More companies to be exempt from auditor attestation of financial controls

The Securities and Exchange Commission (SEC) is moving full steam ahead on plans to finalize a controversial rule that would exempt more than 500 additional companies from the auditor attestation of financial controls. This attestation is required for most public companies under Section 404(b) of the Sarbanes-Oxley Act of 2002. Several large investor groups oppose expanding the exemption.

Overview

Congress passed Sarbanes-Oxley in response to scandals at Enron, WorldCom and others that cost investors approximately $85 billion. Section 404(b) requires businesses to hire independent auditors to attest to management’s assessment of controls.

For several years, businesses have complained that Section 404(b) is costly yet offers little benefit to investors. They argue that many companies are reluctant to go public partly because of heavy compliance burdens. The SEC under Chairman Jay Clayton’s leadership has been sympathetic to their arguments.

However, investor protection advocates believe that auditor attestation of internal control over financial reporting (ICFR) makes it less likely that management will manipulate the company’s financial results. Moreover, studies have shown that a strong emphasis on internal controls has substantially reduced the risk of material misstatement.

Expanded exemption

Under existing law, nonaccelerated filers — companies with less than $75 million in public float — are exempted from this requirement. Public float is the value of a company’s common stock that is publicly traded.

In May 2019, the SEC issued a proposal that would expand this exemption. If the SEC moves forward with plans to adopt the proposed rule — Release No. 34-85814, Amendments to the Accelerated Filer and Larger Accelerated Filer Definitions — it would benefit low-revenue companies even if the funds raised in the public stock markets aren’t small. Under the existing definitions, accelerated filers have a public float of $75 million to $700 million. Large accelerated filers have a public float of more than $700 million.

The proposal would exclude smaller reporting companies (SRCs) that have annual revenues of less than $100 million from complying with Section 404(b). SRCs have less than $250 million in public float. A company with no public float or with a public float of less than $700 million also would qualify as an SRC if it had annual revenues of less than $100 million during its most recently completed fiscal year. Previously, companies could provide scaled disclosure if they had no public float and less than $50 million in annual revenues.

The potential impact

The SEC estimates that an additional 539 companies would be exempted under the proposed changes, including:

  • 525 companies that are currently classified as accelerated filers (or large accelerated filers that have public float of less than $560 million) that would be newly classified as nonaccelerated filers because they have annual revenues of less than $100 million, and
  • 14 companies that are currently classified as accelerated filers that, despite having revenues of at least $100 million, would be newly classified as nonaccelerated filers because they have a public float of at least $50 million but less than $60 million.

Businesses welcome the proposed changes, arguing that compliance burdens deter some companies from going public. In a comment letter to the SEC, the U.S. Chamber of Commerce said it “has long been concerned that a decline in public companies has created fewer opportunities for American families and businesses.”

In another comment letter, the Biotechnology Innovation Organization (BIO) told the SEC, “The information gained by investors from Section 404(b) compliance does not address what investors are most concerned about, and only serves to divert funds from the company’s progress in bringing their product candidate(s) to market.”

On the flip side, investor protection groups disputed the SEC’s assessment that the benefits will outweigh the costs of increased exemptions. The CFA Institute’s comment letter to the SEC said, “Because research demonstrates the heightened need for attestation of internal controls, investors are likely to price the loss of the internal controls audit in their equity risk premium. In other words, eliminating the attestation requirement may reduce the cash outflow associated with the audit of internal controls, but it is likely to be more than offset by a higher discount rate because of a rise in the equity risk premium required by investors when companies seek capital in the public market.”

Coming soon

The SEC has historically taken two or more years to adopt a controversial rule. However, the SEC under Chairman Clayton has accelerated its rulemaking effort, especially on rules that reduce compliance burdens for companies. In this case, a final rule is expected to be issued by April 2020.