Proposed Rule:
Audit Committee Disclosure
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210, 228, 229, and 240
[Release No. 34-41987; File No. S7-22-99]
RIN 3235-AH83
Audit Committee Disclosure
AGENCY: Securities and Exchange Commission
ACTION: Proposed rule
SUMMARY: The Securities and Exchange Commission is proposing new rules and
amendments to its current rules to improve disclosure related to the functioning
of corporate audit committees and to enhance the reliability and credibility of
financial statements of public companies.
DATES: Public comments are due on or before [insert date 45 days after
Federal Register publication].
ADDRESSES: Please send three copies of your comment letter to Jonathan G.
Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549-0609. Comment letters can be sent electronically to
the following e-mail address: rule-comments@sec.gov. Your comment letter should
refer to File No. S7-22-99; if e-mail is used, please include the file number in
the subject line. Anyone can inspect and copy the comment letters in the
Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, D.C.
20549. Electronically submitted comment letters will be posted on the
Commission's internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Mark Borges, Attorney-Adviser, Division of
Corporation Finance (202-942-2900), Meridith Mitchell, Senior Counselor, Office
of the General Counsel (202-942-0900), or W. Scott Bayless, Associate Chief
Accountant, or Robert E. Burns, Chief Counsel, Office of the Chief Accountant
(202-942-4400).
SUPPLEMENTARY INFORMATION: The Commission is proposing amendments to Rule
10-01 of Regulation S-X,1
Rule 310 of Regulation S-B,2 and Item 7 of
Schedule 14A3 under the Securities Exchange
Act of 1934 (the "Exchange Act").4
Additionally, the Commission is proposing new Item 306 of Regulation S-K5
and Item 306 of Regulation S-B.6
I. Executive Summary
We are proposing new rules and amendments to current rules to improve
disclosure relating to the functioning of corporate audit committees and to
enhance the reliability and credibility of financial statements of public
companies. The proposals are based in large measure on recommendations recently
made by the Blue Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees (the "Blue Ribbon Committee").7
The Blue Ribbon Committee's work was designed to promote quality financial
reporting. Underpinning the Blue Ribbon Committee's work "is the
recognition that quality financial accounting and reporting can only result from
effective interrelationships among" corporate boards, audit committees,
senior and financial management, the internal auditor and the outside auditors.8
Among these corporate participants, the Blue Ribbon Committee's focus was on
improving the effectiveness of corporate audit committees. As the Blue Ribbon
Committee said, the audit committee is "first among equals" in the
financial reporting process9 because it is an
extension of the full board, which is the ultimate monitor of the process.
Audit committees play a critical role in the financial reporting system by
overseeing and monitoring management's and the independent auditors'
participation in the financial reporting process. An audit committee can
facilitate communications between a company's board of directors, its
management, and its internal and independent auditors. A properly functioning
audit committee helps to enhance the reliability and credibility of financial
disclosures.
We have seen a number of significant changes in our markets, such as
technological developments and increasing pressure on companies to meet earnings
expectations,10 that make it ever more
important for the financial reporting process to remain disciplined and
credible.11 We believe that additional
disclosures about a company's audit committee and its interaction with the
company's auditors and management will promote investor confidence in the
integrity of the financial reporting process. In addition, increasing the level
of scrutiny by independent auditors of companies' quarterly financial statements
should lead to fewer year-end adjustments, and, therefore, more reliable
financial information about companies throughout the reporting year.
Accordingly, today's proposals would:
- require that companies' independent auditors review the financial
information included in the companies' Quarterly Reports on Form 10-Q or
10-QSB prior to the companies filing such forms with the Commission (see
Section III.A below);
- require that companies include reports of their audit committees in their
proxy statements; in the report, the audit committee must state whether the
audit committee has: (i) reviewed and discussed the audited financial
statements with management; (ii) discussed with the independent auditors the
matters required to be discussed by Statement on Auditing Standards No. 61,12
as may be modified or supplemented;13 and
(iii) received certain disclosures from the auditors regarding the auditors'
independence as required by the Independence Standards Board Standard No. 1,
as may be modified or supplemented,14 and
discussed with the auditors the auditors' independence (see Section III.B
below);
- require that the report of the audit committee also include a statement by
the audit committee whether, based on such review and discussions, anything
has come to the attention of the members of the audit committee that caused
the audit committee to believe that the audited financial statements
included in the company's Annual Report on Form 10-K or 10-KSB, as
applicable, for the year then ended contain an untrue statement of material
fact or omit to state a material fact necessary to make the statements made,
in light of the circumstances under which they were made, not misleading
(see Section III.B below);
- require that companies disclose in their proxy statements whether their
audit committee has adopted a written charter and, if the audit committee
has adopted a charter, to include a copy of the charter as an appendix to
the company's proxy or information statement at least once every three years
(see Section III.C below);
- require that companies whose securities are quoted on Nasdaq or listed on
the American Stock Exchange ("AMEX") or New York Stock Exchange
("NYSE") disclose in their proxy statements certain information
regarding any director on the audit committee who is not
"independent," as defined in the applicable listing standard;
small business issuers would not be required to comply with this requirement
(see Section III.D below); 15
- require that all other companies, including small business issuers,
disclose in their proxy statements whether, if they have an audit committee,
the members are "independent" within the definition of the
National Association of Securities Dealer's ("NASD"), AMEX's or
NYSE's proposed amendments to their listing standards16
and which definition of independence was used (see Section III.D below); and
- create "safe harbors" for the information required to be
disclosed under the proposals to protect companies and their directors from
certain liabilities under the federal securities laws (see Section III.E
below).
II. Background
Accurate and reliable financial reporting lies at the heart of our
disclosure-based system for securities regulation, and is critical to the
integrity of the U.S. securities markets. Investors need accurate and reliable
financial information to make informed investment decisions. As an increasing
number of investors enter our markets, it is important for us to continue our
efforts to promote the highest quality financial reporting. Investor confidence
in the reliability of corporate financial information is fundamental to
maintaining the liquidity and vibrancy of our markets.
Over the past few years, we have seen dramatic changes in the way investors
receive information and the speed with which information can be and is
disseminated to the market. Market demand for information appears to be at an
all time high as technology makes information available to more people more
quickly. These developments have presented companies with an increasingly
complex set of challenges. One such challenge is that companies are under
increasing pressure to meet earnings expectations.17
Unfortunately, we have begun to see cases in which companies have engaged in
inappropriate "earnings management,"18
the practice of distorting the true financial performance of the company.
Distortions may result from inappropriate earnings management and may undermine
the integrity of financial reporting. As Chairman Levitt has stated, when
inappropriate earnings management occurs, "[i]ntegrity may be losing out to
illusion."19
As a result of the changes in our markets and the increasing demands on
companies, our continuing efforts to maintain the integrity of financial
reporting have gained a sense of urgency. Market changes have highlighted the
importance of strong and effective audit committees. Effective oversight of the
financial reporting process is fundamental to preserving the integrity of our
markets. Audit committees can, and should, be the corporate participant best
able to perform that oversight function.
Audit committees oversee and monitor management and the independent auditors
in the financial reporting process, and thereby play a critical role in assuring
the credibility of financial reporting. Audit committees can facilitate
communications between a company's board of directors, its management, and its
internal and independent auditors on significant accounting issues and policies.
They can provide a forum separate from management in which auditors can candidly
discuss any concerns. By effectively carrying out their many functions and
responsibilities, audit committees help to enhance the reliability and
credibility of financial reports.
Since the early 1940s,20 the Commission,
along with the auditing and corporate communities, has had a continuing interest
in promoting effective and independent audit committees. It was, in large
measure, with the Commission's encouragement, for instance, that the
self-regulatory organizations first adopted audit committee requirements in the
1970s. In 1974 and 1978, the Commission adopted rules requiring certain
disclosures about audit committees.21 In
1980, the Commission issued a staff report on corporate accountability that
addresses some of the issues underlying today's proposals.22
Former SEC Commissioner James Treadway led the National Commission on Fraudulent
Financial Reporting that issued recommendations on corporate audit committees in
1987.23
Most recently, the NYSE and NASD sponsored the Blue Ribbon Committee in
response to "an increasing sense of urgency surrounding the need for
responsible financial reporting given the market's increasing focus on corporate
earnings and a long and powerful bull market."24
Representatives from corporations, the accounting profession, and the
self-regulatory organizations, among others, were members of the Blue Ribbon
Committee. In February 1999, the Blue Ribbon Committee issued ten
recommendations. Several of the recommendations call for action by the
Commission, and the proposals in this release are based in large measure on
those recommendations.
The proposals in this release affirm what have long been considered sound
practice and good policy within the accounting and corporate communities.25
While recognizing that the audit committee's role is "clearly one of
oversight and monitoring," the Blue Ribbon Committee explains its
recommendations as helping to ensure that:
[a] proper and well-functioning system exists . . . [whereby] the three main
groups responsible for financial reporting -- the full board including the audit
committee, financial management including the internal auditors, and the outside
auditors -- form a "three-legged stool" that supports responsible
financial disclosure and active and participatory oversight.26
We recognize that how audit committees function may vary from company to
company, and companies need flexibility to determine all of the specific duties
and functions of their audit committees. In that regard, our proposals do not
tell audit committees what specific duties they must carry out or how to
function. In addition, we are not regulating the substance of the discussions
between the audit committee and management or the independent auditors, and, in
fact, we are not requiring disclosure of the substance of the discussions.
We recognize that many in the corporate community are concerned that
increased disclosure about audit committees may expose audit committee members
to additional liability, may make it more difficult for companies to find good
people willing to serve on audit committees, and may impose added costs on
companies. To address those concerns, some of our proposals differ from the Blue
Ribbon Committee's recommendations. The differences are noted below in the
specific discussions of each proposal. In addition, proposed safe harbors that
address the liability concerns are discussed below in Section III.E.
The Blue Ribbon Committee also made recommendations that call for action by
the NASD, the NYSE, or the AICPA. In response, the NASD and NYSE filed with the
Commission proposed rule changes to their listing standards.27
The significant amendments proposed by the NASD, NYSE, and AMEX are:
- a more demanding definition of "independence" for audit
committee members;
- a requirement that audit committees include at least three members,
comprised solely of "independent" directors who are financially
literate,28 with limited exceptions
(under the NASD's and AMEX's proposed amendments to their listing standards,
small business issuers must establish and maintain an audit committee
composed of at least two members; a majority of the members must be
independent directors);
- a requirement that at least one member of the audit committee has
accounting or related financial management expertise; and
- a requirement that companies adopt a written audit committee charter that
outlines certain specified responsibilities of the audit committee.
Other recommendations are directed at the AICPA. The Blue Ribbon Committee
recommends that generally accepted auditing standards be amended to require that
a company's independent auditors discuss with the audit committee the auditors'
judgments about the quality, and not just the acceptability under generally
accepted accounting principles ("GAAP"), of the company's accounting
principles as applied in the company's financial statements. Similarly, the Blue
Ribbon Committee recommends that Statement on Auditing Standards
("SAS") No. 7129 be modified to
require that the independent auditors discuss with the audit committee, or at
least its chairman, and a representative of financial management, the matters
described in SAS 6130 prior to the company
filing its Quarterly Report on Form 10-Q or 10-QSB (and preferably prior to any
public announcement of financial results), including significant adjustments and
accounting estimates, significant new accounting policies and disagreements with
management.
