Document ID: SEC-2007-0872-0003
Agency: sec
Document Type: Proposed Rule
Title: Definition of a Significant Deficiency
Posted Date: 2007-06-27T04:00Z

[Federal Register: June 27, 2007 (Volume 72, Number 123)]
[Proposed Rules]               
[Page 35345-35347]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr27jn07-36]                         

[[Page 35345]]

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Part IV

Securities and Exchange Commission

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17 CFR Parts 210 and 240

Definition of a Significant Deficiency; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 240

[Release Nos. 33-8811; 34-55930; File No. S7-24-06]
RIN 3235-AJ58

 
Definition of a Significant Deficiency

AGENCY: Securities and Exchange Commission.

ACTION: Request for additional comment.

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SUMMARY: We are requesting additional comment on the definition of the 
term ``significant deficiency.'' Because this term is used in the 
Commission's rules implementing Section 302 and Section 404 of the 
Sarbanes-Oxley Act, we believe that a definition of this term should 
also be in the Commission's rules, in addition to being in the auditing 
standards.

DATES: Comment Date: Comments should be received on or before July 18, 
2007.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number S7-24-06 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-24-06. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site at (http://www.sec.gov/rules/proposed.shtml). 

Comments are also available for public inspection and copying in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: N. Sean Harrison, Special Counsel, 
Division of Corporation Finance, at (202) 551-3430, or Josh K. Jones, 
Professional Accounting Fellow, Office of the Chief Accountant, at 
(202) 551-5300, U.S. Securities and Exchange Commission, 100 F Street, 
NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: We are soliciting additional comment on Rule 
12b-2\1\ under the Securities Exchange Act of 1934 (the ``Exchange 
Act'') \2\ and Rule 1-02 \3\ of Regulation S-X.\4\
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    \1\ 17 CFR 240.12b-2.
    \2\ 15 U.S.C. 78a et seq.
    \3\ 17 CFR 210.1-02.
    \4\ 17 CFR 210.1-01 et seq.
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I. Background

    The Commission's rules implementing the requirements of the 
Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley'')\5\ require management 
to disclose to both the audit committee and the external auditor all 
``material weaknesses'' and ``significant deficiencies'' identified 
based upon management's evaluation.\6\ In adopting rules to implement 
these sections of Sarbanes-Oxley, the Commission indicated that these 
terms had the same meaning for purposes of the Commission's rules as 
they had under generally accepted auditing standards and therefore, did 
not specifically define them. Subsequent to the Commission's adoption 
of rules implementing Sections 302 and 404 of Sarbanes-Oxley, the 
Public Company Accounting Oversight Board (``PCAOB'') adopted Auditing 
Standard No. 2,\7\ which revised these definitions. Since the 
Commission's intention in the Adopting Release was to refer to the 
definition used by auditors of public companies, the Commission staff 
issued an interpretation indicating that the PCAOB's definition of 
these terms would apply to the Section 404 rules issued by the 
Commission.\8\
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    \5\ 15 U.S.C. 7262.
    \6\ Release No. 33-8238 (Jun. 5, 2003) [68 FR 36636, Jun. 18, 
2003], referred to herein as the ``Adopting Release.''
    \7\ An Audit of Internal Control Over Financial Reporting 
Performed in Conjunction With an Audit of Financial Statements.
    \8\ See, for example, question 13 of Office of the Chief 
Accountant and Division of Corporation Finance: Management's Report 
on Internal Control Over Financial Reporting and Certification of 
Disclosure in Exchange Act Periodic Reports Frequently Asked 
Questions (revised Oct. 6, 2004), available at http://www.sec.gov/info/accountants/controlfaq1004.htm
.

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    More recently, as part of the Commission's project providing more 
guidance to management on completing its evaluation and assessment of 
internal control over financial reporting (``ICFR'') in accordance with 
Section 404 of Sarbanes-Oxley, the Commission initially sought comment 
on both the terms ``significant deficiency'' and ``material weakness'' 
in its concept release on ICFR requirements,\9\ and then proposed and 
adopted a definition for only the term ``material weakness.'' \10\ As 
part of that rulemaking process, commenters pointed out that while the 
December proposing release \11\ referenced significant deficiencies, 
the Commission did not include a definition of significant deficiency 
within the proposal.\12\ Certain commenters indicated that the 
Commission should include a definition of significant deficiency in the 
Interpretive Guidance.\13\
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    \9\ Release No. 34-54122 (Jul. 11, 2006) [71 FR 40866, Jul. 18, 
2006] available at http://www.sec.gov/rules/concept/2006/34-54122.pdf
.

