidance, "[C]ompanies of all sizes will be able to scale and tailor their evaluation procedures according to the facts and circumstances.  And investors will benefit from reduced compliance costs." 

The guidance does not extend the current deadlines for smaller companies to comply with Section 404.  Under current rules, the management reporting requirements of section 404 become effective for non-accelerated filers for fiscal years ending on or after December 15, 2007, and the auditor reporting requirements become effective for those companies for fiscal years ending on or after December 15, 2008.  The SEC has extended the deadline three times in the past, and Senators Kerry and Snowe had urged a fourth extension. 

The new guidance is expected to provide a principles-based framework for management.  It is not expected to require companies to change their Section 404 practices, but should provide that management may look to the principles in carrying out its assessment. 

The SEC also approved rule amendments to define the term "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."  The SEC also approved amendments regarding the auditor's attestation report on the effectiveness of internal control over financial reporting to more clearly convey that the auditor is not evaluating management's evaluation process but is opining directly on internal control over financial reporting. 

The effective date of the interpretive guidance and rules will be 30 days after their publication in the Federal Register.  We will publish a more detailed analysis of the guidance after the full text becomes available, including information about related rule-making activities by the PCAOB.