III. The Proposals
A. Pre-Filing Review of Quarterly Financial Statements
Under current Commission rules, a company's interim financial statements
contained in its Quarterly Reports on Form 10-Q or 10-QSB need not be reviewed
or audited by independent auditors prior to the company filing such forms with
the Commission.31 We propose to amend Rule
10-01(d) of Regulation S-X and Item 310(b) of Regulation S-B to require that a
company's interim financial statements be reviewed by an independent public
accountant prior to the company filing its Form 10-Q or 10-QSB with the
Commission. The amendments would require that independent auditors follow
"professional standards and procedures for conducting such reviews, as
established by generally accepted auditing standards, as may be modified or
supplemented by the Commission." Under current auditing standards, this
means that the auditors would be required to follow the procedures set forth in
SAS 71, or such other auditing standards that may in time modify, supplement, or
replace SAS 71. Consistent with current rules, we are not proposing to require
that interim financial statements be audited.32
Under current Commission rules, if a company discloses in its filings with
the Commission that an independent auditor has performed a review of interim
financial statements, it must file a copy of the auditor's report.33
We are not proposing to modify that requirement.34
Investors and other users of financial statements rely on, and react quickly
to, quarterly results. Quarterly financial reporting, however, has never been
subject to the same discipline that is applied to annual financial reporting.
Interim financial results are not required to be audited or reviewed by an
independent auditor. It is commonplace, however, for financial analysts to set
quarterly earnings expectations for companies that they follow.35
The consequence of a company failing to meet or exceed these expectations may,
in some cases, result in a precipitous decline in its stock price. As a result,
companies may be experiencing increasing pressure to "manage" interim
financial results. Accordingly, inappropriate earnings management could be
deterred by imposing more discipline on the process of preparing interim
financial information before filing such information with the Commission.36
The reviews required by our proposal should facilitate early identification
and resolution of material accounting and reporting issues because the auditors
will be involved earlier in the year. This is particularly important because
interim financial information generally may include more estimates than annual
financial statements.37 Early involvement
of the auditors should reduce the likelihood of restatements or other year-end
adjustments.
We understand that the five largest U.S. accounting firms and others have
each recently adopted policies to require that their clients have reviews of
quarterly financial statements as a condition to acceptance of the audit.38
Consequently, those firms already have implemented our proposed requirement for
the companies that are audited by those firms.
We request comment on the need for independent auditors to review interim
financial statements before they are filed with the Commission. Will interim
reviews result in more reliable and credible interim financial statements? Will
the involvement of independent auditors at quarterly intervals result in fewer
restatements of Forms 10-Q and 10-QSB as a result of a year-end audit? What
other benefits will be achieved? What will be the additional cost to registrants
if the Commission requires interim reviews? Will having the auditors perform
quarterly reviews shift some of the work away from the year-end audit, and
therefore, result in lower year-end audit fees? What other ways can we enhance
the quality and reliability of interim reporting?
We request comment on whether any modifications to SAS 71 are needed. For
example, is there some formulation that would provide flexibility yet ensure
that interim reviews meet objective minimum standards? In light of the proposed
changes, are any modifications to Item 302(a) of Regulation S-K needed? For
example, should we amend Item 302(a) to require all public companies to provide
supplemental financial information?39
We also request your comments on the scope of the proposed requirement.
Should the requirement apply to all public companies or only certain size public
companies? If only certain size companies, what size and why? Should the
requirement apply not only to interim financial statements contained in
quarterly reports, but those contained in registration statements under the
Securities Act of 1933 ("Securities Act") and Exchange Act as well?
Should we require that interim reviews be completed prior to quarterly
"earnings releases," when a company releases to the public financial
results before the Form 10-Q or 10-QSB is filed?
The Commission recently proposed a requirement providing for the filing of
quarterly financial results on Form 8-K if released prior to the deadline for
filing the Quarterly Report on Form 10-Q or 10-QSB.40
We also solicited comment on whether to shorten the filing deadline for Form
10-Q and 10-QSB. If we adopt those changes, how would that affect your overall
view of these proposals?
Should we require that a report on the independent auditors' review be filed?
41 If so, what liability should attach to
the report?42 Should the report clearly set
forth the scope of the review procedures and degree of reliance that can be
placed on the report? Would the inclusion of a report benefit investors?
We request your comments on whether we should require companies to disclose
whether the quarterly financial statements have been reviewed by independent
auditors. The Blue Ribbon Committee recommends that SAS 71 be amended to require
that audit committees discuss with the auditors the matters covered in SAS 61,
including significant adjustments, management judgments and accounting
estimates, significant new accounting policies and disagreements with
management, prior to the filing of the Form 10-Q.43
If SAS 71 is not amended as recommended by the Blue Ribbon Committee, should the
Commission consider any other changes to its rules, such as to require
disclosure about particular discussions between the audit committee and the
auditors prior the company filing its Form 10-Q or 10-QSB? Should we continue to
permit companies to decide whether to disclose that the independent auditors
have performed the review but eliminate the requirement to file the review
report if such disclosure is made?
B. The Audit Committee Report
Proposed new Item 306 of Regulations S-K and S-B and Item 7(e)(3) of Schedule
14A would require that the audit committee provide a report in the company's
proxy statement (or information statement) disclosing whether the audit
committee has reviewed and discussed the audited financial statements with
management and discussed certain matters with the independent auditors.44
Specifically, under paragraphs (a)(1), (a)(2), and (a)(3) of proposed Item 306
(paragraph (a)(4) is discussed separately, below), audit committees would be
required to state whether:
(1) the audit committee has reviewed and discussed the audited financial
statements with management;
(2) the audit committee has discussed with the independent auditors the
matters required to be discussed by SAS 61, as may be modified or supplemented;45
and
(3) the audit committee has received the written disclosures and the letter
from the independent auditors required by ISB Standard No. 1, as may be modified
or supplemented, and has discussed with the auditors the auditors' independence.
If the company does not have an audit committee, the board committee tasked
with similar responsibilities, or the full board of directors, would be
responsible for the disclosure.
Proposed paragraphs (a)(1), (2), and (3) of Item 306 would require audit
committees to disclose whether the review and discussions took place and whether
the letter and disclosures were received. The proposals would not require audit
committees to perform the review and have the discussions. The proposed
amendments would not require audit committees to take specific actions or adopt
specific procedures. We are not proposing to require disclosure of the details
of deliberations between or among the audit committee members, independent
auditors, and management.46
The required disclosure will help inform shareholders of the audit
committee's oversight with respect to financial reporting, and underscore the
importance of the audit committee's participation in the financial reporting
process. The proposed language of paragraphs (a)(1) and (a)(2) is similar to the
language recommended by the Blue Ribbon Committee. Moreover, the language is
consistent with the Blue Ribbon Committee's recommendation to the AICPA that it
amend SAS 61.47
The disclosure required by paragraph (a)(3) relates to written disclosures, a
letter from the independent auditors, and discussions between the audit
committee and the independent auditors required by ISB Standard No. 1. The
Commission has long recognized the importance of auditors being independent from
their audit clients.48 Public confidence in
the reliability of a company's financial statements depends on investors
perceiving the company's auditors as maintaining integrity and objectivity,
being without conflicting interests with audit clients, and exercising
independent judgment. Accordingly, we think that investors will benefit from the
proposed disclosures.
Paragraph (a)(4) of the proposed rule would require the audit committee to
state in the audit committee's report to be included in the company's proxy
statement whether, based on the review and discussions described in paragraphs
(a)(1) through (a)(3), anything came to the attention of the members of the
audit committee that caused the audit committee to believe that the audited
financial statements included in the company's Annual Report on Form 10-K or
10-KSB, as applicable, for the year then ended contain an untrue statement of
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which they were made, not misleading.
We believe that this proposed amendment would reinforce the audit committee's
awareness and acceptance of its responsibilities, and make visible for investors
the audit committee's role in promoting reliable and transparent financial
reporting.
The proposed language of paragraph (a)(4) differs from the Blue Ribbon
Committee's recommendation.49 Concerns have
been expressed that the language in the Blue Ribbon Committee's recommendation
is a GAAP "certification" that implicitly would require that the audit
committee know all of the nuances of GAAP. We have modified the Blue Ribbon
Committee's language to address that concern. In performing its oversight
function, the audit committee likely will be relying on advice and information
that it receives in its discussions with management and the independent
auditors. Accordingly, the proposed language acknowledges that the audit
committee will be forming its belief based on the discussions with management
and the auditors, but also focuses members of the audit committee on their role
in the financial reporting process. The statement that "nothing came to the
attention of the audit committee members," when combined with the need for
a sound internal reporting system, discussed below, is intended to encourage
audit committees to "ask tough questions of management and outside
auditors"50 to serve the interests of
investors.
This approach is consistent with state corporation law that permits board
members to rely on the representations of management and the opinions of experts
retained by the corporation.51 The Blue
Ribbon Committee noted the "impracticability of having the audit committee
do more than rely upon the information it receives, questions, and assesses in
making this disclosure."52
Some have expressed concerns that requiring a report from the audit committee
will result in increased exposure to liability for the audit committee members.
We do not believe that improved disclosure about the audit committee and
increased involvement by the audit committee should result in increased exposure
to liability. Under state corporation law, the more informed the audit committee
becomes through its discussions with management and the auditors, the more
likely that the "business judgment rule" will apply and provide broad
protection.53
Under both state corporation law and the federal securities laws, if the
audit committee's discussions with management and the independent auditors
become part of the financial reporting process and are used to form a belief
about the financial statements, the likelihood increases substantially that the
audit committee's decisions about the financial statements and other matters
will be protected.54 Those discussions
should serve to strengthen the "information and reporting system" that
should be in place.55 Adherence to a sound
process should result in less, not more, exposure to liability.56
Finally, we believe that the proposed requirement of paragraph (a)(4) is
consistent with our view that by signing documents filed with the Commission,
board members implicitly indicate that they believe that the filing is accurate
and complete. In this regard, we believe that the proposed rule is consistent
with current rules requiring board members to sign the company's Annual Report
on Form 10-K or 10-KSB57 and our recent
proposals to amend the signature sections of Exchange Act and Securities Act
reports.58 As the Commission recently
stated: "When the public sees a corporate official's signature on a
document, it understands that the official is thereby stating that he believes
that the statements in the document are true."59
Proposed paragraph (b) of Item 306 would require that the new disclosure
appear over the printed names of each member of the audit committee.60
The requirement should help to emphasize the importance of the audit committee's
role to shareholders. We do not propose to require that audit committee members
provide individual signatures.
