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From September 2006 Strategic Finance

S T E P H E N B A R L A S , E D I T O R

Section 404 Saga Continues

The Securities & Exchange Commission will issue guidance for corporate
management on how to comply with the provisions of Section 404 of the
Sarbanes-Oxley Act, which requires companies to explain their internal controls
and test them. The SEC issued a “Concept Release” in mid-July that outlined
some of the areas it may address when the guidance is published. No
date for publication was mentioned. Large companies, of course, have had to
comply with 404 for two years. Smaller companies received an initial reprieve,
but, with first-time compliance looming, they are pushing the SEC hard to
make some changes in required compliance. The SEC Advisory Committee on
Smaller Public Companies raised a number of concerns in an April report on
the ability of smaller companies to comply with 404 in a cost-effective manner. That was followed days later by a U.S. Government Accountability Office report that said much the same thing. Of course, larger companies and the U.S. Chamber of Commerce have been arguing for
the past year that Section 404 is too costly. The SEC took a first crack at quieting that murmuring when it issued limited guidance in April 2005 relating to the exercise of professional judgment, the concept of reasonable assurance, and the permitted communications between management and auditors. But this next round of guidance will go further. For example, the 2005 guidance stated that management needs to use “reasoned judgment” in identifying internal controls. But few understood what that meant. The July 2006 Concept Release maintains that “many companies did not efficiently and effectively identify risks to reliable financial reporting and relevant internal control functions, ultimately leading to the identification, documentation, and testing of an excessive number of controls.We are also
skeptical of the large number of internal controls that some companies have
identified, documented, and tested.” Part of the reason for that problem is that corporate management, in implementing Section 404, may have leaned too heavily on the Public Company
Accounting Oversight Board (PCAOB) Auditing Standard No. 2 (AS2), An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of the Financial Statements. Published in June 2004, this was meant for outside auditors, not management. But many corporate financial and accounting departments interpreted AS2 very conservatively, increasing costs far beyond what was necessary. This is

c o n t i nue d o n p a ge 2 4

the problem that the SEC hopes to resolve with its new guidance, which the agency emphasized will be “scalable.” That apparently means the guidance won’t be written only with
small companies in mind but also will take the concerns of Fortune 500 companies into account.

New Chief Accountant

With more expansive 404 guidance now in the SEC pipeline, Conrad Hewitt, the SEC’s new chief accountant, joins the Commission at a critical time. The post was vacant since
Donald Nicolaisen departed last fall. Hewitt, who had been serving on three corporate board audit committees, had otherwise been retired from a full-time job since 1998,
when he was a California state banking official. From 1972 to 1995, Hewitt was the managing partner of Ernst & Young and its predecessor firm, Ernst & Ernst, in the firm’s
Northern California (1986-1995), Seattle (1979-1986), and Honolulu (1972-1979) regions. In his statement upon joining the SEC, Hewitt noted that he has worked with many of the big accounting firms to implement Sarbanes-Oxley and looks forward to working with the PCAOB
“to maximize the protection of shareholders while eliminating excessive costs and burdens both
here and abroad.”

Bill Would Eliminate Some State Taxation of Corporations

Protests from states and local governments forced House Republican leaders to postpone a floor vote on a bill limiting state taxation of corporations. A spokesman for Rep. John Boehner (R.-Ill.), the House Majority Leader, said, “Some misperceptions about [the bill’s] effect on
states” resulted in the vote being delayed, probably until after the August recess. The bill (H.R. 1956) would establish a national standard for when states can collect business activity taxes from multistate companies whose principal locations are outside the state but who have many
customers within the state. The bill has been strongly supported by companies in the retail, financial, and medical industries. The bill would require companies to have a physical presence in a state for at least 21 days before they could be taxed. But there would be some exceptions. The National Governors Association spooked both Republicans and Democrats in the days prior to the scheduled House floor vote by publicizing a study that projected revenue losses to the states would be nearly double the annual losses of $3 billion by 2011 that the Congressional
Budget Office projected. Besides business activity taxes, states couldn’t levy gross receipts, license, or franchise taxes.