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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

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As AS 5 Evolves...
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Posted by: Jack Ciesielski 5/25/2007 6:15 AM
The week's big news, regs-wise at least, was the SEC's approval of its "principles-based" interpretive guidance for management of Section 404 - and the PCAOB's subsequent adoption of those principles in its development of Auditing Standard 5.

Much of the chatter surrounding the new regs at the SEC's Wednesday meeting focused on the efficiencies to be gained from the slimming down of Section 404 afforded by the changes. You can see it in the remarks of Conrad Hewitt, the SEC's chief accountant:

"... we believe that the interpretive guidance for management, when adopted by the Commission will provide for many years in the future a more effective and efficient ICFR evaluation process for existing and future public companies. The guidance will allow companies of all sizes to comply with our rules, while reassuring investors that material weaknesses in internal controls will be brought to light and disclosed."

Well, let's hope so.

You can also see it in the comments of deputy chief accountant Zoe-Vonna Palmrose:

"Overall, these modifications to the proposed guidance are consistent with our objective of rationalizing the planning and conduct of the ICFR evaluation process for all companies, regardless of size, by allowing companies to focus their efforts on those areas that management has identified as posing the greatest risks of material misstatements in the financial statements, not being prevented or detected on a timely basis. This is what investors care about and what's important for achieving reliable financial reporting."

All true - this is what investors care about. And it's important.

Make no mistake however - there is a tremendous amount riding on these changes to the SOX and auditing literature. While market commentators argue about whether or not the bull market is on its last legs or has years to go, it's doubtful if they'd have much to argue about if the kind of confidence crisis experienced from around 2001 to 2002 had lingered.

Reporting-wise, we investors have had charmed lives over the last few years. There haven't been molar-rattling accounting scandals. There have been less concerns about "accounting finesse" in general. There have been multitudinous restatements, but often those have been the result of companies - and their auditors - getting their acts together and doing what should have been done long ago. Investors might have often been inconvenienced by those restatements - but they rarely have had their confidence shattered by them.

Cost of Section 404? We hear lots of talk about them, but it doesn't seem to have had much of an effect on the earnings of companies that have actually had to do something about implementing Section 404. The silver lining that seems to have been ignored: maybe once companies took a look at their systems, fixing them might have improved their management information - and maybe companies were managed better.

The comments of PCAOB member Charlie Niemeier at the PCAOB's Thursday meeting make a good counterpoint to the cost-cutting victory dancing observed in the wake of the two regs approvals. A few excerpts:

"The principal focus of the project to revise our standard on internal control has been to address concerns about costs. What sometimes gets lost, though, is that Sarbanes-Oxley's provisions on internal control reporting and auditing have been resoundingly beneficial to investors. Those benefits have been measured and documented, and they remain uncontroverted.

Both companies and their investors have benefited from the reduced cost of capital researchers have measured at companies whose auditors attest that they have cleaned up internal control problems – on the order of a 150 basis point reduction.

The investing public has received important warnings that some companies' internal control might not detect or prevent a material misstatement. Perhaps the most spectacular example was Refco's disclosure in connection with it's IPO that it had two significant deficiencies in its internal control. Two months later, the company collapsed due to revelations about related party transactions designed to help it hide losses. Instead of learning about the problems only after the fall, this time investors learned there were risks ahead of time.

And we're also seeing unprecedented numbers of companies identify and fix problems in their controls as well as their actual reporting, in most cases before they turn into disasters like Refco . . . and Enron, Worldcom and so many others. Since the first year of internal control reporting and auditing, the percentage of companies reporting material weaknesses has dropped precipitously, from a highpoint of 16.9 percent the first year, to 10.5 percent in the second year. In the third year, as of April 2007 only 5.4 percent of third-year filers had reported material weaknesses.

These benefits outweigh the associated costs, by any measure. Moreover there is encouraging evidence, based on corporate proxy reports, that costs have turned out to be less than some had feared and, quite naturally, have decreased since the first year of implementation."

As I said - there's a lot riding on these new regulations. Let's hope the charmed lives of investors - at least, reporting-wise - continue to be so pleasant once the regs are in place.

* * * * * * * * * * * *

Enjoy the Memorial Day weekend. But don't forget why it exists: if not for those who gave their lives in war, you might not be reading this. And I might not be writing it. So, give thanks, please.

And I won't be writing next week. Memorial Day is the traditional demarcation line for end-of-spring, beginning-of-summer, so I'm crossing that line by taking off next week. Back on June 4th. See you then, and thanks for stopping by.
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