We request your comments on whether the proposed disclosure would provide
useful information to shareholders, and would reinforce the audit committee's
awareness and acceptance of its responsibilities. While the amendments are not
designed to elicit disclosure about the substance of the audit committee's
deliberations, would they nonetheless result in meaningful disclosure? Should we
instead require more complete disclosure about the activities, processes and/or
discussions of the audit committee, such as by requiring the committee to
identify the significant accounting issues it considered and/or discussed with
management and the independent auditors and the conclusions reached about those
issues? Should we require further disclosures about the basis for the audit
committee's belief about the financial statements?
Would the proposed rule's purposes be served if we required less disclosure
about the audit committee than proposed? Are all of the requirements necessary?
For example, should we merely supplement Item 7(e) to require the company to
disclose more generally whether the audit committee has met with management and
the independent auditors to discuss significant accounting issues that developed
in preparing the financial statements? Is the disclosure about discussions with
management sufficient? For example, the Blue Ribbon Committee recommends that
the audit committee be required to state whether they discussed with management
certain of the accounting matters that the audit committee must discuss with the
auditors under SAS 61. Should we require that disclosure?
We request comment on alternative formulations of paragraph (a)(4) of
proposed Item 306. We are considering an alternative formulation, for example,
that would require the audit committee to state whether, based on the review and
discussions with management and auditors, the audit committee is aware of any
material modifications that should be made to the audited financial statements,
and to state whether the audit committee recommended to the Board that the
audited financial statements be included in the company's Annual Report on Form
10-K or 10-KSB (as applicable) filed with the Commission. Another possible
formulation has been suggested by Ernst & Young.61
Will those formulations achieve the intended objectives?
Should we require more disclosure about the auditors' independence? For
example, should we require disclosure about the substance of the discussions
between the audit committee and the auditors regarding the auditors'
independence?
We request your comments on whether the requirement of proposed paragraph (b)
of Item 306 would effectively encourage audit committee members to focus on the
specific disclosure obligation. Would the purpose be served more effectively if
we required individual signatures?
We request your comments on whether the proxy statement/information statement
is the appropriate place for the proposed new disclosure. We propose to include
the disclosure in the proxy materials because we believe that the disclosure may
have a direct bearing on shareholders' voting decisions, and because the proxy
or information statement is actually delivered to shareholders and is accessible
on the SEC's web site. In addition, we are proposing that the disclosure only be
provided in a proxy or information statement relating to an annual meeting of
shareholders at which directors are to be elected (or special meeting or written
consents in lieu of such meeting). We are not proposing to include the new
disclosure in the annual report to shareholders62
because that document is not accessible electronically on our web site, though
under our rules it must be sent to every shareholder.63
The Blue Ribbon Committee, however, recommends that the disclosure be
included in the company's Annual Report on Form 10-K and annual report to
shareholders. Should we instead, or additionally, include the information in one
or both of those documents? Should the disclosure be required only when the
proxy or information statement relates to an election of directors? Should the
disclosure only be required to be provided one time during the year (e.g., in a
proxy statement for an annual meeting at which directors are to be elected, but
not in proxy solicitation material used in a subsequent election contest during
that same year)? What are the implications, if any, if the proxy statement that
includes the audit committee's report is of a later date than the date the Form
10-K is filed? Is it feasible for audit committees' reports to be included in
proxy statements given the timing of the distribution of proxies and the
completion of audit procedures and other events that must occur before the audit
committee report may be finalized?
There may be companies, such as companies registered under Section 15(d)64
of the Exchange Act, that are not required to prepare proxy statements. Should
we require those companies to provide the disclosures in another filing, such as
in the Form 10-K or 10-KSB? Would we need to provide a safe harbor for the
disclosures by those companies? If we do not make the requirement applicable to
Section 15(d) companies, should we keep the text of the new requirement in
Regulation S-K or, for example, move it into Item 7 of Schedule 14A?
C. Audit Committee Charters
We are proposing to require companies to disclose in their proxy statements
or information statements whether their audit committee is governed by a
charter. In addition, if the audit committee has a charter, a copy of the
charter would have to be included as an appendix to the proxy or information
statement at least once every three years. The new requirement would appear in
new paragraph (e)(3) under Item 7 of Schedule 14A.
The new disclosure should help shareholders assess the role and
responsibilities of the audit committee, and help focus committee members on
their responsibilities as expressed in the charter. We believe that audit
committees that have their responsibilities set forth in written charters are
more likely to play an effective role in overseeing the company's financial
reports.
The Blue Ribbon Committee recommends that the audit committee state whether
it has satisfied its responsibilities during the prior year in compliance with
its charter. We are concerned that requiring a statement about compliance with
the charter may have the undesired effect of encouraging skimpy, broadly-worded
and vague committee charters to minimize the audit committee members' exposure
to liability. Accordingly, we are not proposing to require any statements about
whether the audit committee has complied with the charter. The proposed
amendments would not require companies to adopt audit committee charters, or
dictate the content of the charter if one is adopted.65
Should we require companies to disclose whether they have adopted an audit
committee charter, but not require that the charter be attached as an appendix
to the proxy statement? In that case, we ask you to consider whether we should
require a plain English summary of the charter's material terms, rather than a
copy of the entire charter. Would such a disclosure requirement result in
boilerplate disclosures? Is the charter itself useful information for investors?
Should we require the audit committee to disclose whether it has complied
with its charter, as recommended by the Blue Ribbon Committee? We could require,
for example, that the audit committee state whether it has complied in all
material respects with the charter. Would a materiality threshold be
appropriate, or some other threshold, such as compliance in all significant or
substantive respects? We request your comments on whether we should instead
require disclosure about any material deviations by the audit committee from
their charter obligations. We request your comments on whether a requirement to
disclose compliance with an audit committee charter will have the undesired
effect of encouraging skimpy, broadly-worded and vague committee charters. If
any such disclosure is required, would we need to provide a safe harbor from
liability for that disclosure? If so, what kind of safe harbor is needed?
Is requiring that the charter be attached as an appendix every three years
the appropriate time frame? Should we require that it be attached as an appendix
more frequently or less frequently?66
Should we require that the charter also be attached as an appendix when there
has been a material or substantive -- or any -- change in the charter?
Should we require reporting companies whose securities are not listed on the
NYSE or AMEX or quoted on Nasdaq to disclose whether they have a charter? If
these companies do not have a charter, should we require disclosure of the
operative document of the audit committee (articles of incorporation, by-laws,
etc.) or the material terms of the document? If so, should those documents be
filed once every three years or some other interval? If a company does not have
a charter or similar document, should we require disclosure of that fact?
Finally, we seek comments on whether the disclosure is properly included in
the proxy or information statement, as proposed, or whether the disclosure
should be included alternatively, or additionally, in another document, such as
the annual report to shareholders, or the Annual Report on Form 10-K or 10-KSB.
D. Disclosure About "Independence" of Audit Committee Members
As early as 1940, the Commission encouraged the use of audit committees
composed of independent directors.67 As the
Commission staff stated in a report to Congress in 1978, "[i]f the [audit]
committee has members with vested interests related to those of management, the
audit committee probably cannot function effectively. In some instances this may
be worse than having no audit committee at all by creating the appearance of an
effective body while lacking the substance." 68
Further, as the Blue Ribbon Committee noted, ". . . common sense dictates
that a director without any financial, family, or other material personal ties
to management is more likely to be able to evaluate objectively the propriety of
management's accounting, internal control and reporting practices."69
In response to the Blue Ribbon Committee's recommendations, the NYSE, AMEX,
and NASD have proposed amendments to their respective listing standards
regarding, among other things, the "independence" of all audit
committee members. The NYSE's, AMEX's, and NASD's proposed rule changes would
provide a narrowly tailored exception to a requirement that all members of the
audit committee be independent. Specifically, the NYSE, AMEX, and NASD have
proposed that, under exceptional and limited circumstances, one director who is
not independent may be appointed to the audit committee if the Board determines
that membership on the committee by the individual is required by the best
interests of the corporation and its shareholders, and the Board discloses, in
the next annual proxy statement subsequent to such determination, the nature of
the relationship and the reasons for that determination.
Because of the importance of having an audit committee that is comprised of
independent directors, we believe that shareholders should know when a director
who is not independent is a member of an audit committee. We are proposing to
require that companies whose securities are not listed on the NYSE or AMEX or
quoted on Nasdaq, including small business issuers, disclose in their proxy
statements whether, if they have an audit committee, the members are
"independent" within the definition of the NYSE's, AMEX's, or NASD's
proposed amendments to their listing standards. We are also proposing rules to
require that for companies whose securities are listed on the NYSE or AMEX or
quoted on Nasdaq, if the company's board determines in accordance with the
proposed amendments to Section 303.02(D) of the NYSE's listing standards,
Section 121(B)(b)(ii) of the AMEX's listing standards, or Sections
4310(c)(26)(B)(ii) or 4460(d)(2)(B) of the NASD's listing standards, as
applicable and as may be modified or supplemented, to appoint one director to
the audit committee who is not independent (as independence is defined in
Sections 303.01(B)(2)(a) and (3) of the NYSE's listing standards, Section 121(A)
of AMEX's listing standards or Section 4200(a)(15) of the NASD's listing
standards, as applicable and as may be modified or supplemented), the company
must disclose the nature of the relationship that makes that individual not
independent and the reasons for the board's determination. Small business
issuers are not required to comply with this requirement.70
We request comment on whether the disclosures will help inform investors
about the independence of the audit committee. If the proposed amendments to the
NYSE's, AMEX's, and NASD's listing standards are not adopted, are there
disclosures that we could require that would achieve the same purposes? Is the
proposed requirement to disclose the nature of the relationship of the director
who is not "independent" and the basis for the Board's determination
specific enough, or will the requirement result in boilerplate disclosure?
Companies whose securities are not listed on the NYSE or AMEX or quoted on
Nasdaq would be able to choose which definition of "independence" to
apply to the audit committee members in making the disclosure. Whichever
definition is chosen must be applied consistently to all members of the audit
committee. Should we require small business issuers to comply with the
requirement to disclose the nature of the relationship that makes the individual
not independent? Will permitting companies to choose which definition to apply
confuse investors in comparing companies? Should we instead mandate which
definition should be used, and if so, which definition?
E. Proposed Safe Harbors
In making these proposals, we do not intend to subject companies or their
directors to increased exposure to liability under the federal securities laws,
or to create new standards for directors to fulfill their duties under state
corporation law. We do not believe that the disclosure requirements will result
in increased exposure to liability. To the extent the proposed disclosure
requirements would result in more clearly defined procedures for, and disclosure
of, the operation of the audit committee, liability claims alleging breach of
fiduciary duties under state law actually may be reduced.
We recognize that, notwithstanding the audit committee's critical oversight
role of the financial reporting process and financial statements, management
ultimately has responsibility for the company's financial statements. As
discussed above in Section III.B regarding the audit committee's report, the
proposed disclosure requirements differ from the Blue Ribbon Committee's
recommendations in response to liability concerns. In addition, we propose to
follow the Blue Ribbon Committee's recommendation to adopt liability "safe
harbors" to cover the new disclosures.71
The "safe harbors" would track the treatment of compensation committee
reports under Item 402 of Regulation S-K,72
and would appear in proposed paragraph (c) in new Item 306 of Regulations S-K
and S-B and in proposed paragraph (e)(v) of Schedule 14A. Under the "safe
harbors," the additional disclosure would not be considered
"soliciting material," "filed" with the Commission, subject
to Regulation 14A or 14C or to the liabilities of Section 18 of the Exchange
Act, except to the extent that the company specifically requests that it be
treated as soliciting material, or specifically incorporates it by reference
into a document filed under the Securities Act or the Exchange Act.73
We request your comments on whether we should adopt these proposed liability
"safe harbors" to cover the information disclosed under the proposed
amendments. Is a safe harbor necessary?