    \10\ Release No. 34-55929 (Jun. 20, 2007), and referred to 
herein as the ``Interpretive Guidance.''
    \11\ Release Nos. 33-8762; 34-54976 (Dec. 20, 2006) [71 FR 
77635, Dec. 27, 2006].
    \12\ See, for example, letters from Cardinal Health, Inc. 
(Cardinal), Edison Electric Institute, and Protiviti.
    \13\ See, for example, letters from Cardinal and Protiviti.
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II. Discussion

    As part of the Interpretive Guidance rulemaking process, the 
Commission determined that it was appropriate for the Commission to 
include in its rules definitions for certain integral terms associated 
with the Commission's rules implementing Sarbanes-Oxley. Further, in 
light of the comments received in response to the proposed Interpretive 
Guidance, and because Commission rules implementing Section 302(a) of 
Sarbanes-Oxley require that management communicate significant 
deficiencies to the audit committee and the external auditors, the 
Commission has decided to solicit additional comment on a definition 
for ``significant deficiency.'' As a result, we are soliciting 
additional comment on amending Exchange Act Rule 12b-2 and Rule 1-02 of 
Regulation S-X to define the term.
    The purpose of management's obligations with respect to significant 
deficiencies within the Commission's rules is to disclose those matters 
relating to ICFR that are of sufficient importance that they should be 
reported to the external auditor and to the audit committee so that 
these parties can more effectively carry out their respective 
responsibilities with regard to the company's financial reporting, but 
which do not require disclosure to investors. Including a definition of 
significant deficiency in Commission rules, in combination with the

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definition of material weakness, will provide a useful complement to 
the Commission's Interpretive Guidance by enabling management to refer 
to Commission rules and guidance for information on the meaning of 
these terms rather than the referring to the auditing standards.
    In developing the definition, we considered comments received in 
response to the PCAOB's proposed auditing standard for audits of 
internal control over financial reporting. In its proposed auditing 
standard, the PCAOB proposed to define significant deficiency as ``a 
control deficiency, or combination of control deficiencies such that 
there is a reasonable possibility that a significant misstatement of 
the company's annual or interim financial statements will not be 
prevented or detected.'' \14\ Further, a significant misstatement was 
defined as ``a misstatement that is less than material yet important 
enough to merit attention by those responsible for oversight of the 
company's financial reporting.'' In response to the comments received 
on their proposal, the PCAOB decided to modify their proposed 
definition in order to focus the auditor on the communication 
requirement surrounding the term ``significant deficiency'' and to 
provide clarity that auditors are not required to scope their audits to 
search for deficiencies that are less severe than a material weakness. 
We believe that the focus of the term ``significant deficiency'' should 
be the underlying communication requirement that results between 
management, audit committees and independent auditors. As such, we are 
soliciting comment on a definition that focuses squarely on matters 
that are important enough to merit attention by those responsible for 
oversight of the company's financial reporting. Significant deficiency 
would be defined as ``a deficiency, or a combination of deficiencies, 
in internal control over financial reporting that is less severe than a 
material weakness, yet important enough to merit attention by those 
responsible for oversight of a registrant's financial reporting.'' \15\
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    \14\ See PCAOB Proposed Auditing Standard, An Audit of Internal 
Control Over Financial Reporting that is Integrated with an Audit of 
Financial Statements and Related Other Proposals (Release Number 
2006-007, Dec. 19, 2006).
    \15\ This definition of ``significant deficiency'' is also used 
in Auditing Standard No. 5, An Audit of Internal Control Over 
Financial Reporting That is Integrated with An Audit of Financial 
Statements, which was approved by the PCAOB on May 24, 2007.
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    The framework for the definition of significant deficiency varies 
from that recently adopted for ``material weakness.'' Unlike the term 
``material weakness,'' we do not believe it is necessary for the 
definition of significant deficiency to explicitly include a likelihood 
component (that is, reasonable possibility) and that focusing on 
matters that are important enough to merit attention will allow for 
sufficient and appropriate judgment for management to determine the 
deficiencies that should be reported to the auditor and the audit 
committee.

III. Request for Comment

    We request additional comment on defining the term ``significant 
deficiency.'' In addition to general comment, we encourage comments to 
address the following specific questions:
     Would the definition of a ``significant deficiency'' 
facilitate more effective and efficient certification of quarterly and 
annual reports if it were defined as discussed above?
     Conversely, should the definition of ``significant 
deficiency'' include a likelihood component or other specific criteria? 
If so, should we align such a definition with the PCAOB's auditing 
standard, and how?
     We do not anticipate that the definition will impact the 
amount of time it takes for management to evaluate whether identified 
deficiencies are significant deficiencies, nor do we anticipate that 
this definition will affect any existing collection of information. 
However, are there any additional costs or burdens involved in 
evaluating whether identified deficiencies meet the definition of 
significant deficiency? If so, what are the types of costs, and the 
anticipated amounts? In what way can the definition be further modified 
to mitigate such costs while still appropriately describing 
deficiencies that should be disclosed to audit committees and auditors?
     We believe one of the benefits of the definition is that 
it focuses on the desired result of identifying matters that are 
important enough to merit attention, which will allow management to use 
sufficient and appropriate judgment to determine the deficiencies that 
should be reported to the auditor and the audit committee while 
allowing management to use its judgment to determine what those matters 
are. Are there additional potential benefits we have not considered? 
Additionally, a potential consequence of the definition is that, due to 
the flexibility provided in the definition, there may be less 
comparability among companies in terms of what management determines is 
a significant deficiency. Is this accurate? Are there other potential 
costs or burdens? How should we mitigate such costs or burdens?
     Is there any special impact of the definition of 
significant deficiency on smaller public companies? If so, what is that 
impact and how should we address it?

    By the Commission.

     Dated: June 20, 2007.
Nancy M. Morris,
Secretary.
[FR Doc. E7-12300 Filed 6-26-07; 8:45 am]

BILLING CODE 8010-01-P