Summary: The House is on the verge of undermining the SEC's attempt to end the exemption from Sarbanes-Oxley Section 404(b) compliance small companies have had for nearly six years. Now the auditing profession is asking the Senate to support the SEC and delete a provision from the House version of the White House's financial reform plan.

Now that the House Financial Services Committee has sent its version of the Obama administration's financial reform package to the full House, the fight against one of the bill's most controversial provisions has moved to the Senate. The battle concerns an effort to make permanent the small-company exemption for complying with Section 404(b) of the Sarbanes-Oxley Act of 2002.

Failing to delete the exemption from the final version of the bill will create a situation where there will be “little independent scrutiny of financial reporting safeguards at an estimated 6,000 small companies,” wrote Center for Audit Quality executive director Cynthia Fornelli in a December 2, 2009, letter to two senior senators, Connecticut Democrat Christopher Dodd, the chairman of the Banking Committee, and Richard Shelby of Alabama, the panel's ranking Republican. Fornelli cited the benefits small companies gain from an auditor's opinion of management's assessment, including stronger discipline with regard to the internal controls over financial reporting and greater investor confidence in company financial statements.

The support for Section 404(b) was also put in the context of the broader effort to shore-up small businesses trying to emerge from the recession. “Small business may be the backbone of America, but small investors are its nervous system,” Fornelli wrote. “Weakening this critical element of SOX at a time of lingering economic uncertainty may appear to be a step forward for small companies, but in reality it is two steps backward for investors.”

The letter was the second time in less than six weeks the CAQ, which is backed by the AICPA and the major public accounting firms, has complained about the House amendment. An October 26 letter from the group asked senior members of the House Financial Services Committee to leave the provision out of the final reform package, but to no avail.

The House amendment is the latest effort by members of Congress to ease the burden of complying with Sarbanes-Oxley for small companies. Not long after the landmark law was passed to address the accounting problems unmasked by the Enron and WorldCom scandals, business groups began campaigning to reduce its requirements. By mid-decade, the SEC and PCAOB came out with new guidance encouraging businesses and auditors to take steps that would help improve the strength of internal controls without adding excessive costs.

The effort resulted in the SEC's 2007 publication of Interpretive Release No. 33-8810, Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and Release No. 33-8809, Amendments to Rules Regarding Management’s Report on Internal Control Over Financial Reporting.

At the same time that the SEC issued its guidelines, the PCAOB published Auditing Standard (AS 5), An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements. The standard replaced the previous internal control guidance in AS 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements.

A year after the guidance was issued, the SEC said it would study the costs of complying with effects of Section 404. When the cost-benefit analysis was produced in October, with the finding that costs leveled off after increasing during the first few years of compliance, the SEC said it would end the exemption and issued Release No. 33-9072,Internal Control Over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers. The rule said non-accelerated issuers, meaning small businesses with public floats of $75 million or less, would have to comply with Section 404(b) for annual reports filed for years that end June 15, 2010, or later.

After the House amendment negated the SEC's action, commissioner Luis Aguilar said in a speech that lawmakers had made a move that would prevent “smaller public companies from taking advantage of the practical lessons learned from companies that are already complying.”