Should the safe harbors apply to all of the required disclosures or only
certain of the disclosures? Is a safe harbor needed for factual statements? For
example, is a safe harbor needed for the disclosure regarding whether the audit
committee has discussed with the auditors the auditors' independence and
received the written disclosures and letter from the auditors when these
disclosures are factual in nature? Is the scope of the safe harbor appropriate?
IV. Request for Comments
We request your comments on the proposals, other matters that may have an
impact on the proposals, and your suggestions for additional changes. In
addition to the specific questions raised in Section III above, we request your
comment on the matters discussed below.
First, the proposals generally do not distinguish between a Fortune 500
company and a small start-up company reporting on small business forms.74
We request your comment on whether the scope of one or more of the proposed new
requirements should be narrowed to exclude companies under a certain size. If
so, should we exclude companies considered under the Commission's rules to be
"small business issuers" (companies that have revenues and public
float of less than $25 million)? The Commission has proposed to revise the
definition of small business issuer to include companies with less than $50
million in annual revenues, and to delete the public float portion of the test.75
If that proposal were adopted, would that affect your view on the applicability
of today's proposals to small companies? Should there be a higher cutoff, such
as $100 million or $200 million public float and/or revenues? If there should be
a different standard, should it be based on additional or alternative criteria,
such as total assets or reporting history?
The Blue Ribbon Committee's recommendations directed to the Commission are
silent on whether to apply the requirements to all companies, regardless of
size. In preparing your comments, you should consider whether the proportionate
cost of complying with some of the proposals may be greater for smaller
companies than for larger ones. You should also consider, however, that one
recent study found that the incidence of financial fraud at smaller companies
may be greater than at larger companies.76
We also request your comments on whether any or all of the proposals should
apply to investment companies registered under the Investment Company Act of
1940. The proposals for requiring audit committee disclosure as currently
formulated would only apply to closed-end funds. As we discussed above, our
proposals are intended to work in conjunction with the listing standards of the
NYSE, AMEX, and the NASD that would impose requirements on companies for their
audit committees. Because mutual funds are not subject to the listing standards
of an exchange or a national securities association that require companies to
have audit committees, the Commission has not included those funds in the
proposals at this time.77 We also request
your comments on whether interim financial statements of closed-end funds should
be reviewed by independent auditors before being sent to shareholders.78
The proposals would not apply to "foreign private issuers," which
are exempt from the proxy rules, and which are not required to file Quarterly
Reports on Form 10-Q or 10-QSB.79 We
request your comments on whether any one or more of our proposed amendments
should apply to "foreign private issuers."
V. Paperwork Reduction Act
Certain provisions of the proposed amendments to Regulations 14A, 14C, S-X,
S-B, and S-K contain "collection of information" requirements within
the meaning of the Paperwork Reduction Act of 1995 (44 U.S.C. § 3501 et seq.),
and the Commission has submitted proposed revisions to those rules to the Office
of Management and Budget ("OMB") for review in accordance with 44
U.S.C. § 3507(d) and 5 CFR 1320.11. The titles for the collections of
information are: (1) "Proxy Statements -- Regulation 14A (Commission Rules
14a-1 through 14a-15) and Schedule 14A;" (2) Information Statements --
Regulation 14C (Commission Rules 14c-1 through 14c-7 and Schedule 14C); (3)
Regulation S-X; (4) Regulation S-B; and (5) Regulation S-K.80
An agency may not conduct or sponsor, and a person is not required to respond
to, a collection of information unless it displays a currently valid control
number.
Schedule 14A (OMB Control No. 3235-0059)81
and Schedule 14C (OMB Control No. 3235-0057)82
were adopted pursuant to Sections 14(a) and 14(c) of the Exchange Act. Schedule
14A prescribes information that a company must include in its proxy statement to
ensure that shareholders are provided material information relating to voting
decisions. Schedule 14C prescribes information that a company must include in
its information statement under those circumstances.
The Commission currently estimates that Schedule 14A results in a total
annual compliance burden of 173,906 hours. The burden was calculated by
multiplying the estimated number of entities filing Schedule 14A annually
(approximately 9,892) by the estimated average number of hours each entity
spends completing the form (approximately 13 hours).83
The Commission currently estimates that Schedule 14C results in a total annual
compliance burden of 4,448 hours. The burden was calculated by multiplying the
estimated number of entities filing Schedule 14C annually (approximately 253) by
the estimated average number of hours each entity spends completing the form
(approximately 13 hours). The Commission based the number of entities that would
complete and file each of the forms on the actual number of filers during the
1998 fiscal year. The staff estimated the average number of hours each entity
spends completing each of the forms by contacting a number of law firms and
other persons regularly involved in completing the forms. Regulations S-X, S-K,
and S-B do not impose reporting burdens directly on public companies. For
administrative convenience, each of these regulations is currently assigned one
burden hour. Although these regulations set forth disclosure requirements, the
burden associated with the requirements is reflected in the forms and schedules
that refer to those regulations.
We believe that the proposed amendments will bolster investor confidence in
the securities markets by informing investors about the important role that
audit committees play in the financial reporting process and enhance the
reliability and credibility of financial statements of public companies. The
proposed amendments would require companies to include additional disclosure in
Schedules 14A and 14C, including certain information about the company's audit
committee. The audit committee would be required to disclose whether the audit
committee had certain discussions with management and the company's auditors.
The substance of the discussions would not be required to be disclosed. The
proposed amendments would also require companies that have adopted a written
charter to include a copy of the charter as an appendix to Schedules 14A and 14C
at least once every three years. The amendments do not require a company to
prepare a charter. We estimate that, on average, the additional disclosure would
require approximately one additional burden hour per filing, whether on Schedule
14A or 14C. Accordingly, the proposed amendments, if adopted, would result in an
aggregate of 9,892 additional burden hours for Schedule 14A annually, and an
aggregate 253 additional burden hours for Schedule 14C annually. We request your
comments on the accuracy of our estimates.
Compliance with the disclosure requirements is mandatory. There would be no
mandatory retention period for the information disclosed, and responses to the
disclosure requirements will not be kept confidential.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments to: (i)
evaluate whether the proposed collection of information is necessary for the
proper performance of the functions of the agency, including whether the
information will have practical utility; (ii) evaluate the accuracy of the
Commission's estimate of the burden of the proposed collection of information;
(iii) determine whether there are ways to enhance the quality, utility, and
clarity of the information to be collected; and (iv) evaluate whether there are
ways to minimize the burden of the collection of information on those who are to
respond, including through the use of automated collection techniques or other
forms of information technology.
Persons submitting comments on the collection of information requirements
should direct the comments to the Office of Management and Budget, Attention:
Desk Officer for the Securities and Exchange Commission, Office of Information
and Regulatory Affairs, Washington, D.C. 20503, and should send a copy to
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth
Street, N.W., Washington, D.C. 20549-0609, with reference to File No. S7-22-99.
Requests for materials submitted to OMB by the Commission with regard to these
collections of information should be in writing, refer to File No.S7-22-99, and
be submitted to the Securities and Exchange Commission, Records Management,
Office of Filings and Information Services. OMB is required to make a decision
concerning the collection of information between 30 and 60 days after
publication of this release. Consequently, a comment to OMB is assured of having
its full effect if OMB receives it within 30 days of publication.
VI. Cost-Benefit Analysis
The proposed amendments should improve disclosure related to the functioning
of the corporate audit committees. We believe that the proposed amendments will
bolster investor confidence in the securities markets by informing investors
about the important role that audit committees play in the financial reporting
process and enhance the reliability and credibility of financial statements of
public companies. As the Blue Ribbon Committee summarized:
Improving oversight of the financial reporting process necessarily involves
the imposition of certain burdens and costs on public companies. Despite these
costs, the Committee believes that a more transparent and reliable financial
reporting process ultimately results in a more efficient allocation of and lower
cost of capital. To the extent that instances of outright fraud, as well as
other practices that result in lower quality financial reporting, are reduced
with improved oversight, the benefits clearly justify these expenditures of
resources.84
Reviews of Quarterly Financial Statements
We propose to require interim reviews of quarterly financial statements filed
on Form 10-Q or 10-QSB.85 Under the
proposed amendments, the company's quarterly financial statements would have to
be reviewed by independent auditors using "professional standards and
procedures for conducting such reviews, as established by generally accepted
auditing standards, as may be modified or supplemented by the Commission."
Currently, that means that the review would follow the procedures established by
SAS 71. The proposed amendments apply only to the financial information
contained in the company's quarterly report on Form 10-Q or 10-QSB. Accordingly,
it would not impose any requirements on quarterly financial information that may
be released to the public before the filing of the Form 10-Q or 10-QSB, such as
the so-called quarterly "earnings release."
We believe that companies are under increasing pressure to meet financial
analysts' expectations, and that pressure can be even more acute in the context
of reports on quarterly earnings. We believe that the participation of auditors
in the financial reporting process at interim dates will help to counterbalance
that pressure and impose increased discipline on the process of preparing
interim financial information. Auditor involvement in the financial reporting
process earlier in the year should facilitate timely identification and
resolution of significant and sensitive issues and result in fewer year-end
adjustments, which should reduce the cost of annual audits. The increased focus
and discipline imposed on the preparation of interim financial statements should
enhance the efficiency of the capital markets by improving the reliability of
quarterly financial statements.
We do not currently have sufficient information to quantify these or other
potential benefits. We, therefore, request your comments, including supporting
data, on the degree to which the proposal is likely to improve the reliability
of interim financial reporting.
The five largest U.S. accounting firms, the so-called "Big 5," and
some other firms, currently have in place policies that require that their
clients have interim reviews as a condition to acceptance of an audit. The
firms' adoption of these policies, and the acceptance of them by their clients,
indicates that the value of these reviews justifies the associated costs.
Based on the staff's review of the Compustat database containing auditor
information for about 8,600 companies for calendar year 1997, we estimate that
approximately 75% of public companies (about 6,450) are clients of the Big 5
accounting firms, and that approximately 25% (or 2,150) are audited by other
accounting firms. We request your comments on the accuracy of those estimates,
including supporting data. Some of those 2,150 companies are audited by firms
that have quarterly review policies similar to those of the Big 5 firms.
Based on the data provided to staff by the SEC Practice Section of the AICPA
("SECPS"), we estimate the incremental cost to conduct a SAS 71 review
will be nominal for those companies currently audited by the Big 5 firms and for
the remaining companies would range from approximately $1,000 to about $4,000
per quarter. The total cost of upgrading for all companies audited by non-Big 5
accounting firms would be approximately $16 million per year. We request your
comments and supporting empirical data on the accuracy of these estimates and
conclusions.
Firms providing information to the SECPS indicated that the procedures they
currently use are similar, if not the same, as those described in SAS 71. Most
indicated that review reports are seldom issued. The firms also indicated that
they are not aware of (and do not expect) clients switching auditing firms
because of their new policies.
The firms providing information to the SECPS identified several benefits that
they believe would result from the reviews, including better interim reporting,
earlier identification and resolution of accounting issues, improvement in the
quality of accounting estimates, and improved communications between clients and
auditors. Medium and smaller sized accounting firms, however, indicated to the
SECPS that SAS 71 reviews of small companies' interim financial statements may
cause delays in filing Forms 10-Q or 10-QSB, be relatively more costly for small
companies, be hampered by inadequate financial reporting processes, and would
result in small companies shifting work from the company to the CPA firm.
The firms generally indicated, however, that the costs of reviews of
quarterly financial statements vary depending on several factors, including: (i)
the sophistication of the client's accounting and reporting system; (ii) the
quality of the client's accounting personnel; (iii) the identification of
"fraud risk factors;" (iv) the client's industry; (v) the number and
location of the client's subsidiaries; (vi) the seasonality of the client's
business; (vii) the existence of contentious accounting issues; and (viii)
whether there will be a staffing "crunch" at the firm to handle the
reviews each quarter.
Approximately half of the firms consulted believed that the cost of the
reviews would be offset, in part, by a reduction in the annual audit fee,
although the amount of the reduction in audit fees may vary based on, among
other things, the performance of substantive audit procedures during the review,
whether the review results in the client having better internal accounting and
reporting controls, and how the results of the review impact planning for the
annual audit. Because the cost of reviews would be only partially offset by a
reduction of year-end audit fees, overall audit and review fees paid by the
company to the auditors would increase.
Disclosure Related to the Functioning of the Audit Committee
The principal benefits of the proposals are improved disclosure relating to
the functioning of corporate audit committee and enhanced reliability and
credibility of financial statements. The benefits of improved disclosure
regarding the audit committee's communications are not readily quantifiable. We
believe, however, that they would include increased market efficiency due to
improved information and investor confidence in the reliability of companies'
financial disclosures. We request your comments and empirical data on whether
the improved disclosure will have that result.
We believe the costs associated with this proposal would derive principally
from the corresponding disclosure obligations; this is because we are not
placing any substantive requirements on audit committees or their members. Based
on the staff's experience with proxy and information statements, and analogous
cost estimates, we believe that the additional disclosure contemplated by the
proposed amendments would, on average, require approximately three-fourths of a
page in a company's proxy or information statement. A financial printing company
informed the staff that adding up to three-fourths of a page in the proxy
statement would not likely increase the printing cost to the company. That is
because up to an extra three-fourths of a page can normally be incorporated
without increasing the page length by reformatting the document. The printer
reported that adding more than three-fourths of a page could increase costs by
about $1,500 for an average sized company. Accordingly, based on our preliminary
estimates, there should be little, if any, additional printing costs from these
additional disclosures. We seek your comments on the accuracy of these cost
estimates, and we ask you to submit cost data to support your analysis.
We believe, however, that disclosure required by the proposed amendments
could result in other costs. First, some companies may be required to set up
procedures to monitor the activities of the audit committee in order to collect
and record the information required by the proposed amendments. In our view,
such monitoring costs are most likely to result from the proposed disclosure of
the audit committee's discussions with management and the independent auditors
and receipt of disclosures and a letter from the independent auditors.
Second, some companies may seek the help of outside experts, particularly
outside legal counsel, in formulating responses to the new requirements. In some
circumstances, for instance, the audit committee may seek the advice of legal
counsel before making the required disclosure about the audited financial
statements. We request your comments, including supporting data, on the
magnitude of these costs and any other costs that we may not have mentioned.
For purposes of the Paperwork Reduction Act, we estimate that our proposed
disclosures would, on average, impose one additional burden hour on each filer
of Schedule 14A or 14C, or an aggregate annual total of 15,445 additional burden
hours. That estimate is based on current burden hour estimates and the staff's
experience with such filings. We further estimate that approximately 75% of the
extra burden hours, or 11,584 hours, will be expended by companies' internal
staff, and the remaining 25%, or 3,861 hours, by outside professional help.86
These percentage estimates, which are based on current burden hour estimates and
the staff's experience with such filings, reflect the time companies would spend
preparing the additional disclosures in the proxy statement or information
statement.87 Assuming that the internal
staff costs the company an average of about $85 per hour, the aggregate annual
cost for internal staff assistance would amount to approximately $980,000. If we
assume that the outside professional assistance would have an average cost of
approximately $125 per hour, the aggregate annual paperwork cost would be
approximately $500,000. The total annual costs would accordingly be about
$1,500,000. We request your comments on the reasonableness of these estimates
and their underlying assumptions.
These proposals are not intended to increase companies' or directors'
exposure to liability under federal or state law. Indeed, we believe that the
proposal will likely result in better and more reliable financial reporting. As
an extra safeguard, the proposed amendments include liability "safe
harbors" similar to that which applies to compensation committee reports
under current rules.88 We nonetheless
request your comments on whether the proposals could have the unintended effect
of increasing companies' and/or directors' exposure to liability. Your comments
should specifically address the bases for liability concerns, including the
underlying case law if applicable, and your estimates of any additional costs
that may result from increased liability.
Are there any other costs or benefits that we have not identified? Please
identify them and provide data.
VII. Consideration of Impact on the Economy, Burden on Competition, and
Promotion of Efficiency, Competition and Capital Formation
For purposes of the Small Business Regulatory Enforcement Fairness Act of
1996,89 the Commission is requesting
information regarding the potential impact of the proposals on the economy on an
annual basis. Commentators should provide empirical data to support their views.
Section 23(a) of the Exchange Act requires the Commission, when adopting
rules under the Exchange Act, to consider the anti-competitive effects of any
rule it adopts. We do not believe that the proposals would have any
anti-competitive effects since the proposals should improve the transparency,
reliability, and credibility of companies' financial statements. We request
comment on any anti-competitive effects of the proposals. In addition, Section
3(f) of the Exchange Act requires the Commission, when engaging in rulemaking
that requires it to consider or determine whether an action is necessary or
appropriate in the public interest, to consider whether the action will promote
efficiency, competition, and capital formation. We believe that the proposals
would bolster investor confidence in the securities markets by improving the
transparency of the role of corporate audit committees and enhancing the
reliability and credibility of financial statements of public companies.
Accordingly, the proposals should promote capital formation and market
efficiency. We request comment on these matters.
VIII. Initial Regulatory Flexibility Analysis
This Initial Regulatory Flexibility Analysis has been prepared in accordance
with 5 U.S.C. § 603. It relates to proposed amendments to rule 10-01 of
Regulation S-X, Item 310 of Regulation S-B, and Item 7 of Schedule 14A, under
the Exchange Act, and proposed new Item 306 of Regulations S-B and S-K.
A. Reasons for the Proposed Action
The new rules and amendments to current rules are being proposed to improve
disclosure relating to the functioning of corporate audit committees and to
enhance the reliability and credibility of financial statements of public
companies. The proposals are based in large measure on recommendations recently
made by the Blue Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees. The required disclosure will help inform shareholders of the
audit committee's role in overseeing the preparation of the financial statements
and underscore the importance of the audit committee's participation in the
financial reporting process.
B. Objectives
The reviews required by our proposals should facilitate early identification
and resolution of material accounting and reporting issues because the auditors
will be involved earlier in the year. More reliable interim financial
information will be available to investors, and early involvement of the auditor
should reduce the number of restatements or other year-end adjustments. We
believe that the proposed disclosures would reinforce the audit committee's
awareness and acceptance of its responsibilities, and make visible for
shareholders the audit committee's role in promoting reliable and transparent
financial reporting.
C. Legal Basis
The Commission is proposing the amendments and new rules pursuant to its
authority under Sections 2, 13, 14, and 23 of the Securities Exchange Act.
D. Small Entities Subject to the Rule
The proposed amendments would affect small businesses that are required to
file proxy materials on Schedules 14A or 14C and Quarterly Reports on Form 10-Q
or 10-QSB, under the Exchange Act. Exchange Act Rule 0-10 defines "small
business" as a company whose total assets on the last day of its most
recent fiscal year were $5 million or less. We estimate that there are
approximately 830 reporting companies that are not investment companies with
assets of $5 million or less. The Commission bases its estimate on information
from the Insight database from Compustat, a division of Standard and Poors.
Most reporting companies file either a proxy statement on Schedule 14A or an
information statement on Schedule 14C, and all reporting companies must file
quarterly reports on Form 10-Q or 10-QSB. Some companies are not subject to the
14A or 14C requirements because their securities are not registered under
Section 12(b) or 12(g) under the Exchange Act. These companies may, however, be
subject to the Form 10-Q or Form 10-QSB requirements. Because these requirements
turn in part on the number of shareholders and amount of assets -- which are
subject to change -- we have no reliable way to determine exactly how many
reporting small businesses may be affected by the rule proposals.
E. Reporting, Recordkeeping, and Other Compliance Requirements
Under the proposed rules, public companies, both large and small, would be
required to provide certain additional disclosure in their proxy statements
regarding the company's audit committee. Companies would be required to include
reports of their audit committees that include disclosure about whether certain
conversations between the audit committee and management and the auditors took
place. No disclosure of the substance of the discussions is required.
1. Reviews of Quarterly Financial Statements
We propose to require companies to engage their independent auditors to
conduct interim reviews of their quarterly financial statements prior to the
company filing its Form 10-Q or 10-QSB. Based on information provided to the
Commission by the SECPS, it appears that most companies engage their independent
auditors to undertake some level of review of their quarterly financial
statements.
Medium and smaller sized accounting firms indicated to the SECPS that SAS 71
reviews of small companies' interim financial statements may cause delays in
filing Forms 10-Q or 10-QSB, be relatively more costly for all companies, be
hampered by inadequate financial reporting processes, and would result in small
companies shifting financial responsibilities from the company to the CPA firm.
Firms providing information to the SECPS also commented that the costs of
compliance would be partially offset by a reduction in year-end audit fees and
would lead to earlier identification of accounting and auditing issues and an
improvement in the quality of the process used for preparing interim financial
reports.
2. Disclosure Related to the Functioning of the Audit Committee
Some of the proposed amendments would increase disclosure of the audit
committee's role. The increased disclosure will require all entities, large and
small, to spend additional time and incur additional costs in preparing
disclosures. Smaller companies may incur additional costs to set up procedures
to monitor the activities of the audit committee in order to collect and record
the information required by the proposed amendments. Smaller companies may also
incur additional costs in seeking the help of outside experts, particularly
outside legal counsel, in formulating responses to the new requirements.
F. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate, overlap, or
conflict with the proposed rules.
G. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider significant
alternatives that would accomplish the stated objectives, while minimizing any
significant adverse impact on small entities. In connection with the proposed
amendments, the Commission considered the following alternatives: (a) the
establishment of differing compliance or reporting requirements or timetables
that take into account the resources available to small entities; (b) the
clarification, consolidation, or simplification of compliance and reporting
requirements under the rule for small entities; (c) the use of performance
rather than design standards; and (d) an exemption from coverage of the rule, or
any part thereof, for small entities.
We considered not applying the proposals to small business issuers. We
believe investors in smaller companies would want and benefit from the
disclosures about the audit committee and the advantages of interim reviews just
as much as investors in larger companies. In addition, the COSO Report found
that the incidence of financial fraud was greater at small companies.90
The report specifically noted that the "concentration of fraud among
companies with under $50 million in revenues and with generally weak audit
committees highlights the importance of rigorous audit committee practices, even
for smaller organizations."91 In light
of the COSO Report, it may be inconsistent with the purposes of the rule to
exempt small business issuers from the proposed requirement for interim reviews.
We also considered the alternative of only requiring companies whose
securities are listed on the NYSE or AMEX or quoted on Nasdaq to include
disclosures regarding the independence of their audit committee members. We
believe that the proposed amendments that require disclosure regarding the
independence of the members of their audit committee impose only minimal
additional costs but would provide useful information to investors.
The proposed rule amendments and new rules are designed to improve disclosure
relating to the functioning of corporate audit committees and to enhance the
reliability and credibility of financial statements for all public companies,
and currently we do not believe it is feasible to further clarify, consolidate
or simplify the rule for small entities.
H. Solicitation of Comments
The Commission encourages the submission of comments with respect to any
aspect of this Initial Regulatory Flexibility Analysis. In particular, the
Commission seeks comment on: (i) the number of small entities that would be
affected by the proposed rules; (ii) the nature of the impact; and (iii) how to
quantify the number of small entities that would be affected by and/or how to
quantify the impact of the proposed rules. Comment is specifically requested
regarding the number of small entities that are not registered under Section 12
of the Exchange Act that might be affected by the proposed amendments and what
effect, if any, they would have on small entities. Should there be different
requirements for those companies? Should those companies be required to include
the audit committee disclosures in their Forms 10-K or 10-KSB, or in any other
disclosure documents? Please describe the nature of any impact and provide
empirical data supporting the extent of the impact. Such comments will be
considered in the preparation of the Final Regulatory Flexibility Analysis, if
the proposed amendments and new rules are adopted, and will be placed in the
same public file as comments on the proposed amendments and new rules
themselves.
IX. Statutory Bases and Text of Amendments
We are proposing amendments to Rules 10-01 of Regulation S-X and 14a-101
(Schedule 14A) and Item 310 of Regulation S-B, and proposing new Item 306 of
Regulations S-K and S-B, under the authority set forth in Sections 2, 13, 14,
and 23 of the Exchange Act.
List of Subjects
17 CFR Part 210
Accountant, Accounting, Reporting and recordkeeping requirements, Securities
17 CFR Part 228
Reporting and recordkeeping requirements, Securities, Small businesses
17 CFR Parts 229 and 240
Reporting and recordkeeping requirements, Securities
Text of Amendments
In accordance with the foregoing, Title 17, Chapter II of the Code of Federal
Regulations is proposed to be amended as follows:
PART 210 - FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL STATEMENTS,
SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934, PUBLIC UTILITY HOLDING
COMPANY ACT OF 1935, INVESTMENT COMPANY ACT OF 1940, AND ENERGY POLICY AND
CONSERVATION ACT OF 1975
1. The authority citation for Part 210 continues to read as follows:
Authority: 15 U.S.C. 77f, 77g, 77h 77j, 77s, 77z-2, 77aa(25),
77aa(26), 78j-l, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll(d),
79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-37(a), unless
otherwise noted.
2. By amending §210.10-01 by revising paragraph (d) to read as follows:
§ 210.10-01 Interim financial statements.
* * * * *
(d) Interim review by independent public accountant. Prior to filing,
interim financial statements included in quarterly reports on Form 10-Q (17 CFR
249.308(a)) must be reviewed by an independent public accountant using
professional standards and procedures for conducting such reviews, as
established by generally accepted auditing standards, as may be modified or
supplemented by the Commission. If, in any filing, the company states that
interim financial statements have been reviewed by an independent accountant, a
report of the independent accountant on the review must be filed with the
interim financial statements.
PART 228 - INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS
3. The authority citation for Part 228 continues to read as follows:
Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2,
77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn, 77sss, 78l,
78m, 78n, 78o, 78u-5, 78w, 78ll, 80a-8, 80a-29, 80a-30, 80a-37, 80b-ll,
unless otherwise noted.
4. § 228.305 is reserved and § 228.306 is added to read as follows:
§ 228.305 [RESERVED]
§ 228.306 (Item 306) Audit committee report .
(a) The audit committee must state whether:
(1) The audit committee has reviewed and discussed the audited financial
statements with management;
(2) The audit committee has discussed with the independent auditors the
matters required to be discussed by SAS 61, as may be modified or supplemented;
(3) The audit committee has received the written disclosures and the letter
from the independent accountants required by Independence Standards Board
Standard No. 1 (Independence Standards Board Standard No. 1, Independence
Discussions with Audit Committees), as may be modified or supplemented, and
has discussed with the independent accountant the independent accountant's
independence; and
(4) Based on the review and discussions referred to in paragraphs (a)(1)
through (a)(3) of this Item, anything has come to the attention of the members
of the audit committee that caused the audit committee to believe that the
audited financial statements included in the company's Annual Report on Form
10-KSB (17 CFR 249.310b) for the year then ended contain an untrue statement of
a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which they were made, not
misleading.
(b) The name of each member of the company's audit committee (or, in the
absence of an audit committee, the board committee performing equivalent
functions or the entire board of directors) must appear below the disclosure
required by this Item.
(c) The information required by paragraphs (a) and (b) of this Item shall not
be deemed to be "soliciting material," or to be "filed" with
the Commission or subject to Regulation 14A or 14C (17 CFR 240.14a-1 et seq.
or 240.14c-1 et seq.), other than as provided in this Item, or to
the liabilities of section 18 of the Exchange Act (15 U.S.C. 78r), except to the
extent that the company specifically requests that the information be treated as
soliciting material or specifically incorporates it by reference into a document
filed under the Securities Act or the Exchange Act.
(d) The information required by paragraphs (a) and (b) of this Item need not
be provided in any filings other than a registrant proxy or information
statement relating to an annual meeting of security holders at which directors
are to be elected (or special meeting or written consents in lieu of such
meeting). Such information will not be deemed to be incorporated by reference
into any filing under the Securities Act or the Exchange Act, except to the
extent that the registrant specifically incorporates it by reference.
5. By amending § 228.310 by revising the introductory text of paragraph (b)
to read as follows:
§ 228.310 (Item 310) Financial Statements.
* * * * *
(b) Interim Financial Statements. Interim financial statements
may be unaudited; however, prior to filing, interim financial statements
included in quarterly reports on Form 10-QSB (17 CFR 249.308b) must be reviewed
by an independent public accountant using professional standards and procedures
for conducting such reviews, as established by generally accepted auditing
standards, as may be modified or supplemented by the Commission. If, in any
filing, the issuer states that interim financial statements have been reviewed
by an independent public accountant, a report of the accountant on the review
must be filed with the interim financial statements. Interim financial
statements shall include a balance sheet as of the end of the issuer's most
recent fiscal quarter and income statements and statements of cash flows for the
interim period up to the date of such balance sheet and the comparable period of
the preceding fiscal year.
* * * * *
PART 229 - STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES ACT OF
1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND CONSERVATION ACT OF
1975 - REGULATION S-K
6. The authority citation for Part 229 continues to read in part as follows:
Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2,
77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn, 77sss, 78c,
78i, 78j, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll(d), 79e, 79n, 79t,
80a-8, 80a-29, 80a-30, 80a-37, 80b-11, unless otherwise noted.
* * * * *
7. By adding § 229.306 to read as follows:
§ 229.306 (Item 306) Audit committee report.
(a) The audit committee must state whether:
(1) The audit committee has reviewed and discussed the audited financial
statements with management;
(2) The audit committee has discussed with the independent auditors the
matters required to be discussed by SAS 61, as may be modified or supplemented;
(3) The audit committee has received the written disclosures and the letter
from the independent accountants required by Independence Standards Board
Standard No. 1 (Independence Standards Board Standard No. 1, Independence
Discussions with Audit Committees), as may be modified or supplemented, and
has discussed with the independent accountant the independent accountant's
independence; and
(4) Based on the review and discussions referred to in paragraphs (a)(1)
through (a)(3) of this Item, anything has come to the attention of the members
of the audit committee that caused the audit committee to believe that the
audited financial statements included in the company's Annual Report on Form
10-K (17 CFR 249.310) for the year then ended contain an untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which they were made, not misleading.
(b) The name of each member of the company's audit committee (or, in the
absence of an audit committee, the board committee performing equivalent
functions or the entire board of directors) must appear below the disclosure
required by this Item.
(c) The information required by paragraphs (a) and (b) of this Item shall not
be deemed to be "soliciting material," or to be "filed" with
the Commission or subject to Regulation 14A or 14C (17 CFR 240.14a-1 et seq.
or 240.14c-1 et seq.), other than as provided in this Item, or to
the liabilities of section 18 of the Exchange Act (15 U.S.C. § 78r), except to
the extent that the company specifically requests that the information be
treated as soliciting material or specifically incorporates it by reference into
a document filed under the Securities Act or the Exchange Act.
(d) The information required by paragraphs (a) and (b) of this Item need not
be provided in any filings other than a registrant proxy or information
statement relating to an annual meeting of security holders at which directors
are to be elected (or special meeting or written consents in lieu of such
meeting). Such information will not be deemed to be incorporated by reference
into any filing under the Securities Act or the Exchange Act, except to the
extent that the registrant specifically incorporates it by reference.
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934
8. The authority citation for Part 240 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 78k-1, 78l,
78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 78mm,79q, 79t,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
9. By amending § 240.14a-101 by adding paragraph (3) to Item 7(e) to read as
follows:
§ 240.14a-101 Schedule 14A. Information required in proxy statement.
* * * * *
Item 7. Directors and executive officers. * * *
(e) * * *
(3) If the registrant has an audit committee:
(i) Provide the information required by Item 306 of Regulation S-K (17 CFR
229.306).
(ii) State whether the company's audit committee has adopted a written
charter.
(iii) Include a copy of the written charter, if any, as an appendix to the
company's proxy statement unless a copy has been included as an appendix to the
company's proxy statement within the company's past three fiscal years.
(iv)(A) For companies whose securities are listed on the New York Stock
Exchange ("NYSE") or American Stock Exchange ("AMEX") or
quoted on Nasdaq, if the company's Board determines in accordance with the
requirements of Section 303.02(D) of the NYSE's listing standards, Section
121(B)(b)(ii) of the AMEX's listing standards, or Section 4310(c)(26)(B)(ii) or
4460(d)(2)(B) of the National Association of Securities Dealers'
("NASD") listing standards, as applicable and as may be modified or
supplemented, to appoint one director to the audit committee who is not
independent (as independence is defined in Sections 303.01(B)(2)(a) and (3) of
the NYSE's listing standards, Section 121(A) of the AMEX's listing standards, or
Rule 4200(a)(15) of the NASD's listing standards, as applicable and as may be
modified or supplemented), disclose the nature of the relationship that makes
that individual not independent and the reasons for the Board's determination.
Small business issuers are not required to comply with this paragraph
(e)(3)(iv)(A).
(B) For companies, including small business issuers, whose securities are not
listed on the NYSE or AMEX or quoted on Nasdaq, disclose whether, if the company
has an audit committee, the members are independent. In determining whether a
member is independent, the company must use the definition of independence in
Section 303.01(B)(2)(a) and (3) of the NYSE's listing standards, Section 121(A)
of the AMEX's listing standards or Rule 4200(a)(15) of the NASD's listing
standards, as such sections may be modified or supplemented, and state which of
these definitions was used. Whichever definition is chosen must be applied
consistently to all members of the audit committee.
(v) The information required by paragraph (e)(3) of this Item shall not be
deemed to be "soliciting material," or to be "filed" with
the Commission or subject to Regulation 14A or 14C (17 CFR 240.14a-1 et seq.
or 240.14c-1 et seq.), other than as provided in this Item, or to
the liabilities of Section 18 of the Exchange Act (15 U.S.C. § 78r), except to
the extent that the company specifically requests that the information be
treated as soliciting material or specifically incorporates it by reference into
a document filed under the Securities Act or the Exchange Act. Such information
will not be deemed to be incorporated by reference into any filing under the
Securities Act or the Exchange Act, except to the extent that the registrant
specifically incorporates it by reference.
(vi) Investment companies registered under the Investment Company Act of 1940
(15 U.S.C. § 80a-1 et seq. ), other than closed-end investment
companies, need not provide the information required by this paragraph (e)(3).
* * * * *
By the Commission.
Jonathan G. Katz
Secretary
Dated: October 7, 1999
Footnotes
| 1 |
17 CFR 210.10-01. |
| 2 |
17 CFR 228.310. |
| 3 |
17 CFR 240.14a-101. |
| 4 |
15 U.S.C. § 78a et seq. |
| 5 |
17 CFR 229.306. |
| 6 |
17 CFR 228.306. |
| 7 |
See Report and Recommendations of the
Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
Committees (1999) (the "Blue Ribbon Report"). The Blue Ribbon Report
is available on the internet at http://www.nasd.com and http://www.nyse.com. |
| 8 |
Letter from the Chairmen of the Blue Ribbon
Committee to Messrs. Grasso and Zarb, Blue Ribbon Report, at 3. |
| 9 |
Blue Ribbon Report, supra note 7, at 7. |
| 10 |
See, e.g., Jack Ciesielski,
Editorial, More Second-Guessing: Markets Need Better Disclosure of Earnings
Management, Barrons, Aug. 24, 1998, at 47. |
| 11 |
The Commission recently filed 30 enforcement
actions against 68 individuals and companies for fraud and related misconduct in
the accounting, reporting, and disclosure of financial results by 15 different
public companies. See SEC Press Release 99-124 (Sept. 28, 1999). |
| 12 |
See Codification of Statements on
Auditing Standards, AU § 380 ("SAS 61"). |
| 13 |
See Exposure Draft for Proposed
Statement on Auditing Standards: Amendments to Statements on Auditing Standard
No. 61, Communication with Audit Committees and Statements on Auditing Standard
No. 71, Interim Financial Information (Oct. 1, 1999) ("ASB Exposure
Draft"). A copy of the ASB Exposure Draft can be obtained at
www.aicpa.org/members/div/auditstd/drafts.htm. |
| 14 |
Independence Standards Board Standard No. 1, Independence
Discussions with Audit Committees ("ISB Standard No. 1"). A copy
of ISB Standard No. 1 can be obtained at www.cpaindependence.org. |
| 15 |
"Small business issuer" is defined
in Item 10(a)(1) of Regulation S-B, 17 CFR 228.10(a)(1), as a company with less
than $25 million in revenues and market capitalization. |
| 16 |
The listing standards of the NASD, AMEX and
NYSE are available on their websites at: http://www.nasd.com,
http://www.amex.com, and http://www.nyse.com, respectively. See infra
note 27 regarding proposed changes to their listing standards. |
| 17 |
See, e.g., Carol J. Loomis et al., Lies,
Damned Lies, and Managed Earnings, Fortune, Aug. 2, 1999, at 74; Thor
Valdmanis, Accounting Abracadabra, USA Today, Aug. 11, 1998, at 1B;
Bernard Condon, Pick a Number, Any Number, Forbes, Mar. 23, 1998, at 124;
Justin Fox & Rajiv Rao, Learn to Play the Earnings Game, Fortune,
Mar. 31, 1997, at 76. |
| 18 |
See, e.g., In the Matter of
Livent, Inc., Exchange Act Release No. 40937 (Jan. 13, 1999) [68 SEC Docket
2881]; see also SEC v. W.R. Grace & Co., Litigation
Release No. 16008 (Dec. 22, 1998) [68 SEC Docket 2580]. |
| 19 |
Arthur Levitt, Chairman, SEC, Address to the
NYU Center for Law and Business (Sept. 28, 1998). |
| 20 |
In 1940, the Commission investigated the
auditing practices of McKesson & Robbins, Inc., and the Commission's ensuing
report prompted action on auditing procedures by the auditing community. In
the Matter of McKesson & Robbins, Accounting Series Release
("ASR") No. 19, Exchange Act Release No. 2707 (Dec. 5, 1940). |
| 21 |
ASR No. 165 (Dec. 20, 1974) [40 FR 1010]
(requiring disclosure of the existence and composition of the audit committee);
Exchange Act Release No. 15384 (Dec. 6, 1978) [43 FR 58522] (requiring
disclosure of the functions performed and number of meetings held by the audit
committee). |
| 22 |
See Staff of the SEC, Division of
Corporation Finance, Report on Corporate Accountability, A Re-examination of
Rules Relating to Shareholder Communications, Shareholder Participation in the
Corporate Electoral Process and Corporate Governance Generally, 486-510 (Sept.
4, 1980). |
| 23 |
See Report of the National Commission
on Fraudulent Financial Reporting (Oct. 1987) (the "Treadway Report"). |
| 24 |
Blue Ribbon Report, supra note 7, at
17. |
| 25 |
See Advisory Panel on Auditor
Independence ("Kirk Panel"), Strengthening the Professionalism of
the Independent Auditor, Report by the Oversight Board of the SEC Practice
Section, American Institute of Certified Public Accountants ("AICPA")
(Sept. 13, 1994) (the "Kirk Panel Report"); see also the
Treadway Report, supra note 23. |
| 26 |
Blue Ribbon Report, supra note 7, at
7. As noted, the Blue Ribbon Committee indicated that the audit committee,
management, and the independent auditors form a "three-legged stool"
that supports responsible financial disclosure and active and participatory
oversight. If we adopt the proposed requirement for an audit committee report,
shareholders annually will receive reports from two of the groups -- the audit
committee and the independent auditors -- that describe their roles in the
financial reporting process. Some have recommended that the SEC require a report
signed by the chief executive officer or others that acknowledges management's
responsibilities for the financial statements and internal controls. See
Treadway Report, supra note 23, at 44. To date, the Commission has
encouraged the use of management reports, but not required them. The Commission
staff is considering whether requiring management reports, so that investors
will have a report from each of the three main groups responsible for financial
reporting, would be useful to investors and serve the public interest. If we
decide to pursue mandatory management reports, a separate proposing release will
be published for public comment. |
| 27 |
See Proposed Rule Change, NASD, File
No. SR-NASD-99-48; Proposed Rule Change, NYSE, File No. SR-NYSE-99-39. While the
Blue Ribbon Committee's recommendations were directed to the NYSE and the NASD,
the AMEX has filed proposed rule changes to its listing standards in accordance
with the recommendations. See Proposed Rule Change, AMEX, File No.
SR-AMEX-99-38. The AMEX's proposed changes parallel the changes proposed by the
NASD. It is possible that in the future other exchanges will propose to amend
their listing standards in accordance with the Blue Ribbon Committee's
recommendations. At such time, the Commission will evaluate whether the
proposals in this release, if adopted, should be modified with respect to new
listing standards. |
| 28 |
Under proposed amendments to Section
303.01(B)(2)(b) of the NYSE's listing standards, the board of directors would
determine what "financially literate" means. Under proposed amendments
to Rule 4310(c)(26)(B)(i) of the NASD's listing standards and Section 121B(b)(i)
of the AMEX's listing standards, the audit committee members must be able to
read and understand fundamental financial statements, including a company's
balance sheet, income statement, and cash flow statement. |
| 29 |
See Codification of Statements on
Auditing Standards, AU § 722 ("SAS 71"). SAS 71 provides guidance to
independent accountants on performing reviews of interim financial information. |
| 30 |
SAS 61 requires independent auditors to
communicate certain matters related to the conduct of an audit to those who have
responsibility for oversight of the financial reporting process, specifically
the audit committee. Among the matters to be communicated to the audit committee
are: (1) methods used to account for significant unusual transactions; (2) the
effect of significant accounting policies in controversial or emerging areas for
which there is a lack of authoritative guidance or consensus; (3) the process
used by management in formulating particularly sensitive accounting estimates
and the basis for the auditor's conclusions regarding the reasonableness of
those estimates; and (4) disagreements with management over the application of
accounting principles, the basis for management's accounting estimates, and the
disclosures in the financial statements. |
| 31 |
Rule 10-01(d) of Regulation S-X and Item
310(b) of Regulation S-B, 17 CFR 210.10-01(d) and 17 CFR 228.310(b). Under Item
302(a) of Regulation S-K, however, larger, more widely-held companies are
required to provide supplementary financial information at year end that, when
necessary, reconciles amounts previously reported in a Form 10-Q or Form 10-QSB.
See 17 CFR 229.302(a). |
| 32 |
A review of interim financial information
under SAS 71 generally is limited to inquiries and analytical procedures
concerning significant accounting matters, and does not include search and
verification procedures. The objective of a review of interim financial
information differs significantly from the objective of an audit of financial
statements in accordance with generally accepted auditing standards. The
objective of a review of interim financial information is to provide the
accountant with a basis for reporting whether material modifications should be
made for such information to conform with GAAP. The objective of an audit is to
provide a reasonable basis for expressing an opinion regarding the financial
statements taken as a whole. A review may bring to the accountant's attention
significant matters affecting the interim financial information, but it does not
provide assurance that the accountant will become aware of all significant
matters that would be disclosed in an audit. See SAS 71, para. 9
("Objective of a Review of Interim Financial Information"). |
| 33 |
Rule 10-01(d) of Regulation S-X, 17 CFR
210.10-01(d). |
| 34 |
A conforming change to Item 310 of
Regulation S-B, 17 CFR 228.310, is being proposed to require the filing of the
report if the small business issuer discloses in its filings with the Commission
that an independent accountant has performed a review of interim financial
statements. |
| 35 |
The importance of analysts to the proper
functioning of our capital markets is well-recognized. See, e.g., Dirks
v. SEC, 463 U.S. 646, 656 (1983). We do not intend to cast doubt on the
importance of that role or the appropriateness of quarterly earnings estimates. |
| 36 |
In 1989, the Commission issued a concept
release on whether it should propose amendments to its rules to require more
involvement of the independent accountant in the preparation of interim
financial information. See Exchange Act Release No. 26949 (June 20, 1989)
[54 FR 27023]. The Treadway Commission recommended that the SEC require
independent public accountants to review quarterly financial data before a
company releases it to the public. Treadway Report, supra note 23, at 53. |
| 37 |
See Accounting Principles Board
Opinion No. 28. |
| 38 |
One firm's policy apparently applies only to
clients filing selected quarterly financial data under Item 302(a) of Regulation
S-K, 17 CFR 229.302(a). |
| 39 |
Subjecting additional companies to the
requirements of Item 302(a) would result in auditor review of their quarterly
financial information, but the review would not necessarily have to occur on a
timely basis. |
| 40 |
See Exchange Act Release No. 40632A
(Nov. 13, 1998) [63 FR 67174] (the "Securities Act Reform Release"),
at Section XI.B, in which we solicited comment on whether to shorten the filing
deadline for quarterly reports to within 30 days after the first three fiscal
quarters. |
| 41 |
SAS 71 provides guidelines for the
preparation of a report. |
| 42 |
See, e.g., Rule 436 of
Regulation C of the Securities Act, 17 CFR 230.436. Rule 436 provides that a
report on unaudited interim financial information shall not be construed to be a
part of a registration statement prepared or certified by an accountant within
the meaning of Sections 7 and 11 of the Securities Act. |
| 43 |
Blue Ribbon Report, supra note 7, at
36. |
| 44 |
At least in some measure, these discussions
are already prescribed by the auditing literature. See SAS 61. |
|
45 |
See ASB Exposure Draft, supra
note 13. |
| 46 |
The proposals, of course, are not intended
to either diminish or enhance a company's current disclosure obligations under
the proxy rules. |
| 47 |
Blue Ribbon Report, supra note 7, at
33. |
| 48 |
The federal securities laws recognize the
importance of independent auditors. See, e.g., Items 25 and 26 of
Schedule A of the Securities Act and Sections 12(b)(1)(J) and 13(a)(2) of the
Exchange Act, 15 U.S.C. §§ 78l(b)(1)(J) and 78m(a)(2). |
| 49 |
The Blue Ribbon Committee's recommendation
is for the audit committee to state that, in reliance on the review and
discussions with management and the auditors, the audit committee "believes
that the company's financial statements are fairly presented in conformity with
Generally Accepted Accounting Principles (GAAP) in all material respects."
Blue Ribbon Report, supra note 7, at 35. |
| 50 |
See supra note 19. |
| 51 |
Delaware General Corporation Law, for
example, states that board members are "fully protected in relying in good
faith upon the records of the corporation and upon such information, opinions,
reports or statements presented to the corporation by any of the corporation's
officers or employees . . . or by any other person as to matters the member
reasonably believes are within such other person's professional or expert
competence . . . ." Del. Code Ann. tit. 8, § 141(e). |
| 52 |
See Blue Ribbon Report, supra
note 7, at 34; see also id. at 7 ("The [audit]
committee's job is clearly one of oversight and monitoring, and in carrying out
this job, it acts in reliance on senior financial management and the outside
auditors."). |
| 53 |
See 1 American Law Institute, Principles
of Corporate Governance: Analysis and Recommendations 134-98 (1994); In
re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967-70 (Del. Ch.
1996). |
| 54 |
We note that under Section 11 of the
Securities Act, 15 U.S.C. § 77k, Section 10(b) of the Exchange Act, 15 U.S.C.
§ 78j(b), and other provisions of the federal securities laws, the members of
an audit committee may have additional responsibilities, beyond the statement
contemplated in subparagraph (a)(4), with respect to material misstatements and
omissions. The Commission previously has stated that if "an officer or
director knows or should know that his or her company's statements concerning
particular issues are inadequate or incomplete, he or she has an obligation to
correct that failure." Report of Investigation Pursuant to Section 21(a)
of the Exchange Act Concerning the Conduct of Certain Former Officers and
Directors of W.R. Grace & Co., Exchange Act Release No. 39157 (Sept. 30,
1997) [65 SEC Docket 1581]. |
| 55 |
Caremark, 698 A.2d at 970 (boards
must assure "themselves that information and reporting systems exist in the
organization that are reasonably designed to provide to senior management and to
the board itself timely, accurate information sufficient to allow management and
the board, each within its scope, to reach informed judgments concerning both
the corporation's compliance with law and its business performance"). |
| 56 |
See generally Report of the
Public Oversight Board ("POB"), "Directors, Management, and
Auditors: Allies in Protecting Shareholder Interests," in which the POB
discusses, among other things, a recommendation of the Kirk Panel to require
audit committees to discuss with management and the auditors the quality of the
accounting principles and judgments used in preparing financial statements. The
POB notes its belief that compliance with that recommendation would not increase
the exposure of board members to litigation because, among other things, the
procedures will reduce the possibility that the financial statements are in fact
misleading, thereby reducing the danger of finding directors at fault, and the
additional steps taken should be persuasive in convincing courts and juries that
the financial statements were prepared with care. |
| 57 |
The signature requirement is described in
General Instruction D of Form 10-K and General Instruction C of Form 10-KSB. The
Commission amended the signature requirements for Form 10-K in 1980 in order to
"enhance director awareness of and participation in the preparation of the
Form 10-K information." See Securities Act Release No. 6176 (Jan.
15, 1980) [45 FR 5972]. |
| 58 |
Securities Act Reform Release, supra
note 40, at Section XI.C. |
| 59 |
Brief for Securities and Exchange
Commission, Amicus Curiae, at 7, Howard v. Everex Systems, Inc. (9th Cir.
1999) (No. 98-17324) (citing cases). |
| 60 |
This approach is consistent with the current
treatment of the report from the company's compensation committee. See
Instruction 9 to Item 402(a)(3) of Regulation S-K, 17 CFR 229.402. |
| 61 |
See Exhibit 1 to Letter from Ernst
& Young to Harvey J. Goldschmid, General Counsel, and Lynn E. Turner, Chief
Accountant, SEC (Aug. 20, 1999). A copy of the letter has been placed in the
public file for this rulemaking. |
| 62 |
See Rule 14a-3 of the Exchange Act,
17 CFR 240.14a-3. |
| 63 |
Nothing, of course, would preclude a company
from including such disclosures in its annual report to shareholders or in any
other report. |
| 64 |
15 U.S.C. § 78o(d). |
| 65 |
We note, however, that, in response to the
Blue Ribbon Committee recommendations, the NYSE, NASD, and AMEX have proposed to
require the audit committee to: (1) adopt a formal written charter that is
approved by the full board of directors and that specifies the scope of the
committee's responsibilities, and how it carries out those responsibilities,
including structure, processes, and membership requirements; and (2) review and
reassess the adequacy of the audit committee's charter on an annual basis. |
| 66 |
For example, only certain documents on file
with the Commission may be incorporated by reference for more than five years. See
General Instruction (a) to Regulation S-K, 17 CFR 229.10(a). |
| 67 |
See supra note 20. |
| 68 |
Staff of the SEC, 95th Cong., 2d Sess.,
Report to Congress on the Accounting Profession and the Commission's Oversight
Role, Subcommittee on Governmental Efficiency and the District of Columbia of
the Senate Committee on Governmental Affairs, at 97 (Comm. Print July 1978). |
| 69 |
Blue Ribbon Report, supra note 7, at
22. |
| 70 |
The NASD and AMEX excluded small business
issuers from certain of the proposed amendments to their listing standards,
including the requirement that all audit committee members be independent. |
| 71 |
Blue Ribbon Report, supra note 7, at
35. |
| 72 |
See Instruction 9 to Item 402(a)(3)
of Regulation S-K, 17 CFR 229.402(a)(3). |
| 73 |
Of course, the antifraud provisions of these
Acts would continue to apply. |
| 74 |
The proposed disclosure requirements about
the independence of audit committees does, however, distinguish between
companies whose securities are listed on the NYSE or AMEX or quoted on Nasdaq
and all other companies. |
| 75 |
See Securities Act Reform Release, supra
note 40, at Section V.E.2. |
| 76 |
See Beasley, Carcello, and Hermanson,
Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies
(Mar. 1999) (study commissioned by the Committee of Sponsoring Organizations of
the Treadway Commission) (the "COSO Report"). |
| 77 |
See proposed paragraph
(e)(3)(vi) of Item 7, Schedule 14A. The proposed rules also exclude unit
investment trusts ("UITs") from the disclosure requirements because
they do not have boards of directors and, therefore, do not have audit
committees. |
| 78 |
Because closed-end and open-end funds and
UITs generally are not required to file Form 10-Qs, these investment companies
would not be subject to the proposal requiring the review of quarterly financial
statements filed on Form 10-Q. Business development companies, however, are
required to file Form 10-Qs and would be subject to the proposal. |
| 79 |
A "foreign private issuer" must
file reports on Form 6-K promptly after the information required by the Form is
made public in accordance with the laws of its home country or a foreign
securities exchange. See 17 CFR 240.13a-16(b). The proposed amendments
would, however, apply to a "foreign private issuer" that elected to
file reports under the disclosure rules for U.S. companies. |
| 80 |
The Commission is not proposing any changes
to Forms 10-Q or 10-QSB. |
| 81 |
17 CFR 240.14a-101. |
| 82 |
17 CFR 240.14c-101. |
| 83 |
Thirteen hours is 25% of the total company
reporting time (75% is shown as cost). |
| 84 |
Blue Ribbon Report, supra note 7, at
19. |
| 85 |
See Section III.A above. |
| 86 |
These assumptions are based on the staff's
experience with these filings. We believe that a company's internal staff will
typically carry most of the burden of preparing the proposed additional
disclosures, and will consult with outside professionals only on specific issues
that the company may periodically encounter in preparing the proxy statement or
information statement. |
| 87 |
The estimate does not include the amount of
time the audit committee would spend conducting the discussions with the
independent accountants and management to which new Item 306 of Regulation S-K
and the amendments to Item 7 of Schedule 14A refer. The amendments, if adopted,
would not require that the audit committee hold the discussions, but merely that
it disclose whether the discussions have taken place. |
| 88 |
See supra note 72. |
| 89 |
Pub. L. No. 104-121, tit. II, 110 Stat. 857
(1996). |
| 90 |
See generally, COSO Report, supra
note 76. In fact, the COSO Report specifically found that a "regulatory
focus on companies with market capitalization in excess of $200 million may fail
to target companies with greater risk for financial statement fraud
activities." Id. at 4. |
| 91 |
Id. at 5. |
http://www.sec.gov/rules/proposed/34-41987.htm
